Open Sesame? Not for now, Alibaba – Part 1

by Dorsey & Whitney LLP

For months Alibaba Group Holding Limited (“Alibaba”) had tried to convince the Stock Exchange of Hong Kong Limited1 (“SEHK”) that they should open their doors to the internet giant. Alibaba had proposed a system through which a handpicked group of “partners” would nominate a majority of its board. At the time, commentators rushed to report that Alibaba was seeking to implement a dual share class structure, threatening investor protections. Alibaba had offered an alternative take and tried to convince the public that there was no story at all: their proposed partnership structure merely offered an “alternative view of good corporate governance2”. Charles Li, the Chief Executive of the SEHK was meanwhile hearing voices from all sides in his dreams3.

Recently Alibaba announced it had finally given up its attempts in Hong Kong and would instead seek a listing in the United States. Many commentators had warned that if Hong Kong stands its ground it may well be left with no one knocking, as other exchanges around the world open their doors to the next wave of listings by technology companies.

This eUpdate is part 1 in a series of eUpdates on this topic. Part 1 asks: what is it about Hong Kong as a listing venue that did not work for Alibaba? And should Alibaba’s decision to seek its fortune in the United States prompt a rethink for Hong Kong regulators?

Alibaba’s quest

Over the last year, Alibaba had been in discussions with regulators in Hong Kong on how to translate their “guiding philosophy into a form of corporate governance in connection with a potential listing” on the SEHK. While Alibaba may have originally preferred to achieve this through a simple dual share class structure4, knowing this is contrary to the SEHK’s Rules Governing the Listing of Securities (“Listing Rules”) they proposed a partnership structure which would enable a group of partners, comprised of founders and top managers “to set the company’s strategic course without being influenced by the fluctuating attitudes of the capital markets5”. The partners, they believe, would enable the company to preserve its culture and safeguard the development of the company long after its original founders have gone. In essence, the partners would be entitled to nominate the majority of Alibaba’s directors for a shareholder vote6, and would nominate an alternative if shareholders reject a candidate7. Investors would still have the right to elect independent directors, and vote on major and related party transactions8. This proposal was rejected by Hong Kong regulators in late September 2013. Most commentators linked this rejection to a potential violation of the one-share, one-vote principle of the SEHK. Discussions between Alibaba and the SEHK were said to continue, but after months of speculation, Alibaba announced on March 16, 2014 that it had decided to commence the IPO process in the United States9. Although Hong Kong was Alibaba’s natural first choice, the company has said the United States will allow the company to continue to pursue its “long-term vision and ideals”.

In his article last year, Joe Tsai, co-founder and Executive Vice Chairman of Alibaba noted “[w]e understand Hong Kong may not want to change its tradition for one company, but we firmly believe that Hong Kong must consider what is needed in order to adapt to future trends and changes. The question Hong Kong must address is whether it is ready to look forward as the rest of the world passes it by”. Alibaba said in its recent statement that they “respect the viewpoints and policies of Hong Kong and will continue to pay close attention to and support the process of innovation and development of Hong Kong”. Further, they left the door open if the rules change in Hong Kong: “[s]hould circumstances permit in the future, we will be constructive toward extending our public status in the China capital market in order to share our growth with the people of China10”.

The Hong Kong tradition

But why was the SEHK unable to open its doors to Alibaba? The reasons are intertwined and deeply ingrained in Hong Kong’s regulatory regime. Firstly, the SEHK’s strong adherence to the principle of equality of treatment for all shareholders, while principally designed to protect minority shareholders, would also rule out granting special nomination rights to a small minority of shareholders. Secondly, while Alibaba did not actually propose listing two classes of shares, the principle of “one-share, one-vote”, which underlies the SEHK’s prohibition of dual share class structures, would also rule out granting special rights that would effectively result in some shareholders having super voting power.

Equality of treatment and protection of minorities

Through their rules, policies and attitudes, time and time again we see the regulators in Hong Kong take an almost paternalistic approach to protecting Hong Kong’s retail investors. Hong Kong’s Listing Rules state that they are “designed to ensure that investors have and can maintain confidence in the market11” by requiring that “all holders of listed securities are treated fairly and equally12" and that directors act in the interests of shareholders as a whole “particularly where the public represents only a minority of shareholders13”. The rules seek to secure for shareholders other than controlling shareholders, certain assurances and equality of treatment which their legal position might not otherwise provide14.

The general rules protecting minorities are used by the SEHK to underpin various policies dealing with shareholder rights that they have not written into the Listing Rules. For example, to comply with the general rule requiring equal treatment of all shareholders, the SEHK’s policy on pre-IPO investments does not permit atypical special rights, or rights which do not extend to all other shareholders, to survive after listing. Likewise, “cornerstone investors” given preferential placing in an IPO are only permitted if the placing is at the IPO price and the investors receive no direct or indirect benefits other than their guaranteed allocation.

The SEHK’s ideology of protecting minorities has also found expression in specific listing rules, such as those on related parties, or connected transactions as they are known in Hong Kong. The connected transactions rules contained in Chapter 14A of the Listing Rules are designed to protect the interests of shareholders when the issuer group enters into transactions with connected persons by making connected transactions subject to various hurdles, such as disclosure by announcement or prior shareholder approval.

Prohibition on dual share-class structures

Hong Kong’s Listing Rules specifically state that the share capital of a new applicant must not include “B shares”, shares of which the proposed voting power does not bear a reasonable relationship to the equity interests of such shares when fully paid. The foundations of this rule date back to the late 1980s. On April 8, 1987, the then Chairman of the SEHK and the Commissioner for Securities15, the predecessor of the Securities and Futures Commission (“SFC”), made a joint statement that the two agreed that no further new issues of B shares would be allowed to list on the SEHK16. On September 14, 1988, the SEHK and the Securities Commission released a joint announcement in which they agreed that as a general rule, the SEHK would not list any new B shares of a listed issuer and would not permit listed companies to issue any new B shares17.

These moves had been prompted by a series of dual-share proposals by a number of companies at the time, which were essentially aimed at allowing controlling shareholders to increase their voting power. Jardine Matheson Holdings Ltd. proposed a class of B shares that held the same voting rights as the existing A shares, but was available to the founder family at one-tenth the price18. This was followed by proposals from Cheung Kong (Holdings) Ltd. and Hutchison Whampoa Ltd., each proposing a bonus issue of one B share for every two ordinary shares19.

Swire Pacific Ltd. is the only existing company with two classes of shares on the SEHK, namely Swire “A” (SEHK: 0019) and Swire “B” (SEHK: 0087)20, both of which were listed before the practice was banned. Under this structure, five B shares are equivalent (in terms of cash flow rights, dividend payments etc.) to one A share, while each share, whether A or B, carries one vote at meetings of shareholders21.

The backstory

What is behind the paternalistic nature of the Hong Kong regulators that drives their approach to investors, steering away from the disclosure-based regimes common in jurisdictions such as the United States?

Primarily, it is the high concentration of ownership of listed companies in Hong Kong. The SEHK believes that about 75% of the issuers in Hong Kong have a dominant shareholder, for example an individual family or state-owned entity, that owns 30% or more of the issued shares22. The CFA Institute more recently quoted the percentage of publically traded companies in Hong Kong that have a controlling shareholder at 53.9%, based on a sampling of companies23. In any case, the number is high when contrasted with 4%, 7.6% and 8.4% in Australia, the United Kingdom and the United States respectively24. Hong Kong is by no means unique; the People’s Republic of China (“PRC”), Malaysia and Singapore have percentages of 61.1% and 34.5% and 46.3% respectively.

The SEHK has noted that in many cases, the dominant shareholders in Hong Kong control the issuers through complex ownership structures and appoint and nominate the board members, family members themselves often holding directorships in family-controlled issuers. “Given the ownership concentration and the lack of separation of owners from managers, the key corporate governance risk is the possible expropriation of minority shareholders by the dominant shareholders25". As a result, the Listing Rules take a prescriptive approach, closely regulating the actions of its listed companies, rather than relying on disclosure.

Another reason why the disclosure regime works well in a jurisdiction such as the United States is because it is backed by an armoury of strong sanctions that may be imposed by the Securities and Exchange Commission and balanced with an aggressive litigious culture of class actions. U.S. Federal and state regulations offer flexibility in shareholding structures as long as all risks are thoroughly disclosed. In addition, investors in the United States have been leaders in corporate governance activism and indeed many class voting structures have lost favour in recent years. By contrast, while the possibility of some forms of derivative action exists, Hong Kong does not currently have a strong class action deterrent which would accommodate class actions against listed issuers or their directors. Hong Kong is still a long way from the activist investor culture which would balance the possible abuses by majority shareholders that may arise in the context of a less proactive and prescriptive regulatory approach by the Hong Kong regulators.

Does Hong Kong need to consider a re-write?

On March 17, 2014, Charles Li said in response to Alibaba’s plans for an IPO in the United States that the SEHK needs “to find ways to make our market more responsive and competitive, particularly with respect to new economy or technology companies”. In earlier comments, Charles Li had noted that, “losing one or two listing candidates is not a big deal for Hong Kong; but losing a generation of companies from China’s new economy is26". Around the time of Alibaba’s recent announcement, social media company Weibo Corp. and online cosmetics retailer Jumei International Holding also filed for U.S. IPOs27.

Charles Li previously called for public consultation noting “significant changes to the rules and policies should be adopted only after proper consultation with the community so that they will stand the test of time28”. News reports in October last year subsequently noted that the Listing Committee of the SEHK “discussed a possible market consultation on different shareholding structures at their meeting this week29”. The Chief Executive of the SEHK commented following Alibaba’s announcement: “[w]e have to consider possible changes where they might be necessary, with everything according to our due process. The Listing Committee's work on shareholding structures didn’t start because of Alibaba and will not end now because of Alibaba30".

In his recent blog posting Charles Li discussed how Hong Kong investors may lose out by having to sit on the sidelines or overcome the inconvenience of participating in a remote offering if Hong Kong maintains its “nominal regulatory purity” and stands by its “one share, one vote” policy31. However, if the SEHK changed its stance, how would it protect those investors? Specifically, could Hong Kong maintain its strict principles of equality of treatment for all shareholders, requiring directors to act in the interests of shareholders as a whole, yet in some cases give special rights to small minorities? Allowing directors to act in the interests of a minority is arguably worse than allowing them to act in the interests of the controlling shareholder, which the SEHK has been at pains to avoid. The merits of adopting rules to lure technology companies with multi-class structures also need to be carefully considered. In the next instalment we will consider whether multi-class structures are actually imperative to the success of this new wave of technology companies and take a look at the reaction to multi-class shareholdings in other jurisdictions.

1   The SEHK operates the stock market of Hong Kong and is a wholly-owned subsidiary of Hong Kong Exchanges and Clearing Limited (“HKEx”). The HKEx is a listed company (SEHK: 0388) on the stock market of Hong Kong.
2   “Alibaba Offers an Alternative View of Good Corporate Governance” by Joe Tsai, co-founder and Executive Vice Chairman of Alibaba, Alizila, September 26, 2013.
3   “Voices on investor protection” by Charles Li, Charles Li Direct, HKEx, September 25, 2013.
4   “Alibaba’s loss won’t damage the Hong Kong stock market” by Tom Holland, South China Morning Post, September 26, 2013.
5   See footnote 2.
6   “HKEx to Alibaba: Thanks, but No Thanks” by Isabella Steger, Wall Street Journal, September 25, 2013.
7   According to an unnamed person familiar with Alibaba’s thinking. See “Alibaba Said to Plan U.S. IPO After H.K. Talks Break Down” by Lulu Yilun Chen and Jonathan Browning, Bloomberg, September 26, 2013.
8   See footnote 2.
9; “Alibaba announces it will seek US listing” by Charles Clover, Financial Times, March 16, 2014.
10  “Alibaba and the battle for financial supremacy: James Saft” by James Saft, Reuters, March 18, 2014.
11  HKEx Main Board Listing Rules (“MBLR”) 2.03.
12  MBLR 2.03(4).
13  MBLR 2.03(5).
14  MBLR 2.03.
15  The stock and commodities markets in Hong Kong were regulated by two part-time commissions then – one for securities and the other for commodities trading. Their executive arm, the Commission for Securities and Commodities Trading, headed the Office of the Commissioner for Securities and Commodities Trading. See
16  Hong Kong Securities and Derivatives Markets Historical Events, HKEx Fact Book 2013.
17  See footnote 16.
18  “Alibaba’s demands have echoes in Hong Kong’s history” by Paul Davis, Financial Times, October 1, 2013.
19  “Alibaba’s spotlight on HK regulation” by David Webb, Webb-site, September 18, 2013.
20  This refers to the dual-share class structure of Swire Pacific Ltd. It is different from the concept of A shares and B shares in the PRC. A shares in the PRC context are shares of companies incorporated in the PRC and are traded in the PRC’s A-share markets. The prices of A shares are quoted in RMB. B shares are shares of companies incorporated in the PRC and traded on the B-share markets (Shanghai and Shenzhen stock exchanges). B shares are eligible for foreign investment provided the investment account is in the proper currency.
21  Prospectus of Swire Properties Limited (SEHK: 962);
22  Estimated by SEHK based on HKEx and ETNet statistics as of March 2012, Consultation Paper on review of connected transaction rules, April 2013.
23  “Shareowner Rights Across the Markets: Individual Reports for 28 Different Markets”, by CFA Institute, August 2013. Percentages cited reflect information gathered by GMI Ratings on about 76 companies in Hong Kong as of 31 August 2012.
24  “Shareowner Rights Across the Markets: Individual Reports for 28 Different Markets”, by CFA Institute, August 2013.
25  “Consultation Paper on Review of Connected Transaction Rules” by HKEx, April 2013.
26  “Taking the debate forward: Should Hong Kong act on non-standard shareholding structures?” by Charles Li, Charles Li Direct, HKEx, October 24, 2014.
27  “Sina Weibo files for $500 million U.S. IPO”, Reuters, March 14, 2014; Cosmetics Site Jumei, Founded by Forbes China “30 Under 30 Member, Files for U.S. IPO” by Russell Flannery, Forbes, April 13, 2014.
28  See footnote 3.
29  “Hong Kong mulls listing rules change after failed Alibaba talks”, Hong Kong Agence France-Presse, October 31, 2013.
30  HKEx News Release, “Charles Li’s Comments on Alibaba’s US Listing Plan”, March 17, 2014.
31  “Are we asking the right questions about weighted voting rights?” by Charles Li, Charles Li Direct, HKEx, April 7, 2014.

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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