Further Guidance on Pre-IPO Investments from the Hong Kong Stock Exchange

by Orrick, Herrington & Sutcliffe LLP


It is common for financial investors such as private equity funds and hedge funds to invest in unlisted securities of private companies (e.g., through the subscription of convertible debt instruments, preference shares and/or warrants) with a view to exit their investments in a future initial public offering (“IPO”) of such companies. A company that seeks to list its securities in Hong Kong on The Stock Exchange of Hong Kong Limited (the “Stock Exchange”) must disclose the main terms of any such pre-IPO investment for review and scrutiny by the Stock Exchange, which may require certain terms and investor’s special rights to be modified and/or removed before it will grant approval of that company’s listing application. It is, therefore, important for an investor to understand and take into account the requirements of, and general approach taken by, the Stock Exchange in dealing with pre-IPO investments if it contemplates making an investment in a company that may list its securities on the Stock Exchange.

There are no clear requirements on pre-IPO investments under the Rules Governing the Listing of Securities on the Stock Exchange (the “Rules”). The general principles governing pre-IPO investments are set out in Main Board Listing Rules 2.03(2) and (4) (GEM Rules 2.06(2) and (4)) of the Stock Exchange, which require the issue and marketing of securities to be conducted in a fair and orderly manner and that all holders of listed securities be treated fairly and equally. Issues considered by the Stock Exchange in related listing decisions about pre-IPO investments include whether the investor assumes substantial risk in the investment, the timing of the investment, the timing of completion of payment for the investment, special rights that are only available to the investor and the level of discount of subscription price for the investor to the proposed IPO offer price.

Interim Guidance

The Stock Exchange issued Interim Guidance (HKEx-GL29-12) in October 2010, which provides that pre-IPO investments must be completed either (a) at least 28 clear days before the date of the first submission of the first listing application form; or (b) 180 clear days before the first day of trading of the issuer’s securities, except in very exceptional circumstances. Pre-IPO investments are considered completed when the funds are irrevocably settled and received by the issuer. While the Interim Guidance provides useful clarification on how the Stock Exchange deals with pre-IPO investments, there remains a fair amount of uncertainty on the viability of particular terms of a pre-IPO investment (in the context of a Hong Kong listing) absent a specific ruling by the Stock Exchange.

On 25 October 2012, the Stock Exchange published two guidance letters on pre-IPO investments to further clarify the Stock Exchange's approach in dealing with pre-IPO investments:

  1. HKEx-GL43-12 (Guidance on Pre-IPO Investments), which serves to consolidate past listing decisions on pre-IPO investments and principles applicable after the introduction of the Interim Guidance (HKEx-GL29-12), and
  2. HKEx-GL44-12 (Guidance on Pre-IPO Investments in Convertible Instruments),which sets out the current practice of the Stock Exchange in dealing with convertible instruments (e.g. convertible or exchangeable bonds, notes or loans and convertible preference shares (together as “CBs”)) issued to pre-IPO investors.

Guidance on Pre-IPO Investments (HKEx-GL43-12)

In the Guidance Letter HKEx-GL43-12, the Stock Exchange sets out its approach in dealing with certain special rights attached to pre-IPO investments:

(a) Special rights that may not survive after listing:

  • Price adjustment: Price adjustment provisions related to the subscription, or conversion into, of securities to be listed that effectively create two different prices for the same securities for the pre-IPO investor and other shareholders at the time of listing (e.g., a guaranteed discount to the IPO offer price or an adjustment linked to the market capitalization of the shares) are considered contrary to the principles of the Rules and are not allowed.
  • Put or exit option: Put or exit option granted to the pre-IPO investor to put the investments back to the issuer or its controlling shareholder is only allowed if the issuer’s listing does not take place.
  • Director nomination right: Contractual right of the pre-IPO investor to nominate a director should not survive after listing. The pre-IPO investor, however, may nominate or appoint a director to the board before the issuer’s listing and such director would be subject to retirement and re-appointment requirements under the issuer’s constitution after listing.
  • Veto right: Contractual right of the pre-IPO investor to exercise veto power over the issuer’s major corporate actions should be terminated upon listing.

(b) Special rights that generally may not survive after listing unless certain condition(s) is/are met:

  • Negative pledges: Negative pledges should generally be removed before listing unless they are widely accepted provisions in loan agreements, are not egregious and do not contravene the fairness principle in the Rules. The Stock Exchange may require confirmation from the sponsor that the relevant negative pledges which remain after listing are in line with normal terms of debt issues.
  • Prior consent for certain corporate actions/changes in articles: Terms which provide that prior consent of the pre-IPO investor is required before certain corporate actions can proceed should be removed before listing unless the issuer can demonstrate that the relevant terms are not egregious and do not contravene fundamental principles of the Rules to the disadvantage of other shareholders.
  • Exclusivity right and no more favourable terms: Terms providing exclusivity right to the pre-IPO investor and terms restricting the issue of securities on more favourable terms to other investors by the issuer may not survive after listing unless an explicit “fiduciary out” clause is in place so that the directors are allowed to ignore the terms if complying with the terms would constitute a breach of their fiduciary duties.
  • Information right: Information right could only survive after listing if the pre-IPO investor is only entitled to receive information which is at the same time made available to the general public so as to avoid unequal dissemination of information.

(c) Special rights that may be allowed at the time of listing or to survive after listing depending on their nature:

  • Anti-dilution right: Exercise of an anti-dilution right by the pre-IPO investor in the IPO is allowed at the time of listing where (i) the allocation is necessary in order to give effect to the pre-existing contractual right of the pre-IPO investor under the relevant investor rights agreement; (ii) full disclosure of such pre-existing contractual entitlement and the number of shares to be subscribed by the pre-IPO investor be made in the prospectus and the allotment results announcement; and (iii) the proposed subscription will be conducted at the IPO offer price.

    However, such anti-dilution right should be extinguished upon listing to be in line with pre-emptive rights afforded under the Rules.
  • Profit guarantee: Profit guarantee is allowed to survive after listing if the compensation is settled by a shareholder (but not the issuer) and the compensation is not linked to the market price or capitalisation of the shares.

(d) Special rights that are allowed to survive after listing:

  • Representation/attendance right: Right to nominate senior management and committee representative contractually granted to the pre-IPO investor (but appointment is subject to the decision of the board) is allowed to survive after listing.
  • Right of first refusal and tag-along right: Right of first refusal and tag-along right granted by the controlling shareholder of the issuer are allowed to survive after listing as these rights are purely contractual rights between two shareholders.

In the Guidance Letter HKEx-GL43-12, the Stock Exchange further sets out its approach in dealing with other pre-IPO related matters:

  • On qualified IPOs: Subject to the requirement that the compensation amount is set out in or derived from the investment agreement, the agreement may provide for the pre-IPO investor to receive a certain amount of compensation if a qualified IPO is not achieved within a specified period of time.
  • On lock up and public float: The pre-IPO investors are usually requested by the issuer to lock-up their pre-IPO shares for a period of six months or more. These shares are counted as part of the public float so long as the shares are not financed directly or indirectly by a connected person of the issuer.

Guidance on Pre-IPO Investments in Convertible Instruments (HKEx-GL44-12)

In the Guidance Letter HKEx-GL44-12, the Stock Exchange sets out its approach in dealing with pre-IPO investments involving CBs:

  • On conversion price linked to IPO price or market capitalisation: The conversion price for the CBs should be set at a fixed dollar amount or at the IPO offer price. Where the CBs are convertible into shares at a price based on a guaranteed discount to the IPO offer price or the conversion is linked to the market capitalisation, the Stock Exchange considers that these would create two different prices for the same securities which are inconsistent with the principles of the Rules and may give rise to concerns that the pre-IPO investor does not bear the same investment risk as the public investors.
  • On conversion price reset mechanism: Any conversion price reset mechanism of the CBs (e.g., where the conversion price reset mechanism is based on the lower of a fixed price and a floating market price) should be removed as it is considered to be contrary to the principles of the Rules.
  • On mandatory or partial conversion: Partial conversion of CBs is only allowed if all atypical special rights enjoyed by the pre-IPO investor are terminated after listing.
  • On redemption and early redemption: The Stock Exchange considers that the internal rate of return on the principal amount of the CBs to be redeemed represents a compensation for the investment and risk undertaken by the bondholders. Such early redemption is allowed, but should be distinguished from other cases where the bondholders do not undertake any risk and the investment money is not paid yet.
  • On prospectus disclosure: The issuer is required to disclose additional information about the CBs in the “Financial Information” and “Risk Factors” sections of the prospectus to explain the impact of the CBs on it.
  • On interim and annual reports disclosure: The issuer is required to disclose additional information in its interim and annual reports to enable investors to be aware of the dilution impact on the issuer’s shares in the event that all outstanding CBs are converted as at the relevant year end or period end.

The Guidance Letter HKEx-GL43-12 is available at: www.hkex.com.hk/eng/rulesreg/listrules/listguid/Documents/gl43-12.pdf

The Guidance Letter HKEx-GL44-12 is available at: www.hkex.com.hk/eng/rulesreg/listrules/listguid/Documents/gl44-12.pdf

For more information on this topic, please liaise with Maurice Hoo or your usual contact at Orrick.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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