IPO governance: new guidance
A new guidance note, published by the Institute’s Securities Law and Regulation Interest Group, gives practical guidance on IPO due diligence and the role of company secretaries in helping companies to transition from the private to the public realm.
The right to raise public money on the capital market comes with a number of obligations, in particular the obligation to have in place appropriate corporate governance practices that will protect shareholder interests. The due diligence process required to go public in Hong Kong imposes a degree of quality control on the entities seeking listing to maintain a quality market. It is also designed to ensure that prospective investors can access the information they need to assess whether a company is a good investment. The IPO process is a long and complex one and company secretaries, whether as part of the in-house team or as corporate service providers, play a key part in ensuring that the necessary due diligence is observed and that appropriate internal controls and governance structures are in place.
Last month the Institute’s Securities Law and Regulation Interest Group published its first guidance note on this complex area of practice. The guidance note highlights the importance of company secretaries understanding both the detailed requirements of the IPO due diligence process and the rationale behind them. ‘This would more effectively assist the company secretary in discharging the duty of trusted adviser to the chairman and/or board of directors, and allow the company secretary to be in a better position as influencer including as to good governance. Accordingly, this guidance note seeks to set out basic requirements and the points that the company secretary needs to know and to pay attention to,’ the guidance states.
Why go public?
The guidance first addresses the issues that should be considered before a decision to go public is made. The rationale will differ of course depending on the specific circumstances of the company. The decision to go public is usually about accessing capital for expansion and to fund growth, but this is certainly not the only consideration. The decision may be part of a desire to enhance the company’s public profile, status and image, or to facilitate a transition from a family-run business to becoming a professionally managed firm.
The guidance note makes it clear that the comprehensive and intricate IPO due diligence exercise, as well as the ongoing listing requirements, bring a governance dividend. This is perhaps the most valuable aspect of the process. The IPO requirements, and ongoing listing requirements, are designed to build up strong and independent boards, effective risk management and effective internal controls. The IPO process usually also results in significant improvements to the information disclosure standards of IPO applicants.
Other potential benefits of going public listed by the guidance note include those set out below.
Building confidence among stakeholders. Stakeholders, such as customers, suppliers, financiers and advisers, generally take comfort from the fact that listed companies have gone through a rigorous legal, financial and corporate due diligence. In particular, the higher information disclosure requirements of a listed company give comfort to stakeholders.
Enhancing loyalty of staff and other core personnel. Going public also gives organisations the ability to develop employee motivation schemes, such as employee share options. Employee share options can encourage staff and core members to be more efficient in their work in order to support the company’s growth and profitable development – which in turn increases the operational and financial efficiency of the company and its market value.
Improving debt finance terms. Banks feel more confident to extend loans to listed companies, often in larger amounts, under smaller collateral, for longer maturities and with lower interest rates.
Facilitating mergers and acquisitions and other growth strategies. As a listed company, it is much easier to carry out mergers and acquisitions as compared to a private company. The processes are relatively simpler as valuations are largely market driven based on the stock price and the company’s assets, for example.
The IPO process
One of the most useful aspects of the Institute’s new guidance note is a single page synopsis of the IPO listing process according to Hong Kong’s current requirements. The ‘Flowchart of IPO process and vetting procedures’ forms the centrepiece of the guidance note and provides an excellent overview for practitioners of the actions and documents required at each stage of the process.
The IPO requirements
Directors and controlling shareholders
Directors of a listing applicant must satisfy the stock exchange that they have character, experience and integrity and are able to demonstrate a standard of competence commensurate with their position as directors of a listed issuer. In particular, the prospectus must disclose any instances of non-compliance or the conviction record involving a director. Having a past non-compliance or conviction record does not necessarily mean that a person cannot be accepted as a director of a listed issuer, but there may be concern as to the applicant’s suitability for listing and the suitability of the individual to act as a director.
IPO due diligence also focuses on the role of controlling shareholders. Where persons are controlling shareholders, they will be able to exert substantial influence over the operation and management of the applicant even if they are not formally appointed as directors, or have previously resigned as directors. The issue of the applicant’s suitability therefore may not be solved by that person refraining from acting as the applicant’s director, and it may even break management continuity.
The guidance notes that there are strict requirements regarding the ability of controlling shareholders to dispose of their shares or their interest in the issuer, if such disposal would result in them ceasing to be a controlling shareholder, within the first year after listing.
In addition, controlling shareholders must undertake to disclose to the issuer and the stock exchange any pledge/charge of any securities beneficially owned by them for a 12-month period commencing from the listing date.
The IPO process seeks to control and make transparent any transactions between a proposed listed group and connected persons. ‘Connected persons’ include:
- directors, the chief executive or substantial shareholders of the listed issuer or any of its subsidiaries
- ex-directors of the listed issuer or any of its subsidiaries in the last 12 months
- the supervisor of a PRC issuer or any of its subsidiaries, and
- their respective associates.
For the purpose of IPOs, the prospectus concerns only continuing connected transactions spanning across the listing date. Prior to IPO, there is no connected transaction concept. Although profits from transactions with connected persons or closely related parties do not necessarily have to be disregarded in assessing whether the listing requirements are met, when these transactions are excessive, this may raise a concern as to whether the applicant is suitable for listing.
One of the most complex areas of IPO due diligence concerns the requirements relating to any potential conflicts of interest between ‘insiders’ and ‘outsiders’ when a company goes public. The Institute’s new guidance note covers these requirements in detail. Where a controlling shareholder, substantial shareholder, director or any of their respective close associates (as the case may be depending on whether it is listed on the Main Board or GEM Board) has interest in a business which competes, or is likely to compete, either directly or indirectly, with the listing applicant’s business, full disclosure shall be made in the prospectus.
The competing interest is normally regarded by the stock exchange as a disclosure issue. However, in extreme cases where in the view of the stock exchange there are inadequate arrangements to manage conflicts of interest and delineation of businesses between the listing applicant and other businesses under common control, the exchange may reject the listing application for suitability for listing.
Hong Kong also has requirements relating to ‘undue reliance’. For example, the prospectus must disclose details of how the listing applicant is capable of carrying on its business independently of the controlling shareholder (including any close associate thereof) after listing. When considering independence issues, the exchange will generally require the company to take into account: financial independence, operational independence and management independence. The issue of reliance on controlling shareholders can usually be dealt with by disclosure in the prospectus but where the degree of dependence is excessive, this may translate into a concern about the suitability for listing.
Where a listing applicant relies heavily on a single major supplier or customer, the exchange may consider it an extreme case which impacts on suitability for listing.
Where a listing applicant’s major customer is also its major supplier, the exchange may consider that the listing applicant is not capable of carrying on its business independently of the major customer/major supplier. When the listing applicant’s supply and sales are dominated by the same party, the listing applicant’s relationship with this party will be fundamental to its business. If the listing applicant is unable to demonstrate that it is capable of carrying on its business independently of this party, it will translate into a concern about its suitability for listing.
The Institute’s new guidance also provides a useful summary of the financial requirements for IPO applicants. Currently companies wishing to list on the Main Board need to have a market capitalisation of at least HK$200 million at the time of listing. The market capitalisation at the time of listing is determined by multiplying the number of issued shares by the expected issue price. Companies wishing to list on the GEM Board need to have a market capitalisation of at least HK$100 million at the time of listing. Companies wishing to list on the Main Board also need to have profits totalling HK$50 million in the last three years (with HK$20 million in the most recent year and an aggregate of HK$30 million in the two preceding years).
The guidance also covers the requirements relating to existing shareholders and investors in the business. Any person may invest in a business to be listed by acquiring new shares or convertible instruments from a listing applicant, or acquiring existing shares from an existing shareholder. However, shareholders above certain thresholds set out in the guidance must disclose their shareholding. Pre-IPO investments must be completed 28 clear days before submission of the listing application. Pre-IPO investments are considered completed when the funds for the underlying shares are irrevocably settled and received by the listing applicant (in the case of an issue of new shares by the listing applicant), or existing shareholders (in the case of a transfer or sale of existing shares by existing shareholders). Special rights to pre-IPO investors which do not extend to all other shareholders may exist and be exercised up to listing, but are not permitted to survive after listing, to comply with the general principle of even treatment of shareholders under the listing rules. Pre-IPO investors are also usually requested by the applicant to lock-up their pre-IPO shares for a period of six months or more.
Track record, ownership and management continuity
The guidance also looks at the requirements in Hong Kong relating to track record, ownership and management continuity.
Listing applicants for the Main Board are required to have:
- a trading record of at least three financial years
- ownership continuity and control for at least the most recent audited financial year, and
- management continuity for at least the three preceding financial years.
Listing applicants for the GEM Board are required to have:
- a trading record of at least two financial years
- ownership continuity and control for at least the most recent audited financial year, and
- management continuity for at least the two preceding financial years.
The ownership continuity requirement means that the listing applicant has to demonstrate that, for at least the most recent financial year up until the time immediately before listing there has been no change to any controlling shareholder(s) or, where there is no controlling shareholder, the single largest shareholder, identified at the beginning of the most recent financial year.
‘Controlling shareholder’ means any person or group of persons who are:
- entitled to exercise or control the exercise of 30% or more of the voting power at general meetings, or
- in a position to control the composition of a majority of the board of directors.
Ownership continuity and control could be satisfied by aggregating the shareholding interests and control of a group of shareholders, where such shareholders could show that they jointly affected their ‘management and control’ as a unit.
Listing applicants must demonstrate that there has been no change in the majority of the applicant’s board of directors and senior management of its principal operating subsidiaries during the preceding three (Main Board) or two (GEM Board) financial years. The exchange focuses on the substance of a listing applicant’s management when examining management continuity. In some cases the management continuity requirement could be satisfied where less than a majority of the board of directors and senior management, or even just one single dominant director, continued to serve throughout the trading record period.
SIDEBAR: The HKICS Interest Groups
The Securities Law and Regulation Interest Group is one of seven groups set up last year under the Technical Consultation Panel to look into key areas of corporate governance and company secretarial practice with a view to producing guidance to Institute members and the wider profession and community.
The members of the Securities Law and Regulation Interest Group are: Daniel Wan (Chairman), Agnes Wong, CK Poon FCIS FCS, Bill Wang FCIS FCS and Professor CK Low FCIS FCS. Mohan Datwani FCIS FCS(PE) serves as secretary.
The six other Interest Groups cover the following areas: competition law; company
law; ethics, bribery and corruption; public governance; takeovers, mergers and aquisitions; and technology. The guidance notes in this series are available from the Publications section of the Institute’s website: www.hkics.org.hk.
Please contact Mr Datwani if you have any suggestions about topics relevant to this interest group, or generally, at: firstname.lastname@example.org.