Asia: Corporate Newsletter - July 2013

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Effect of regulatory non-compliance on suitability of listing

Under the Listing Rules, a listing applicant must be considered by the Hong Kong Stock Exchange (SEHK) as suitable for listing before it can be listed. The question of suitability depends on many factors - one of which is the applicant's compliance with applicable laws and regulations. This is especially the case if a substantial part of the applicant's profits are derived from regulatory breaches, because in such a case there will be doubts as to whether the applicant will still be able to meet the requisite profit/financial test requirements if it were fully compliant with the relevant laws and regulations. In determining the effect of regulatory non-compliance on an applicant's suitability for listing, the SEHK will usually consider various factors, namely: (i) the nature, extent and seriousness of the breaches in question, (ii) the impact of such breaches on the applicant's operations, and (iii) the rectification and precautionary measures and how promptly these measures were put in place.

This question of suitability was raised in a recent Listing Decision (LD73-2013), which involved a retailer listing applicant that owned three principal retail stores. One of these stores (Store A) contributed over 30% of the company's revenue during the track record period, however, the use of certain floors of the store was not permitted under the occupation permit and constituted a material breach under the relevant building laws. The company submitted a proposal to rectify the unauthorised building works, but the rectification would take six months to complete and Store A's sales were expected to be reduced by 50% during this period. If the company's rectification proposal was rejected by the authorities then Store A would need to move to another location, where it would take approximately four months for renovation works.

The SEHK mainly focused on two factors in this case, ie the impact of the regulatory breaches and the rectification/precautionary measures. In particular, the SEHK considered that the company's rectification proposal was uncertain, and that irrespective of whether the rectification proposal was approved by the building authorities the company's future operations would be seriously affected. The SEHK also took into account the conduct of the company's directors and considered that they had not taken sufficient steps to rectify the breaches, especially since the rectification proposal was only submitted to the relevant building authorities months after they had been identified. Also of relevance was the substantial decline in financial performance of the company subsequent to the track record period, which cast doubt on the sustainability of the company's business. That decline, coupled with the uncertainties relating to the proposed rectification works for Store A described above, meant that the company was not suitable for listing for the time being.

This Listing Decision is a good reminder to listing applicants that there are other important factors to pay attention to apart from the usual profit/financial test requirements during the track record period. In this case, the company was able to satisfy the profit test under the Listing Rules even after adjusting its results for the track record period (ie assuming that Store A had been operating without the regulatory breaches), nevertheless, its listing application was still rejected due to (i) the uncertainties relating to the regulatory breaches which would impact upon the company's future performance and (ii) the company's deteriorating financial performance after the track record period. Listing applicants should therefore be mindful of any instances of regulatory non-compliances in their business because the SEHK may only approve their application after they have demonstrated compliance for a reasonable period of time (which may then delay the company's own business plans). Sponsors should equally be alert to these regulatory issues during the due diligence process as they are required to form a view as to whether a listing applicant has adequate and sufficient procedures, systems and controls for compliance with the relevant rules and regulations.

Disclosure of commercially sensitive information in notifiable transactions

The Listing Rules require listed companies to disclose to the market (in the form of an SEHK announcement) various types of transactions that have a material impact on their financial position. Depending on the size of the transaction, the Listing Rules may also require listed companies to seek shareholder approval before they can proceed with such transactions. The Listing Rules set out the details that companies must disclose for such notifiable transactions, for example, the commercial terms of the transaction in question. However, companies can apply for a waiver from disclosure of such details - for instance, companies will sometimes argue that the details of the transaction are commercially sensitive information. Two recent Listing Decisions provide examples of where the waiver application was successful.

In the first case (LD67-2013), the listed company in question was a financing service provider which operated a pawn loan/money lending business. It proposed to provide a secured entrusted loan to a borrower on normal commercial terms, and that loan constituted a discloseable transaction under the Listing Rules. The listed company sought a waiver from disclosing the identity of the borrower, the interest rate, amount of interest and service fees receivable under the transaction on the bases that (i) the actual interest rates and service fees might undermine the company's competitiveness in the market, and (ii) the company's customers would be unwilling to allow it to disclose their identities in public documents.

The second case (LD68-2013) involved a listed company that was principally engaged in hotel investment, and which intended to acquire a building in Hong Kong for redevelopment purposes. The company entered into a provisional sale and purchase agreement with the vendor, which constituted a discloseable transaction. The company applied for a waiver from the requirements to disclose the vendor's principal business activities, the name and address of the target property and the conditions precedent for completion of the acquisition. The company submitted that the terms of the acquisition were determined after arm's length negotiations, however, since it was still having ongoing negotiations with other vendors, such details were commercially sensitive and the disclosure of which would be prejudicial to the company's interests.

The SEHK granted waivers from the relevant disclosure requirements in both cases. However, there are two noteworthy points which underpin these decisions:

  • The transactions in both cases were discloseable transactions and were not significant to the listed companies in question. In LD67-2013, the SEHK made it clear that if the transaction constituted a major transaction instead, then the company would have to make full disclosure of the transaction and comply with the applicable shareholder approval requirements; and
  • The listed companies proposed alternative disclosures in their respective waiver applications. In LD68-2013, for instance, the company proposed to disclose (i) the independence of the vendors from the listed company and its connected persons, (ii) the district where the target property was located, and (iii) a statement that completion of the acquisition was subject to the satisfaction of various conditions.

Furthermore, listed companies should note that these decisions largely depend on the facts of the case, and that the commercial sensitivity of the details of a transaction should not, by itself, override the obligations of the company to disclose material information to investors. If a company does indeed decide to proceed with a waiver application, it should consider providing meaningful alternative disclosures which would allow investors to understand the nature of the proposed transactions.

Disclosure of unaudited net profits after track record period

The SEHK has recently published a new Frequently Asked Questions Series 23 (Series 23) on the disclosure of a new listing applicant's unaudited net profits after its track record period in a listing document.

The disclosure in listing documents of updated revenue/profit figures after the track record period may sometimes be required, for example, where the applicant shows a deteriorating trend in its revenue or profits. The aim of this is to provide investors with more updated financial information. However, according to the SEHK's views in Series 23, if these figures are unaudited then they will constitute a profit forecast/estimate under the Listing Rules because they will result in an investor ascertaining the applicant's estimated levels of profits or losses since the latest audited financial period.

The practical consequence of this is that these profit forecast figures will need to be reviewed and reported on by the applicant's reporting accountants and sponsors, and their reports must be set out in the listing document. Ideally, these figures should cover a period which terminates at the same time as the applicant's financial year. If that is not the case (eg where the figures only cover a three-month period), then the applicant should seek a waiver from the SEHK or alternatively disclose in the listing document a review report by an independent auditor together with interim financial statements and notes, and a management discussion on the relevant unaudited financial information. A review report by an independent auditor will also likely be required in cases where the applicant's unaudited financial information after the track record period is already published in a jurisdiction outside Hong Kong (such as cases where the applicant is already listed on another exchange).

Latest developments in the PRC: state council abolished and delegated to lower level authorities several administrative approvals for investment projects

As a step to carry forward the reform of the administrative system and to speed up the transformation of government functions, the State Council issued its Decision on Abolishing and Delegating the Power of Approval of a Batch of Items Requiring Administrative Approval (国务院关于取消和下放一批行政审批项目等事项的决定) (State Council's Decision) on 15 May 2013. The State Council's Decision has abolished 71 administrative approval items and delegated the approval power of 20 items to lower level authorities. This is seen as a welcome move for the Chinese government to encourage and facilitate investments in China.

The list of abolished and delegated items covers a wide range of matters which are mainly relating to investment activities. The industry sectors affected by the list include infrastructure, energy, natural resources, telecommunications, transportation, media and culture etc. Amongst these items, the following are particularly noteworthy for foreign investors:

Abolished or delegated NDRC approval

There are in total 13 approval items previously issued by the National Development and Reform Commission (NDRC) that have been abolished by the State Council's Decision, for example:

  • Investments in expansion of civil airports,
  • Investments in pulp projects,
  • Development of new oil fields with annual yields of more than one million tons,
  • Development of new gas fields with annual yields of more than two billion cubic metres,
  • Polyester projects with daily outputs of more than 300 tons,
  • Renovation and expansion of ethylene projects; and
  • Investments in medical towns, university towns or other park construction projects;

By the same token, there are 12 NDRC approval items which have been delegated to the provincial NDRC or local NDRC, including:

  • Distributed gas power generation projects,
  • Coal-fired backpressure power projects,
  • Coal exploitation projects within the ore fields under the PRC State program with an annual increase of production capacity of less than 1.2 million tons,
  • Non-cross-border and non-trans-provincial oil and gas pipeline network projects,
  • Potash fertiliser or phosphate fertiliser projects; and
  • Wind power stations.

Abolished MOFCOM approvals

  • Approval by the Ministry of Commerce (MOFCOM) for foreign cooperation contracts relating to oil, natural gas and coal bed gas; and
  • MOFCOM approval for the types of overseas commodity futures transactions that can be conducted by domestic organisations or individuals.

Other approvals

  • Delegation of the authority to register representative offices of foreign enterprises to provincial branches of the State Administration for Industry and Commerce (SAIC),
  • elegation of authority to verify foreign enterprises conducting business in China to provincial branches of SAIC; and
  • Abolishment of the approval by the Ministry of Transportation for mergers and acquisitions relating to international shipping operators and international shipping agency businesses.