Introduction

On 26 July 2019, the Stock Exchange of Hong Kong Limited (the “Exchange”) completed the consultation process and finalised the conclusion in relation to backdoor listing and continuing listing criteria. The result of the consultation comments and proposals are reflected in amendments to the Listing Rules, which will take effect on 1 October 2019.

Background

Backdoor listings, also refers to as reverse takeovers (“RTO”), involve transactions and arrangements that are structured to achieve a listing status of the acquired assets while circumventing the requirements that apply to a new listing applicant. Closely related to backdoor listings are various activities involving “shell companies”. Shell companies are commonly described as listed companies that are maintained with a low level of business operations as vehicles for backdoor listings. Backdoor listings and shell activities could undermine the integrity and quality of a market, and may affect investor confidence. Therefore, the Exchange undertook a series of measures, including the consultation, to enhance the longer-term health, quality and sustainability of the Hong Kong market.

Changes in rules concerning backdoor listing

In addition to the amendments, the Exchange also publishes three guidance letters and an FAQ to provide guidance and further explanation on the application of the amended Listing Rules:-

• Guidance on application of the reverse takeover rules (Guidance Letter GL 104-19);
• Guidance which concerns large scale issues of securities (Guidance Letter GL 105-19) this will replace Guidance on cash company rules (Guidance Letter GL 84-15);
• Guidance on sufficiency of operations (Guidance Letter GL 106-19); and
• Frequently asked questions on the notifiable transaction requirements relating to securities transactions.

The amendments address evolving market practices in backdoor listing and improve the regulation of shell activities. Among the changes, the Exchange codified and revised the test of an RTO transaction, tightened the compliance requirements for RTO and extreme transactions, and amended the continuing listing criteria for listed issuers in the Main Board Listing Rules and GEM Listing Rules.

Definition of an RTO transaction

Under the RTO Rules, the Exchange will regard to two tests, namely the principle based test and bright line test.

The principle based test empowers the Exchange to give an opinion on whether an acquisition is an attempt to achieve a listing of assets to be acquired and a means to circumvent the new listing requirements or not. Previously, the six assessment factors of whether there is any RTO under the principle based test were contained in the Guidance on application of the reverse takeover requirements under Rule 14. 06(6) (GEM Rule 19. 06(6)) (Guidance Letter GL 78-14, superseded). The Exchange now codifies the six assessment factors with modifications made to the last two factors:-

• Size of the acquisition(s) relative to the size of the listed issuer
• Quality of the acquisition target
• Nature and scale of issuer’s business before the acquisition(s)
• Fundamental change in principal business of the issuer
• Change in control/de facto control of the issuer (other than at the level of its subsidiaries)
• Series of transactions and/or arrangements (this includes acquisitions, disposals and/or change in control or de facto control of the issuer that take place in reasonable proximity (normally within 36 months) or are otherwise related).

The bright line test applies to very substantial acquisitions from an issuer’s controlling shareholder within 36 months from a change in control of the issuer. In other words, if there is a change of control and a very substantial acquisition within 36 months (previously 24 months) after persons gaining control, such acquisitions will be regarded as RTO and shall be treated as a new listing. The bright line test is originally contained in Main Board Listing Rule 14. 06(6) (GEM Listing Rule 19. 06(6)) and will be regrouped in Note 2 to Main Board Listing Rule 14. 06B (GEM Listing Rule 19. 06B).

Rules restricting disposals after change in control

The Exchange replaces the existing Main Board Listing Rules 14. 92 and 14. 93 (GEM Listing Rules 19. 91 and 19. 92) with a new Main Board Rule 14. 06E (GEM Listing Rule 19. 06E). Rule 14. 06E restricts (a series of) disposals (or distributions in specie) of all or a material part of the issuer’s business proposed at the time of or within 36 months after a change in control of the issuer unless the remaining business can meet the requirements under Main Board Listing Rule 8. 05 (or Rule 8. 05A or 8. 05B) (GEM Listing Rule 11. 12A (or Rule 11. 14)) regarding track record requirement and continuity requirement. The Exchange may also apply the restriction to disposals (or distribution in specie) at the time or within 36 months after a change in de facto control (as set out in the principle based test) of the issuer. Rules on disposal restrictions discourage circumvention of the bright line test by deferring a disposal such that the assets acquired would not result in a very substantial acquisition.

Disallowing backdoor listing through large scale issue of securities

The Exchange codified Guidance Letter GL84-15 (superseded) in the new Main Board Listing Rule 14. 06D  (GEM Listing Rule 19. 06D) to disallow backdoor listing through large scale issue of securities for cash, where:-

• there is, or will result in, a change in control or de facto control of the issuer, and;
• the proceeds will be applied to acquire and/or develop new business that is expected to be substantially larger than the issuer’s existing principal business.

As explained in Guidance Letter GL 105-19, Main Board Listing Rule 14. 06D (GEM Listing Rule 19. 06D) is a purposive test and is assessed based on all relevant facts and circumstances of the issuer. Examples of relevant factors are:-

• the nature and scale of the issuer’s business and its financial position before the fundraising;
• its business plans and the intended use of proceeds; and
• whether there is, or will be, any change in control or de facto control of the issuer.

Requirements for extreme transactions

In relation to extreme transactions, the Exchange:-

• codifies the compliance requirements for “extreme VSAs” (very substantial acquisition) requirements in Guidance Letter GL78-14 in Main Board Listing Rule 14. 06C (GEM Listing Rule 19. 06C) and renames this category of transactions as “extreme transactions”. The revised rules require the issuer to appoint a financial adviser to perform due diligence on the acquisition targets and make a declaration (in the form set out in a new Appendix 29). The declaration covers matters including the ability of the targets and the enlarged group to meet the Rules requirements and the requirement of the circular content;
  
• imposes additional eligibility criteria on the requirements of ‘extreme transactions’ such that:-
  • the issuer must operate a principal business of substantial size which will continue after the transaction (Main Board Listing Rule 14. 06C(1)(b) or GEM Listing Rule 19. 06C(1)(b));
    
• In paragraph 44(ii) of Guidance Letter GL104-19, the Exchange provides that, as a general guidance, a principal business of substantial size may include an issuer with annual revenue or total asset value of HK$1 billion or more based on the latest published financial statements. The Exchange will also consider the issuer’s financial position, the nature and operating model of the business and the issuer’s future business plans when assessing the size of the issuer.
  
• the issuer must have been under the control or de facto control of the same person(s) for a long period (normally not less than 36 months) and the transaction will not result in a change in control or de facto control of the issuer (Main Board Listing Rule 14. 06C(1)(a) or GEM Listing Rule 19. 06C(1)(a)).

Tightened compliance requirements regarding RTO and extreme transactions

In gist, where a transaction is ruled as an RTO, the issuer will be treated as if it were a new listing applicant under Main Board Listing Rule 14. 54. and GEM Listing Rule 19. 54.

In particular, the Exchange adds a new rule to the compliance requirements regarding RTO (Main Board Listing Rule 14. 54(1) and GEM Listing 19. 54(1)) and extreme transactions (Main Board Listing Rule 14. 06C(2) and GEM Listing Rule 19. 06C(2)) that, the acquisition targets in an RTO or extreme transaction must meet the requirements of Main Board Listing Rules 8. 04 and 8. 05 (or 8. 05A) (GEM Listing Rules 11. 06 and 11. 12A), and the enlarged group to meet all the new listing requirements in Chapter 8 of the Rules except Rule 8. 05 (Chapter 11 of the GEM Listing Rules except Rule 11. 12A).

The Exchange also adds a new rule to the compliance requirements for RTO in Main Board Listing Rule 14. 54(2) (GEM Listing Rule 19. 54(2)) that if the RTO is proposed by an issuer which does not have a sufficient level of operations or assets, the acquisition targets must also meet the requirement of Main Board Listing Rule 8. 07 that there must be an adequate market in the securities for which listing is sought (or for GEM issuer, the requirement that there will be sufficient public interest in the business of the acquisition targets and the enlarged group and in the securities for which listing is sought).

According to paragraph 50 of Guidance Letter GL 104-19, “sufficient public interest” in the acquisition targets may be demonstrated by, for example, conducting a public offer or other analysis with evidence.

Changes in rules related to continued listing criteria to tackle listed shell companies

Continuing Listing Criteria for Listed Issuers  – Sufficiency of operations

The Exchange makes the following amendments to the listing rules in relation to continuing Listing Criteria for Listed Issuers. In the current Main Board Listing Rule 13. 24 (GEM Listing Rule 17. 26), it is specified that an issuer shall carry out a business with a sufficient level of operations OR shall have assets of sufficient value to support its operations to warrant its continued listing. In the new Main Board Listing Rule 13. 24 (GEM Listing Rule 17. 26), it is amended that:-

• an issuer shall carry out a business with a sufficient level of operations AND shall have assets of sufficient value to support its operations to warrant its continued listing;
  
• proprietary securities trading and/or investment activities by an issuer’s group are normally excluded when considering whether the issuer can meet Main Board Listing Rule 13. 24(1) (GEM Listing Rule 17. 26(1)) (except for those carried out by a member of the issuer’s group that is a banking company, an insurance company, or a securities house that is mainly engaged in regulated activities under the SFO).

If the issuer fails to meet the continuing listing requirement under Main Board Listing Rule 13. 24 (GEM Listing Rule 17. 26), the issuer may be subject to the delisting procedures under Main Board Listing Rule 6. 01(3) (GEM Listing Rule 9. 04(3)).

Cash companies

In current listing rules relating to cash companies, if for any reason (including a notifiable transaction), an issuer that consists wholly or substantially of cash or short-dated securities (which is defined as ‘securities such as bonds, bills or notes which have less than 1 year to maturity’ in Main Board Listing Rule 14. 82 (GEM Listing Rule 19. 82)) will not be regarded as suitable for listing and will be suspended. In new listing rules,

• the definition of “short-dated securities” in Main Board Listing Rule 14. 82 (GEM Listing Rule 19. 82) is extended to cover investments that are easily convertible into cash and rename it as “short-term investments”;
  
• as per Note 2 of Main Board Listing Rule 14. 82 and Note 2 of GEM Listing Rule 19. 82, examples of ‘short-term investments’ include
  • bonds, bills or notes which have less than 1 year to maturity;
  • listed securities (whether on the Exchange or otherwise) that are held for investment or trading purposes; and
  • investments in other financial instruments that are readily realisable or convertible into cash.
    
• the exemption under Main Board Listing Rule 14. 83 (GEM Listing Rule 19. 83) is also confined to cash and short-term investments held by members of an issuer’s group that are banking companies, insurance companies or securities houses.

Transactional period

A transitional period of 12 months from the effective date will apply to listed issuers that do not comply with the new Main Board Listing Rules 13. 24 or 14. 82 (GEM Listing Rules 17. 26 or 19. 82) strictly as a result of the Rule amendments. Nevertheless, the transitional arrangement will not apply to issuers that do not comply with the current requirements under Main Board Listing Rules 13. 24 or 14. 82 (GEM Listing Rules 17. 26 or 19. 82), or become non-compliant with the new Main Board Listing Rules 13. 24 or 14. 82 (GEM Listing Rules 17. 26 or 19. 82) after the effective date (1 October 2019).

Key takeaways

The Listing Rules are amended to combat backdoor listings and shell creation activities. The amendments mainly codify the Exchange’s existing guidance set out in the guidance letters and listing decisions with a view to reducing listed companies from being used as tools for backdoor listings and restricting the creation of shell companies.

It remains the position that an acquisition by a listed company of a target company larger than itself within close proximity of a change of control will be treated as an RTO necessitating a new listing application. Yet some modifications as high-lighted hereinabove are made. The RTO bright line test is also supplemented by the rules restricting disposals to discourage investors from re-sequencing an RTO transaction.

Nonetheless, as explained in three guidance letters, the Exchange does recognize the need of genuine re-organization and financing. The Exchange will assess the transaction based on all relevant facts and circumstances of the issuer. Issuers are also encouraged to seek opinion from their legal advisors on the application of the aforementioned rules if they are going to re-organize their group companies, acquire a new business, dispose of their original listing business and/or enter into other large transactions.

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.