Earlier this year, the Stock Exchange of Hong Kong Limited ("SEHK") issued a Consultation Paper to propose the admission of listing applicants with corporate shareholders who hold weighted voting rights ("WVR"). The corporate WVR beneficiary regime is a progression from the WVR regime for individuals, which was introduced in 2018 for natural person shareholders under Chapter 8A of the Listing Rules. Given the proliferation of unicorn startups in Mainland China and other places, it is important that the SEHK remains attractive to all potential issuers in order to not lose favorable listings to competing stock exchanges, particularly given that the SEHK has a relatively higher concentration of "old economy" companies.
The assessment for market participants is therefore whether the benefits of outsized control relative to economic interest by a corporate shareholder justifies the attendant corporate governance risks, and, if so, whether the safeguards proposed by SEHK are sufficient. The establishment of the individual WVR beneficiary regime, and the performance and demand for the shares of issuers who have listed under the regime, show that SEHK and market participants agree that it is justified: with appropriate safeguards, the WVR granted to individual shareholders is a welcome development in Hong Kong capital markets. However, corporate shareholders having WVRs introduces new risks. This article explores whether this proposal is justified and, if so, what safeguards should be implemented.
Risks of Corporate WVR Beneficiaries & Safeguards proposed by SEHK
The primary risks of a WVR beneficiary stem generally from the misalignment of shareholder interests inherent in WVR structures, in which a shareholder's control is disproportionately larger than its economic exposure and risk. This issue is further exacerbated if the relevant beneficiary is a corporation: it may be that the listing applicant is ultimately controlled by a person who, through the corporate WVR beneficiary, only has a small and indirect economic stake in it. Secondly, unlike in the case of an individual, the actual persons (such as the directors, senior management or shareholders) who control the corporate WVR beneficiary may change over time, regardless of the corporate WVR beneficiary's continuing stake in the issuer. Thirdly, corporate WVR beneficiaries, unlike individuals, cannot be directors of the listing applicant and thus cannot be bound by fiduciary duties.
The SEHK has proposed several safeguards in its consultation paper, by (i) establishing substantial thresholds for listing applicants seeking to maintain a corporate WVR beneficiary and (ii) prescribing ongoing restrictions to mitigate the risk of abuses arising from WVRs.
In order to ensure that corporate WVR beneficiaries provide enough of a clear and justifiable benefit to a listing applicant, the SEHK has proposed "ring-fencing" eligibility requirements which are a combination of bright-line thresholds and "soft" tests for which broad guidelines are given but ultimate discretion lies with the SEHK. This approach retains the power of the SEHK to make judgment calls on whether a listing applicant's corporate WVR beneficiary provides enough value to the listing applicant and its shareholders to justify its WVR.
The SEHK proposals require the following from listing applicants and their proposed corporate WVR beneficiaries:
- The corporate shareholder must be a company listed on the SEHK, New York Stock Exchange or the Main Market of the London Stock Exchange with a premium listing.
- The corporate shareholder must be an "innovative company" as described in the SEHK's WVR guidance letter HKEX-GL-93-18 or has a track record of investment in and contributions to "innovative companies".
- The corporate shareholder must have a market capitalization of at least HK$200 billion.
- The corporate shareholder should have had at least an economic interest of not less than 10 percent and been materially involved in the management or the business in the listing applicant for a period of not less than two years prior to the listing application. Further, it should not have less than 30 percent of the economic interest in the applicant and be the single largest shareholder (save for any other individual WVR beneficiaries) at the time of listing and maintain its 30 percent shareholding thereafter on an ongoing basis.
- In order to ensure that a corporate shareholder leads a substantial ecosystem and does not effectively introduce a WVR structure over a material part of its assets, the listing applicant must not, at the time of listing, represent more than 30 percent of the corporate WVR beneficiary in terms of market capitalization.
- The listing applicant must demonstrate that it is part of the same "ecosystem" of innovative companies as the corporate WVR beneficiary (which is the ecosystem "leader" that owns and provides access to the ecosystem), and that this ecosystem relationship is unique and not easily replicable by the listing applicant on its own or with other business partners.
- If, after listing, the corporate shareholder's contributions to the listing applicant, such as access to its ecosystem, is disrupted or terminated for more than 12 months, its WVRs will lapse. The SEHK proposes requiring the issuer's corporate governance committee to confirm, on a six-monthly and annual basis, that they are not aware of any circumstances for the WVR attaching to a corporate shareholder's shares to be terminated on the foregoing basis.
The SEHK has also introduced additional safeguards to limit the potential risks of abuse by corporate WVR beneficiaries, as follows.
- The WVRs attaching to a corporate shareholder's shares must not be more than five times the voting power of ordinary shares.
- The SEHK proposes requiring that an officer (ie a director, manager or secretary, or any other person involved in the management) of the corporate WVR beneficiary must serve as director of the issuer and act as the representative of the corporate WVR beneficiary on the board of the issuer.
- The WVRs attaching to the shares of the corporate shareholder shall also be subject to a "time-based sunset" of ten years: the WVRs will lapse ten years after listing unless it is renewed through the approval of independent shareholders for further periods of five years.
Comments on the proposed safeguards
The safeguards are certainly a step in the right direction, but the mechanisms should be adjusted and further considered to ensure the dual objectives of attracting relevant listing applicants and protecting ordinary shareholders are furthered.
Minimum economic interest
The current proposal requires corporate WVR beneficiaries to have upon listing a 30 percent economic interest in the listing applicant and to maintain that ratio on an ongoing basis, with an automatic "top-up" mechanism that protects them against dilution below the required level. In the event that, after listing, the corporate shareholder's shareholding dips below 30 percent (eg, due to dilution after exercise under share option schemes), SEHK proposes allowing the corporate shareholder to "top-up" on ordinary shares on a non-preemptive basis without the need for shareholders' approval to maintain its 30 percent shareholding. Although we agree that the minimum economic interest should be 30 percent at the time of listing, the threshold should be lowered to 20 percent on an ongoing basis thereafter to provide for a "buffer zone" for share issuances. Under the current proposal, and assuming the maximum WVR ratio of 5 votes per weighted share, if a corporate WVR beneficiary held a 30 percent economic interest upon listing, its effective voting rights will stand at about 68.2 percent. After listing, if the issuer were to exercise its 20 percent general mandate to issue new shares, its economic interest would be reduced to 25 percent and its voting rights would be down to 62.5 percent. It would still have majority control, but be required to subscribe for ordinary shares to bring its economic interest back to 30 percent. This top-up exercise would only increase its voting power from 62.5 percent to 63.8 percent. If the buffer zone is provided for, the listed issuer has room to issue new shares up to an amount equivalent to 50 percent of its share capital at the time of listing without needing to top-up. And, at 20 percent economic interest, the listed issuer would still command 55.6 percent of the votes, and therefore retain majority control. The buffer zone strikes a balance between requiring a reasonable economic interest, while catering to a corporate WVR beneficiary's interests.
Furthermore, this top-up mechanism bundles the interests of the listed issuer with the costs of its corporate WVR beneficiary, because the automatic top-up subscription must be made on terms that are no more favorable (to the corporate WVR beneficiary) than the original issue. On the one hand, the listed issuer wishes to determine the best possible price for the issue of new shares to third party subscribers. On the other hand, the corporate WVR beneficiary may desire a lower subscription price for topping-up. In other words, any exercise which requires a share issuance that causes a dilution below the minimum economic interest threshold will translate into a proportionate cost for the beneficiary in its top-up subscription. This situation is undesirable, as it introduces a counteractive pressure on future equity financing exercises or commercially beneficial employee incentive schemes.
It is also unclear why a corporate WVR beneficiary may obviate the connected transactions provisions of the Listing Rules. The current proposal amounts to an anti-dilution provision for a select type of connected person, in which they are permitted to maintain their shareholding in situations where other shareholders would suffer dilution. We would therefore recommend that where the economic interest of the corporate WVR beneficiary falls below 20 percent under our proposal and requires top-up, such subscription shall be subject to the connected transaction rules and be tabled at an extraordinary / special general meeting for independent approval.
It should also be questioned why the minimum economic interest prior to listing need only be maintained at 10 percent for two years prior to the listing application, but 30 percent upon listing under the current proposal. This would contemplate a situation where a corporate WVR beneficiary triples its economic interest soon before its listing application. The time period of two years also sits uncomfortably with the conventional three-year track record period. This concern has been voiced by other market participants. Accordingly, it may be more appropriate to require the corporate WVR beneficiary to maintain 30 percent economic interest for three financial years prior to the listing application.
Interaction between Sunsets
The current proposal suggests that, in the event that a corporate shareholder's WVR lapses, a portion of the individual WVR beneficiary's (if there is one) WVR shall be converted to ordinary shares so as to preserve his or her previous voting power at the same level as before. However, the proposal states that the same need not apply in the opposite scenario and the lapse of an individual beneficiary's WVR will not trigger a proportionate reduction of a corporate beneficiary's WVR to prevent its voting power from disproportionately increasing. The treatment of corporate shareholders should be in line with those of individual shareholders in this regard, as the "sunset" of an individual beneficiary's WVR without an adjustment on other WVRs may cause a material disruption and a change in the control structure of the issuer, even if this is for a limited period of time.
Taking this one step further, assuming that an individual beneficiary's WVR has lapsed and a corporate WVR beneficiary's voting rights have increased as a result, when the time comes for a vote on whether to renew the corporate beneficiary's WVR, the question that will be put before independent shareholders is whether the WVR should subsist at that increased level or not at all. It appears to be an all-or-nothing vote: there would not be an option to vote to return the corporate WVR beneficiary's voting power to the level it was at upon listing.
Change of control
The proposals of SEHK do not require the WVRs of a corporate beneficiary to fall away upon a change of control in the beneficiary. The reason given is that a change in control in the corporate WVR beneficiary should not affect its WVR, since eligibility for the WVR was established by the corporate shareholder and not its controller(s). However, WVRs are not granted only based on the qualifications of the corporate shareholder, such as its market capitalization and provision of continued access to its ecosystem. The WVRs granted to corporate shareholders are based in part on the experience and caliber of the persons entitled to actually exercise such voting rights.
Therefore, as suggested by certain market participants, it may be appropriate to provide that the continuation of a corporate beneficiary's WVRs be subject to an independent shareholders' vote upon a change of control in the corporate WVR beneficiary.
The sunset period of 10 years renewable by 5-year terms may be a rather long time, especially in the context of innovative companies. We consider renewal terms of 3 years to be more appropriate.
As an added measure to ensure compliance with the ongoing requirements, the board of directors of both the issuer and the corporate WVR beneficiary should be required to provide annual confirmations that it has duly complied with all Listing Rules concerning their respective obligations.
On balance, while corporate WVRs should be introduced subject to safeguards, the SEHK may wish to consider if the proposed safeguards should be adjusted to strike a better balance between creating a competitive listing destination and investor protection.
We bear in mind that Hong Kong is a free market of sophisticated investors. Investors understand that innovative companies are often high risk but are of high growth potential and corporate governance risks would be priced in by the market. We should have faith in the sophistication of the Hong Kong investor and in their ability to evaluate an issuer with a corporate WVR beneficiary.