HKSE Issues Consolidated Guidance on Pre-IPO Investments

by Wilson Sonsini Goodrich & Rosati

In October 2012, the Hong Kong Stock Exchange (HKSE) issued two guidance letters addressing certain major issues relating to pre-IPO investments. Guidance letter HKEx-GL43-12 (the "Consolidated Guidance Letter") consolidates various listing decisions on the general principles relating to special rights attached to pre-IPO investments previously issued by the HKSE. Guidance letter HKEx-GL-44-12 (the "CB Guidance Letter") sets out the HKSE's current practice in dealing with convertible instruments (i.e., convertible or exchangeable bonds, notes or loans, and convertible preference shares, also known as the "CBs") issued to pre-IPO investors.

Regulatory Background

Rules 2.03(2) and (4) of the Rules Governing the Listing of Securities on the HKSE (the "Listing Rules") require that the issue and marketing of securities be conducted in a fair and orderly manner and that all holders of listed securities be treated fairly and equally (the "Equal Treatment Principle").

Pre-IPO investors (including venture capital and private equity funds) typically are offered special shareholder rights by the investee company seeking listing on the HKSE (the "Proposed ListCo"). Such special rights, which are not made available to all shareholders, generally are not permitted to survive listing due to the Equal Treatment Principle. In the past, the HKSE has issued a series of listing decisions to provide interpretative guidance of the Equal Treatment Principle in this context. The Consolidated Guidance Letter now consolidates and further clarifies all of the principles set out in such previous listing decisions, and these past listing decisions are now superseded.

CBs issued to pre-IPO investors typically are structured in such a way that they are not shares in form, but the investors holding the CBs would enjoy a risk-return profile that is similar to or better than that of a shareholder. In view of the Equal Treatment Principle, the HKSE in the past has requested the removal of the conversion price reset mechanism of CBs and the termination of all special rights for holders of CBs. Such practice is maintained in the CB Guidance Letter with further clarification for the purpose of implementation.

In addition, the HKSE has imposed restrictions on the timing of pre-IPO investments to avoid pre-IPO investors taking advantage of public shareholders by making investments shortly before the IPO. In 2010, the HKSE issued a guidance letter that required pre-IPO investments to be completed either (i) at least 28 clear days before the date of the first submission of the first listing application form or (ii) 180 clear days before the first day of trading of the applicant's securities, except in very exceptional circumstances (such as the Proposed ListCo being in severe financial distress). HKSE approval is given on a case-by-case basis. Pre-IPO investments are considered completed when the funds are settled irrevocably and received by the Proposed ListCo.

Guidance on Atypical Special Rights in Connection with Pre-IPO Investments

The Consolidated Guidance Letter sets out a comprehensive list of special rights offered in connection with pre-IPO investments, and it provides guidance on whether they are allowed to survive upon listing. Set forth below is a tabular summary of the special rights that can survive the listing and those that cannot.

Special Rights Unable to Survive HKSE Listing

Price Adjustment Provisions

Any price adjustment provisions (e.g., a guaranteed discount to the IPO price or share price, or an adjustment linked to the market capitalization of the Proposed ListCo) are not allowed. Price adjustment mechanisms effectively create two different prices for the same securities for pre-IPO investors and other shareholders at the time of listing, which potentially could have a disruptive effect. These mechanisms are contrary to the Equal Treatment Principle.

Put or Exit Options

All put or exit options granted to pre-IPO investors to sell back the investments to the Proposed ListCo or its controlling shareholder(s) are against the Equal Treatment Principle since such investment protection significantly reduces the investment risk for pre-IPO investors and is not available to other shareholders. The put/exit option is only allowed if the Proposed ListCo remains a private company. Namely, put or exit options are allowed only in the event of a failure to achieve a qualified IPO within a specified timeframe.

Director Nomination Rights

Any contractual right of a pre-IPO investor to nominate a director should not survive after listing, as such right generally is not available to other shareholders.

However, the pre-IPO investors may nominate or appoint one or more directors to the board before the Proposed ListCo's listing. Such director(s) will be subject to the resignation/retirement and re-appointment requirements under the Proposed ListCo's articles of association after listing.

Veto Rights

Any contractual rights to exercise veto power over the Proposed ListCo's major corporate actions (e.g., the making of any petition or passing of any resolution for winding-up, the carrying on of any business other than the business being carried on by the group, or the amalgamation or merger by any member of the group with any other company or legal entity, etc.) should be terminated upon listing.

Anti-dilution Rights

Anti-dilution rights should be extinguished upon listing to comply with Rules 13.36 (pre-emptive rights to all shareholders unless general mandate obtained at the annual general meeting) and 10.04 (no preferential treatment when allocating securities) of the Listing Rules. However, exercise of these anti-dilution rights by the pre-IPO investors in connection with the IPO is permissible at the time of the listing when:

  • the allocation is necessary to give effect to the pre-existing contractual rights of the pre-IPO investors under the relevant investor rights agreement;
  • full disclosure of the pre-existing contractual entitlement of the pre-IPO investors contained in the relevant investor rights agreement and the number of shares to be subscribed by the pre-IPO investors will be made in the prospectus and the allotment results announcement; and
  • the proposed subscription will be conducted at the IPO price.

Profit Guarantee

Profit guarantee is not allowed if (i) it is settled by the Proposed ListCo or (ii) the compensation thereunder is linked to the market price or market capitalization of the Proposed ListCo.

However, where compensation is settled by a shareholder as a private arrangement between a shareholder and a pre-IPO investor and the compensation thereunder is not linked to the market price or capitalization of the Proposed ListCo, such guarantee will be allowed to survive upon listing.

Special Rights Allowed to Survive HKSE Listing

Negative Pledges

Negative pledges that may survive the listing (i) must be widely accepted provisions in loan agreements, (ii) must not be egregious, and (iii) do not contravene the fairness principle in the Listing Rules.

Negative pledge provisions that are regarded as "widely accepted" include:

  • those that prohibit the creation or effecting of any mortgage, charge, pledge, lien, or other security interest on a listing applicant's assets and revenues; and
  • those that prohibit the disposal of any interest in the economic rights or entitlements of a share the controlling shareholder owns or controls to any person.

The HKSE will review all other negative pledges and may require confirmation from the sponsor that those that remain after listing are in line with normal terms of debt issues.

Prior Consent for Corporate Actions

Examples of the corporate actions subject to prior consent of pre-IPO investors include:

  • a declaration of dividend by any member of the Proposed ListCo group;
  • the sale, lease, or transfer of a substantial part of the Proposed ListCo's business or assets;
  • any amendments to the applicant's constitutional documents; and
  • any change in executive directors.

The above terms should be removed before listing unless the Proposed ListCo can demonstrate that the relevant terms are not egregious and do not contravene the Equal Treatment Principle.

Exclusivity Rights and No More Favorable Terms

A pre-IPO investment agreement may include terms that the Proposed ListCo is not allowed to issue or offer any shares or other forms of securities to any direct competitor of the pre-IPO investor or to other investors on terms more favorable than the terms on which the shares are issued to the pre-IPO investor.

These rights potentially can prevent the board of the Proposed ListCo from considering bona fide alternative proposals that would be in the best interest of the Proposed ListCo and its shareholders as a whole.

These rights can survive after listing if the investment agreement is modified to include an explicit "fiduciary out" clause so that directors are allowed to ignore such restrictions if complying with such restrictions would constitute a breach of their fiduciary duties. The directors would not be prevented from exercising their judgment in deciding whether to undertake certain corporate actions in the best interest of the Proposed ListCo.

Information Rights

Information rights can survive after listing if the pre-IPO investor is only entitled to receive published information or information that is made available to the public shareholders at the same time. If the Proposed ListCo provides price-sensitive information to the pre-IPO investor, the Proposed ListCo needs to comply with the disclosure requirement under Listing Rule 13.09 unless safe harbors in the Listing Rules apply.

Management Representation / Attendance Rights

These contractual rights allow a pre-IPO investor to nominate senior management and committee representatives, but any such appointment is subject to the decision of the board. The board is not contractually bound to approve the pre-IPO investor's nomination(s) without further review, as it owes fiduciary duties to all shareholders.

Right of First Refusal and Tag-Along Rights Granted by Controlling Shareholder

The HKSE considers these rights, which are intended to protect the pre-IPO investor's interest in the Proposed ListCo by placing certain selling restrictions on the controlling shareholder to prevent it from selling its shares to other parties, to be purely contractual rights between two shareholders.

Guidance on the Practices in Connection with CBs Issued to Pre-IPO Investors

Conversion Price Linked to IPO Price or Market Capitalization

The conversion price for the CBs should be at a fixed dollar amount or at the IPO price. Where the CBs are to be converted into shares at a price based on a guaranteed discount to the Proposed ListCo's IPO price or the conversion is linked to market capitalization, this essentially creates two different prices for the same securities at listing, which is inconsistent with the Equal Treatment Principle. This also may give rise to concerns that the pre-IPO investor does not bear the same investment risk as public investors.

Conversion Price Reset

Any conversion price reset mechanism of the CBs should be removed, as they are considered to be contrary to the Equal Treatment Principle.

Partial Conversions

Partial conversion of the CBs is allowed only if all special rights attached to the CBs are terminated after listing. This avoids the situation where a pre-IPO investor continues to enjoy special rights as a bondholder by holding a small portion of CBs after converting a significant portion of such CBs into shares.

Redemptions and Early Redemptions

Certain CBs provide the option for bondholders to redeem the outstanding CBs early at a price that enables the bondholders to receive a fixed internal rate of return on the CBs' principal amount. Upon maturity, all outstanding CBs shall be payable such that the bondholders shall receive the same fixed IRR. Such early redemption is allowed and should be distinguished from other cases where the bondholders do not undertake any risk and the investment money is not paid.

Disclosure Requirements

Certain prescribed information is required to be disclosed in the "Financial Information" and "Risk Factors" sections of the prospectus to explain the impact of the CBs on the Proposed ListCo. Such information includes:

  • qualitative analysis on the cash flow and cash position in the event of the redemption;
  • terms and impact of early redemption;
  • maximum number of shares that would be converted and the corresponding change in shareholding in the Risk Factors section; and
  • expected source of cash inflows upon listing, particularly the Proposed ListCo's existing cash position, the additional positive operating cashflow it expects to generate, and estimated net proceeds from the IPO.

Certain additional information also should be disclosed in the Proposed ListCo's interim and annual reports upon listing to enable investors to be aware of the potential dilution impact on the shares of the Proposed ListCo.

Additional Information

A copy of the Consolidated Guidance Letter can be downloaded at

A copy of the CB Guidance Letter can be downloaded at

For more information on the Consolidated Guidance Letter and the CB Guidance Letter or any related matters, please contact any of the following lawyers in Wilson Sonsini Goodrich & Rosati's China practice: Weiheng Chen, Zhan Chen, Lisa Fang, Kefei Li, Khoon Jin Tan, or Yurong Ye.

The firm's Hong Kong law practice currently operates through Chen & Associates, a firm of solicitors associated with Wilson Sonsini Goodrich & Rosati, P.C. (Hong Kong).

This briefing provides a summary of the matters discussed in the Consolidated Guidance Letter and the CB Guidance Letter. Specific legal advice should be obtained in relation to any issues in connection therewith. If there is any conflict or discrepancy between the Listing Rules and any of the guidance letters, the Listing Rules shall prevail.

Written by:

Wilson Sonsini Goodrich & Rosati

Wilson Sonsini Goodrich & Rosati on:

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