Introduction

The Stock Exchange of Hong Kong Limited (the “Exchange”) issued a new consultation paper on 22 September 2017 (“Consultation Paper”), under which the amendments (“Amendments”) to the Listing Rules (“Listing Rules”) were proposed. In particular, Chapters 7, 13, 14A and Appendix 16 of the Main Board Listing Rules, and Chapters 10, 17, 18 and 20 of the GEM Listing Rules would be amended. The Consultation Paper aims at addressing questionable structures or practices by some listed issuers that might not afford a fair treatment of minority shareholders or an orderly market for securities. The closing day of the consultation process is 24 November 2017.

Back in December 2016, the Exchange and the Securities and Futures Commission (“SFC”) issued a joint statement, emphasizing the importance of fair and equal treatment of all shareholders when conducting rights issues and open offers, and that the Exchange and the SFC have been working closely to monitor such transactions and review the relevant Listing Rules.

Highly Dilutive Capital Raisings

Problematic behaviours include deeply discounted fund raisings through rights issues, open offers and specific mandate placings. These fund raising methods are defined in the Listing Rules as follows:

1.        Rights issue is defined as “an offer by way of rights to existing holders of securities which enables those holders to subscribe securities in proportion to their existing holdings.”

2.        Open offer is defined as “an offer to existing holders of securities to subscribe securities, whether or not in proportion to their existing holdings, which are not allotted to them on renounceable documents.”

3.        Placing is defined as “the obtaining of subscriptions for or the sale of securities by an issuer or intermediary primarily from or to persons selected or approved by the issuer or intermediary.” 

Current Rules

Currently, the Listing Rules require that all new issues of shares must first be offered to existing shareholders, unless the issuer seeks a mandate from the shareholders to issue new shares. For instance, the issuer may not conduct placing unless it obtains either (a) a specific mandate for such share issues; or (b) a prior mandate for issuing shares, subject to a limit of up to 20% on the issue size and price discount (i.e. general mandate). On the other hand, rights issues and open offers (collectively “pre-emptive offers”) allow all existing shareholders to participate and as such they may generally be conducted without special approval by shareholders. However, minority shareholders’ approval for any pre-emptive offers is required by the Listing Rules if the pre-emptive offer would increase the issuer’s number of issued shares or market capitalisation by more than 50%. Also, the controlling shareholder (or directors and chief executive if there is no controlling shareholder) and his/her/its associates must abstain from voting in favour of the resolution.

Issues

Because the existing shareholders may or may not subscribe to the new shares, the above transactions could materially dilute the voting rights and value of public shareholders’ investments, and increase share volatility. In the case of highly dilutive pre-emptive offers, further problems may arise.

Generally, a highly dilutive pre-emptive offer refers to a pre-emptive offer in which the offer price is set at a deep discount to market prices. It is of the Exchange’s concerns that highly dilutive pre-emptive offers were conducted with the ulterior purpose of diluting minority shareholders’ interests. In particular, these offers are structured in such a way that was so unattractive to minority shareholders so that insiders can acquire a large number of unsubscribed shares at very low prices. Further, in deeply discounted fund raisings, insiders may be able to sell shares on the market and then subscribe new shares at very low prices. While these highly dilutive pre-emptive offers were approved by minority shareholders, practically the turnout rates at the shareholders’ meetings were usually very low. Meanwhile, for highly dilutive specific mandate placings, it is of the Exchange’s concerns that these transactions may not have clear commercial rationale for the issuer but resulted in the introduction of new controlling or substantial shareholders. This raised questions on whether these transactions were for the purposes of facilitating other activities rather than to meet the issuer’s capital requirements. All in all, despite these transactions are strictly in compliant with the Listing Rules, there are questions about whether they would be in the best interest of all shareholders.

Proposals

The proposed Amendments on highly dilutive pre-emotive offers include:

1.        An issuer may not undertake highly dilutive pre-emptive offers that would result in a “material” value dilution to non-subscribing shareholders unless the issuer can satisfy the Exchange that there are exceptional circumstances.

2.        The proposed threshold of “material” value dilution is set at 25%, calculated with reference to the offer ratio and the discount of the offer price to the market price before the offer announcement.

Valuation dilution is calculated by:

(No. of new shares to be issued x % price discount) / No. of issued shares as enlarged by the offer

For example, if the issuer offers 2 new shares for every 10 existing shares at a 50% price discount to the market price of HK$10. The valuation dilution would be: (2 x 50%)/12 = 8.3%. The theoretical price of shares after the offer would be HK$9.17 (10 x (1-8.3%)).

3.        Issuer may not place new shares under specific mandate that would result in value dilution of 25% or more (see above for formula).

4.        An issuer may not place new shares under specific mandate that would result in value dilution of 25% or more unless the issuer can satisfy the Exchange that there are exceptional circumstances. (i.e. the 25% threshold would also apply to specific mandate placing.)

5.        The Exchange will aggregate all pre-emptive offers and specific mandate placings undertaken by an issuer over a 12-month period immediately prior to the date of the currently proposed share offer. The limit on value dilution of 25% would be calculated on a cumulative basis. The cumulative value dilution would be calculated by reference to:

a.        the aggregate number of shares issued during the 12-month period, compared to the number of issued shares immediately prior to the first offer or placing; and

b.        the weighted average of the price discounts (each price discount is measured against the market price of shares at the time of the offer).

6.        The threshold of 50% as minority shareholders’ approval remains unchanged.

Rights Issues and Open Offers

There are two distinctive differences between rights issues and open offers. In a rights issue the issuer must offer new shares to shareholders in proportion to their existing shareholding and is renounceable (i.e. shareholders do not wish to subscribe for new shares may sell their nil-paid rights on the Exchange), whereas in an open offer the issuer may offer shares to existing shareholders not in proportion to their existing shareholding and is non-renounceable (i.e. shareholders cannot dispose their rights to subscribe).

Current Rules

Currently, the Listing Rules require that all rights issues and open offers must be fully underwritten. This is to provide a degree of certainty to an issuer and enable it to plan on the basis of assured fund.

Issues

It can be seen that open offers provide less protection to shareholders than rights issues. In an open offer, given the non-renounceable feature the non-subscribing shareholders would lose the value of subscription rights. As a result, those that do not want to suffer value dilution loss would be forced to sell their shares. If the terms of the open offers are highly dilutive, many minority shareholders may want to sell their shares and further depressing the share price. In addition, in an open offer the proportion of unsubscribed shares that would be taken up by the underwriter would normally be higher than rights issues. As a result, a controlling shareholder acting as underwriter can increase his shareholdings by taking up the unsubscribed shares. Indeed, where the controlling or substantial shareholder underwrites the offer, there may be a conflict of interest.

Proposals

The proposed Amendments include:

1.        Minority shareholders’ approval is required for all open offers, unless the new shares are to be issued under the authority of an existing general mandate.

2.        Controlling shareholders (or directors and chief executive if there is no controlling shareholder) cannot vote in favour of the resolution.

3.        The requirement of having an independent financial adviser to opine on the terms of the offer remains unchanged.

4.        In relation to underwriting:

a.        Remove the mandatory underwriting requirement

b.        If the issuer chooses to engage underwriters to underwrite the pre-emptive offers, they should be persons licensed by the SFC and be independent from the issuer and its connected persons.

c.         Subject to the connected transaction requirements, controlling shareholders may still take up all or most of the unsubscribed shares in pre-emptive offers.

d.        Controlling shareholders may continue to act as underwriters, subject to the compensatory arrangement (see below) being made compulsory

e.        Remove the connected transaction exemption for underwriting and sub-underwriting of pre-emptive offers by connected persons. (Consequently, independent shareholders’ approval would be required if controlling or substantial shareholders propose to act as underwriter).

Arrangements for Unsubscribed Shares in Pre-Emptive Offers

Current Rules

Currently the Listing Rules describe two types of arrangements for the disposal of any new shares that are not taken up by shareholders:

1.        the issuer may make arrangements to allow shareholders to apply for the unsubscribed shares in excess of their pro rata entitlement (“excess application arrangement”).

2.        the issuer may sell the unsubscribed shares in the market and return any premium to the non-subscribing shareholders (“compensatory arrangement”).

The implication is that in compensatory arrangement, shareholders who do nothing may still be compensated through a distribution of funds raised from the sale of unsubscribed shares in excess of the offer price. In an excess application arrangement, existing shareholders may apply for the unsubscribed shares in excess of their entitlements and benefit from the price discount of offers shares not subscribed by other shareholders.

Issue

Both arrangements are not mandatory under the currently Listing Rules. There are some concerns that controlling shareholders are in a position to take advantage of the excess application arrangement. Through their knowledge of the level of subscription, they can make very large excess applications to squeeze out other shareholders’ excess applications in the event the offer is under-subscribed, thereby increasing the portion of excess shares allocated to them.

Proposal

The Amendment proposes to require that issuers must adopt either the excess application arrangement or the compensatory arrangement in pre-emptive offers. In the Consultation Paper the Exchange acknowledged that compensatory arrangement is likely to be “fairer” arrangement to all shareholders. However, the Exchange is of the view that the issuer should be given the option to decide whether to provide excess application arrangement or compensatory arrangement.

Placing of Warrants and Convertible Securities
under the authority of a General Mandate

Current Rules

Currently, the Listing Rules require that an issuer may seek general mandate from shareholders for the issue of new securities up to 20% of the number of issued shares as at the date of the shareholders’ approval of the mandate.  Presumably, this general mandate rule provides issuers with flexibility to raise funds quickly from the market. Also, the Listing Rules impose a 20% discount limit on the issue price for the placing of securities for cash consideration, against a benchmarked price, which is the higher of (a) the closing price on the date of the arrangement; and (b) the average closing price in the 5 previous trading days.

Issues

In a placing of securities that involves the issue of warrants, options or convertible securities, the subscribers benefit from the time value of the conversion option. However, the general mandate rule may not properly protect shareholders as the benchmarked price does not take this into account.

Proposals

The Amendment proposes to:

1.        disallow the use of general mandate for placing of warrants or options for cash. This means that issuers would be required to obtain specific mandates;

2.        restrict the use of general mandates to placings of convertible securities where the initial conversion price is no less that the benchmarked price of the underlying shares at the time of the placing. Outside this a specific mandate must be sought.

Other Proposed Amendments

In the Consultation Paper, the Exchange also proposed to:

1.        require disclosure of the use of proceeds from all equity fundraisings in interim and annual reports

2.        impose a minimum price requirement on subdivision or bonus issue of shares

3.        disallow subdivisions or bonus issues of shares if the theoretical share price, after adjustment for the subdivision or bonus issue, is less than HK$1 or HK$0.5

4.        require a demonstration period of six months to ensure that a high share trading price is not temporary and a proposed share subdivision is justified.

Summary