Dechert LLP

Hong Kong Exchanges and Clearing Limited (the “HKEx”) on 27 November 2020 issued a consultation paper outlining its proposal to increase the profit requirement for listing of shares on the Main Board of HKEx (the “Proposed Profit Requirement”).

Current Profit Requirements and the reasons for the reform

In accordance with Listing Rule 8.05(1)(a) (the “Original Profit Requirement”), a prospective applicant must have a minimum amount of profit attributable to shareholders of (1) HK$20 million in the most recent financial year; and (2) HK$30 million in aggregate in the two preceding financial years generated from activities in its ordinary and usual course of business. This rule has remained unchanged since its introduction in 1994, as it was concluded in consultation reviews in the past that it served as a good indicator of an applicant’s financial performance.

However, the minimum market capitalization requirement (the “Market Capitalization Requirement”) was increased from HK$200 million to HK$500 million in 2018, after the HKEx published the Consultation Conclusions on Review of the Growth Enterprise Market (GEM) and Changes to the GEM and Main Board Listing Rules in December 2017.

Since then, as the Original Profit Requirement remained unchanged, the HKEx has observed an increase in applicants, especially those with a proposed market capitalization at time of listing of less than HK$700 million, with profits which only marginally meet the Original Profit Requirement. These applicants happened to have relatively higher valuation and historical P/E ratios as compared to those of their listed peers. As a number of them failed post listing to meet the profit forecasts they projected as part of their listing applications, HKEx believes that the increase in valuation was merely a response to satisfy the Market Capitalization Requirement revised in 2018, instead of genuine expectation of growth, and this has led to regulatory concerns over the reasonableness of their valuations.

Proposed Profit Requirements 

Against this background, the HKEx has proposed to increase the Original Profit Requirement to enhance the overall quality of Main Board issuers. The HKEx has put forward two options:

  • The minimum profit requirement will be increased by 150 percent, based on the percentage increase in the Market Capitalization Requirement in 2018, from HK$200 million to HK$500 million, (“Option 1”).
  • The minimum profit requirement will be increased by 200 percent, based on the approximate percentage increase in the average closing price of the Hang Seng Index from 9,541 in 1994 when the Original Profit Requirement was introduced, to 27,569 in 2019, (“Option 2”).

Set out below are details of the Proposed Profit Requirement:

 

Current

Option 1

Option 2

Proposed increase (%)

/

150%

200%

In aggregate for the first two years (HK$ million)

30

75

90

For the last financial year (HK$ million)

20

50

60

Total (HK$ million)

50

125

150

Implied historical P/E ratio (based on the net profit for the last financial year and Market Capitalization Requirement revised in 2018)

25 times

10 times

8 times

Impact

If adopted, the Main Board of HKEx would have one of the most stringent financial eligibility criteria in the world for IPOs. To illustrate the impact, based on HKEx’s own analysis, Options 1 and 2 would have resulted in 59 percent (437) and 65 percent (486) of the 745 Main Board listing application between 2016 and 2019 (which relied on the Original Profit Requirement) being found ineligible for listing, respectively.

In particular, the proposed rule would largely affect small or mid-sized companies with intention to list on the Main Board. The HKEx noted that these applicants may opt for GEM for a lower listing eligibility criteria. Businesses in relevant industries (such as mining and biotech) may also rely on specific rules devised for them.

Transition arrangements

To minimize the impact of the Proposed Profit Requirement on applicants who had already commenced plans to apply for a Main Board listing based on the Original Profit Requirement, HKEx has proposed certain transitional arrangements before the full implementation of the Proposed Profit Requirement.

The HKEx stated that the Proposed Profit Requirement, if adopted, will come into effect no earlier than 1 July 2021 (the “Effective Date”) to allow time for prospective applicants to make a listing application. A Main Board listing application will be reviewed under the Original Profit Requirement if it is submitted prior to and remains active as of the Effective Date. Such applications may only be renewed once after the Effective Date for continued assessment under the Original Profit Requirement, provided such renewal is made within three calendar months from the date on which the previous application lapsed. Any subsequent renewals will cause the applicant to be assessed under the Proposed Profit Requirement.

Temporary relief due to COVID-19

Further, given the spread of the COVID-19 pandemic and the general economic downturn in 2020, the HKEx also proposed to introduce temporary relief from the Proposed Profit Requirement, if an applicant meets the following conditions:

  • Its aggregate profit during the track record period meets the aggregate profit threshold;
  • It had a positive cash flow generated from operating activities in the ordinary and usual course of business before changes in working capital and taxes paid in the last financial year during the track record period;
  • It can demonstrate that the conditions and circumstances leading to its inability to meet the Proposed Profit Requirement are temporary. The HKEx will assess the profitability in the last financial year/period as a means of whether the applicant has recovered or is recovering from the adverse market conditions;
  • The track record period must have at least six consecutive months that fall within the 2020 calendar year; and
  • Adequate disclosure is made in its listing document.

Conclusion

HKEX acknowledges that, given the expected impact, the introduction of the Proposed Profit Requirement would cause an influx of applicants ahead of the changes. Despite this, through a more stringent profit requirement, HKEx seems determined to enhance market quality and to strengthen Hong Kong’s role as Asia’s premier international financial center.

If the Proposed Profit Requirement is adopted, the GEM board (which does not have a profit requirement) will remain available for companies whose business has not reached the profitability required.

×