There has been a heated debate over “shell creation” and backdoor listing (also known as “reverse takeover(s)”, “RTO(s)”) in recent years, which enables a potential buyer of the issuer to secure listing status without going through the application process which is subject to stringent requirements under the Listing Rules. In June 2018, The Stock Exchange of Hong Kong Limited (the “Stock Exchange”) published the Consultation Paper on “Backdoor Listing, Continuing Listing Criteria and Other Rule Amendments”, in which they sought market views on the proposed amendments to the Listing Rules on, amongst other things, backdoor listing. The corresponding Consultation Conclusion was published on 26 July 2019 and, despite some differing views from the market, most of the proposed amendments have been adopted. This article aims to provide an overview of the key amendments to the existing Listing Rules in relation to RTO (the “RTO Rules”) which came into effect on 1 October 2019. The Listing Rules cited in this article refer to the Main Board Rules and the amendments apply equally to the GEM Rules, unless otherwise stated.
Key Amendments to the Existing RTO Rules
Definition of an RTO Transaction
Under Rule 14.06(6), an RTO is defined as an acquisition or series of acquisitions which, in the opinion of the Stock Exchange, constitutes an attempt to achieve a listing of the assets acquired and a means to circumvent the new listing requirements (the “Principle Based Test”). Such definition was retained and relabelled as Rule 14.06B.
The six assessment factors (the “Factors”) that complement the Principle Based Test were set out in Guidance Letter HKEX-GL78-14 (superseded by Guidance Letter HKEX-GL104-19 on 1 October 2019). These Factors have been codified in Note 1 to Rule 14.06B with modifications made to the last two factors:
a) acquisition size relative to the size of the issuer;
b) fundamental change in principal business;
c) nature and scale of the issuer’s business;
d) quality of the acquisition targets;
e) change in control (as defined in the Takeovers Code) or de facto control of the issuer without limiting to only Restricted Convertible Securities; and
f) series of transactions and/or arrangements, including acquisitions, disposals and/or change in control or de facto control that take place in reasonable proximity (normally within 36 months instead of 24 months) or are otherwise related.
Bright Line Tests set out under Rule 14.06(6)(a) and (b), have been removed and incorporated in Note 2 to Rule 14.06B with an extension to the aggregation period:
a) The acquisition or series of acquisitions (aggregated under rules 14.22 and 14.23) constitutes a very substantial acquisition involving a change of control of the listed company; or
b) The acquisition or series of acquisitions from the controlling shareholder within 36 months from a change in control, either individually or together constitute a very substantial acquisition.
Backdoor Listing Through Large Scale Issue of Securities
The definition of a cash company was given under Rules 14.82 to 14.84 and Guidance Letter HKEX-GL84-15 (superseded by Guidance Letter HKEX-GL105-19 on 1 October 2019) provided direction on how these rules should be applied in situations where substantial amounts of cash were injected into an issuer. Guidance Letter HKEX-GL84-15 has been codified in Rule 14.06D to disallow backdoor listing through large scale issue of securities for cash which will result in a change in control or de facto control of the issuer. The proceeds will be applied with the aim of circumventing the new listing requirements on the acquisition targets to acquire and/or develop a new business that is expected to be substantially larger than the issuer’s existing principal business.
Tightening the Compliance Requirement for RTOs and Extreme Transactions
Under Guidance Letter HKEX-GL78-14, extreme very substantial acquisitions (the “Extreme VSAs”) are acquisitions which the Stock Exchange considers “extreme” by reference to the Factors. Under the new RTO regime, Extreme VSAs requirements have been codified under Rule 14.06C and renamed as “extreme transactions”. In order to demonstrate to the Stock Exchange that there is no attempt to circumvent the requirements for new listing applicants under Chapter 8 of the Listing Rules that would otherwise constitute an RTO, the issuer must:
a) have been under the control or de facto control of the same person(s) for a period of not less than 36 months and the transaction will not result in a change in control or de factor control of the issuer; or
b) according to Guidance Letter HKEX-GL104-19, operate a principal business of substantial size with an annual revenue or total asset value of HK$1 billion or more, and;
c) ensure that the acquisition target(s) meets the requirements of Rules 8.04 and 8.05 and the enlarged group must meet all the new listing requirements set out in Chapter 8 of the Listing Rules (except Rule 8.05 to ease the restrictions on smaller issuers).
Where the RTO is proposed by a Rule 13.24 (sufficient operations) issuer, the acquisition targets must also meet the requirement of Rule 8.07, under which the Stock Exchange must be satisfied that there will be sufficient public interest in the target business.
Restrictions on Disposals
Rules 14.92 and 14.93, which stipulated that an issuer may not dispose of its existing business within 24 months after a change in control, will be replaced by Rule 14.06E. This Rule imposes restrictions on a disposal or distribution in specie to shareholders that involves all or a material part of the issuer’s existing business at the time of, or within 36 months from a change in control, unless the remaining business or the assets acquired by the issuer can meet the requirements of Rule 8.05. Rule 14.06E essentially complements the Bright Line Tests in discouraging investors from re-sequencing an RTO transaction by acquiring a new business before disposing of its original business, thereby circumventing the bright line test.
Impact of the Amendments to the RTO Rules
The respondents of the Consultation Paper generally considered that the tightened RTO Rules may limit the business development and strategies of the issuers. Nevertheless, the Stock Exchange has clarified that the amendments to the RTO rules were made based on their observations of issuers and with a clear objective to address issues that include: (i) arrangements that circumvented the existing RTO Rules by structuring an RTO transaction as a series of smaller acquisitions or through a series of acquisitions and disposals; and (ii) arrangements that involved an investor acquiring control of an issuer and using the issuer as a listing platform to achieve the listing of new businesses that may have no connection with the issuer’s original principal business.
Additionally, the Consultation Conclusion aims to align with other Guidance Letters such as HKEX-GL96-18, where the Stock Exchange sets out broad principles regarding the suitability of continued listing for an issuer. In particular, the Stock Exchange observed that a number of newly listed issuers whose controlling shareholders either changed or gradually sold down their interests shortly after the regulatory lock-up period post-listing, matched the characteristics of shell companies. The Stock Exchange is concerned that these shell companies will invite speculative trading activities which can lead to opportunities for market manipulation, insider trading and unnecessary volatility in the market after listing.
Typically, a shell company would be sold at a premium to the new buyer to secure a listing status in exchange for the controlling interest in the issuer. This can be achieved by transferring existing shares or by issuing a large scale of securities to the new buyer without going through the stringent application process. The new buyer, who has now become the controlling shareholder of the issuer, would then inject his business, which may not meet the new listing requirements, into the issuer, compromising the quality of listing. With the implementation of the new RTO Rules, the requirements for backdoor listing would be indifferent from that for a new listing and a backdoor listing is therefore no longer an easier route to achieve a listing status.
An issuer will have to be extra cautious now, particularly when it comes to acquisitions of any new business other than its principal business, due to the extension of the relevant aggregation period for acquisitions from 24 months to 36 months after a change in control or de facto control. During such period, the Stock Exchange will keep an eye on all of the issuer’s acquisition activities which might fall into the scope of a series of arrangements of RTO. It is more challenging for the issuer who purposely attempts to carry out transactions outside of the 36-month period. The Stock Exchange may still exercise their discretionary power to deem any acquisitions, whether or not they are completed, as an RTO which is conducted right after such period and require the acquisition targets to fulfil all requirements as if it was a new listing.
The position of the RTO Rules remains the same as anti-avoidance provisions designed to prevent the circumvention of new listing requirements for the assets acquired and/or to be acquired. On the same day the consultation conclusion was published, the SFC issued a statement on backdoor listings and shell activities. It is clear that the Stock Exchange has strong support from the SFC to tackle these activities. In essence, the new regime is mostly codification of practices of the Listing Department and the Listing Committee. We believe that this is the right approach for greater transparency of the local regulators. We are also glad to see that the Stock Exchange has issued a consultation paper on Codification of General Waivers and Principles relating to IPOs and Listing Issuers and Minor Rules Amendments in August 2019, which shows their commitment to utilising the proper channel of market consultations, in light of concerns that this may not always be the case. An international financial hub not only requires proactive and responsible regulators, it also needs a fair and transparent regime where market practitioners and concerned parties know what they ought to do and what they ought not to do.