Peter Brien, Benita Yu and Jing Chen of Slaughter and May review the new approach taken by The Stock Exchange of Hong Kong when assessing reliance and competition, and summarise the impact of the key changes on an applicant’s suitability for listing.
The Stock Exchange of Hong Kong Limited (the Exchange) issued guidance in March 2019 detailing its new approach to assessing a listing applicant’s: (i) reliance on other parties; and (ii) competition with its controlling shareholder group. This article highlights the key changes and how they impact an applicant’s suitability for listing.
In short, it appears there is now more scope for applicants to be listed with a higher degree of competition and reliance provided certain conditions are met.
Under the Listing Rules, where a listing applicant has a controlling shareholder with an interest in a business apart from the applicant’s business that competes or is likely to compete (directly or indirectly) with the applicant’s business, the disclosures set out under Listing Rule 8.10 must be made – this includes disclosure of facts demonstrating the applicant is capable of carrying on its business independently of the competing business. Competition with and independence from controlling shareholders are therefore interrelated.
Listing decisions LD51-2 and LD51-3 clarified when competition issues might impact an applicant’s suitability for listing, and LD52-2 assessed management independence from a controlling shareholder. These listing decisions have now been superseded by the new Guidance Letter on Competition between the Businesses of a New Applicant and its Controlling Shareholder (GL100-19).
Under the previous listing decisions, competition was seen as a disclosure issue except in ‘extreme cases where, in the view of the Exchange, there were inadequate arrangements to manage conflicts of interest and delineation of businesses’. An extreme case would raise concerns about an applicant’s suitability for listing. However, it was not entirely clear if an extreme case referred to a case where there were inadequate arrangements to manage conflicts of interest and/or an extreme degree of competition.
In practice, it became common for applicants to resolve competition issues by delineating the businesses and obtaining an enforceable non-compete undertaking from the controlling shareholder to ensure ongoing delineation. Where delineation was not possible, it was considered that an applicant whose business had a significant degree of competition with the business of the controlling shareholder would unlikely be regarded as suitable for listing.
The Exchange makes it clear that where there is competition, its focus will be on how actual or potential conflicts of interest are managed for the purpose of demonstrating that the applicant is capable of carrying on its business independently.
The guidance states the greater the possibility of actual or potential conflicts of interest, the greater the need for enhanced conflict management measures to ensure management independence. The assessment of the possibility of actual or potential conflicts of interest will depend on the facts, including the extent of competition and the relevant industry.
The Exchange also confirms there is no competition if there is clear delineation between the businesses of the controlling shareholder group and the applicant. The guidance gives non-exhaustive examples of delineation, which are generally in line with the previous listing decisions (for example, delineation by geographic location, customer-base, non-substitutable products/services in the same industry). The guidance notes that enforceable non-compete undertakings are not mandatory, but are helpful to ensure continued delineation or to limit competition after listing.
The emphasis is now upon the effectiveness of governance measures to manage conflicts of interest in light of any competing business, rather than necessarily minimising the competition. Therefore even a material degree of competition with the controlling shareholder group may be acceptable, provided there are robust governance measures in place.
Reliance on another party (whether it is a controlling shareholder, customer, supplier or other party) is primarily a disclosure issue, and there are specific disclosure requirements under the Listing Rules that are intended to give investors a sense of an applicant’s extent of reliance on its controlling shareholder (and close associates), major suppliers and customers. However, reliance may impact an applicant’s suitability for listing in certain circumstances.
The Exchange has updated its Guidance Letter on Suitability for Listing for New Applicants (GL68-13) to, amongst other things, set out a new approach to assessing when reliance may raise suitability concerns. Previous listing decisions on reliance issues have been withdrawn.
The guidance letter previously stated that suitability concerns would arise if the degree of reliance was excessive. In addition, various listing decisions shed light on how the Exchange would assess this depending on the identity of the counterparty.
For example, reliance on the parent group would involve assessing the applicant’s financial, operational and management independence from the parent group. For connected persons and other closely related parties, the Exchange would consider whether the applicant derives a significant portion of its turnover and net profit from connected transactions. For major customers and suppliers, the Exchange would consider if reliance is extreme by reference to (amongst others) the applicant’s ability to find substitute customers, the likelihood for the level of reliance to decrease, the industry landscape, any long-term contracts and whether the reliance is mutual. In listing decision LD107-1, the Exchange took into account factors such as industry landscape, a decreasing trend of reliance and an effort to diversify when assessing whether reliance could be addressed through disclosure.
In July 2018, the Exchange issued a guidance letter for new applicants in the internet technology sector or that have internet-based business models (the Internet Sector Guidance). The Exchange was prepared to accept a higher level of reliance for applicants in these sectors (without the need to demonstrate a decreasing trend of reliance or an effort to diversify) due to the industry landscape being dominated by a few players, provided there are long-term agreements in place, transactions were on normal commercial terms and disclosure was made.
Under the updated guidance, material reliance on another party is considered a matter of disclosure if, in the absence of any red flags to indicate otherwise: (i) the relationship is unlikely to materially adversely change or terminate; or (ii) the applicant is or will be able to effectively mitigate its exposure to the counterparty.
Examples of material reliance under the guidance letter include:
- high customer and/or supplier concentration
- limited number of distribution channels to market products, and
- dependence on another party for critical functions (e.g. sales, distribution, procurement).
- When assessing mitigation, the Exchange will likely still give weight to cogent steps of mitigation even if they are not yet fully implemented.
The guidance does not specify examples of ‘red flag’ scenarios. However, a potential example could be the one set out in the Guidance Letter on a Listed Issuer’s Suitability for Continued Listing (GL96-18). This guidance highlights that where an issuer’s supply and sales are both dominated by the controlling shareholder (or its associates) and those transactions become its sole or primary source of revenue, that issuer may become unsuitable for continued listing. This is due to concerns that it would be a captive company serving the controlling shareholder.
The updated guidance sets out the relevant disclosure requirements for applicants with material reliance, which includes disclosing the basis that the likelihood of the relevant relationship changing/ending is low, or the basis that the applicant is/will be able to effectively mitigate its exposure.
The Internet Sector Guidance has also been updated to reflect the revised approach.
The Exchange had previously accepted a higher degree of reliance for applicants in internet sectors. It has now broadened this to all applicants.
Under the updated guidance, the Exchange’s focus will be on the likelihood that the relevant relationship will terminate or change for the worse and the extent to which such exposure could be mitigated.
Peter Brien, Benita Yu and Jing Chen; Partners, Slaughter and May
Copyright: Slaughter and May
More information on the new approach taken by The Stock Exchange of Hong Kong to assessing issues of a listing applicant’s reliance and competition can be found on the Hong Kong Exchanges and Clearing Ltd website: www.hkex.com.hk.