Bonnie Yung (Partner)
Prior to going public, it is very common for a company to be owned entirely or substantially by its founders and/or early investors, which are the “controller shareholders” of a listing applicant. As controlling shareholder(s) are able to exert substantial influence on the listing applicant, the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (the “MB Listing Rules”) and the Rules Governing the Listing of Securities on GEM (the “GEM Listing Rules”, together with the MB Listing Rules, the “Listing Rules”) set out certain requirements and obligations relating to controlling shareholders, which may affect the qualification and suitability for listing of a listing applicant. In this article, by examining the relevant rules and guidance letters issued by The Stock Exchange of Hong Kong Limited (the “Exchange”), we will explore the major issues relating to controlling shareholders that a listing applicant should be aware of when preparing for listing in Hong Kong.
Rule 1.01 of the MB Listing Rules provides the definition of “controlling shareholder” as any person who is or group of persons who are together:
Guidance Letter HKEX-GL89-16 (“GL89-16”) provides further guidance on the Exchange’s interpretation of the definition of “controlling shareholder”.
According to GL89-16, the process of identifying the “controlling shareholder(s)” of a listing applicant is a case-specific exercise and depends on the facts and circumstances of each case. It also points out that the Exchange has the power to deem any shareholder to be a “controlling shareholder” or a group of “controlling shareholders” of an issuer based on the facts and circumstances of that case.
To allow a better understanding of who may fall within the definition of a “controlling shareholder”, we will examine below a few common examples of ownership structures of a listing applicant and the Exchange’s interpretations as set out in GL89-16.
In Example 1, Mr. A and Mr. B are both controlling shareholders as they are both entitled to exercise 30% or more of the voting power at general meetings of the listing applicant.
On the other hand, Mr. C is not a controlling shareholder of the listing applicant.
Based on a similar analysis, in Example 2, the SPV and Mr. A are both considered as controlling shareholders of the listing applicant as Mr. A controls the SPV which in turn holds 30% or more of the voting power at general meetings of the listing applicant. Consequentially, Mr. B and Mr. C should not be regarded as controlling shareholders.
However, on the basis that Mr. A, Mr. B and Mr. C have agreed to restrict their ability to exercise direct control over the listing applicant by holding their interests through a common investment holding company (i.e., the SPV), the Exchange will rebuttably presume that Mr. A, Mr. B and Mr. C are a group of controlling shareholders of the listing applicant.
A point to note is that Example 2 assumes that the SPV is an investment vehicle of Mr. A, Mr. B and Mr. C which exclusively holds their interests in the listing applicant and has no operations. If such investment vehicle does not exclusively hold the interests in the listing applicant and/or has other businesses, the Exchange will assess it on a case-by-case basis.
Set out below are the key issues relating to “controlling shareholders” which a listing applicant has to be aware of:
(i) Ownership continuity and control requirement
One of the conditions under the profit or cash flow test which a listing applicant must satisfy for its trading record to be counted towards the minimum required profit or cash flow is the ownership continuity and control requirement.
The main purpose of this requirement is to avoid the risk of instability in control and management of the listing applicant in the running up to listing. It enables the Exchange to ensure that the listing applicant’s financial performance resulted from the actual dynamics between the controlling shareholder(s) and the management for at least the last financial year of the track record period, which also means that the listing applicant is capable of operating as an integrated unit under the influence of the same controlling shareholder(s).
If the listing applicant fails to satisfy this requirement, the Exchange may be concerned that the listing applicant has been “packaging” its businesses in order to meet the basic eligibility listing requirements. However, if there is any change in the controlling shareholder but the listing applicant can prove that, despite such change, the influence on the management of the company has not been materially affected, the listing applicant may still be able to satisfy the ownership continuity and control requirement.
Practically speaking, the Exchange’s requirements are that:
a) Main Board and GEM listing applicants shall demonstrate “ownership continuity and control” for at least the most recent financial year up until the time immediately before the offering and/or placing becomes unconditional (the “Relevant Period”). The Exchange applies the definition and interpretation of “controlling shareholder” as set out in Section 2 of GL89-16 when applying the interpretation of “ownership continuity and control”. When there is no controlling shareholder or a group of controlling shareholders, references to “controlling shareholder” or “a group of controlling shareholders” in GL89-16, where applicable, would be to the single largest shareholder or the group of shareholders being considered as the single largest shareholder, as the case may be;
b) there shall be no change to any controlling shareholder(s) identified at the beginning of the most recent financial year, for at least the Relevant Period;
c) for a listing applicant with a group of controlling shareholders with direct interests in the listing applicant to satisfy the ownership continuity and control requirement, for at least the Relevant Period:
e) if there is any change in the voting interests held by each shareholder constituting the group of controlling shareholders, the Exchange will assess whether such change amounts to a material change on a case-by-case basis. Potential listing applicants are encouraged to consult with the Exchange in advance on any plans to transfer any voting interest in the listing applicant (or common investment company as the case may be).
(ii) Listing applicant’s independence from its controlling shareholders
A listing applicant has to determine the identity of its controlling shareholder(s) immediately upon completion of the offering and/or placing, and disclose in the listing document the details of any such controlling shareholder(s) as required to be disclosed under the Listing Rules, including but not limited to the name or names of any such controlling shareholder(s) and the amount of its or their interest in the share capital of the listing applicant.
It is also a fundamental requirement under paragraph 27A in Appendix 1A to the Listing Rules that the listing document discloses how the listing applicant is satisfied that it is capable of carrying on its business independently of the controlling shareholder(s) (including any close associate of such controlling shareholder(s)) after listing, as well as the particulars of the matters that it relied on in making the statement.
In assessing a listing applicant’s independence, the Exchange will consider the listing applicant’s financial aspects, operational aspects (such as independent access to supplies or raw materials for production, independent access to customers and independence of production or operation capabilities) and management aspects, which are usually disclosed under the heading “Relationship with Controlling Shareholders” in a listing document. Where the degree of dependence on its controlling shareholder(s) is excessive, it may raise concerns about the listing applicant’s suitability for listing.
Suitability for Listing: Sustainability of Business
Rule 2.06 of the MB Listing Rules (Rule 2.09 of the GEM Listing Rules) states that there is no bright line test in determining what would render a listing applicant and its business unsuitable for listing. To provide better guidance to listing applicant, the Exchange issued a Guidance Letter HKEX-GL68-13 (“GL68-13”) which sets out non-exhaustive factors that the Exchange would take into consideration when assessing whether a new listing applicant is suitable for listing.
One of the key factors which may affect the suitability for listing which controlling shareholders of a listing applicant may play a part in is relating to the sustainability of business of the listing applicant. Where there is material reliance on another party (the “Relevant Counterparty”) by the listing applicant, it may threaten the listing applicant’s business sustainability if it is likely that the relationship with such party may materially adversely change or terminate. One of the examples of material reliance as set out in GL68-13 is dependence on another party, such as the controlling shareholder and its close associates (the “Controlling Shareholder Group”) for critical functions, such as sales, distribution and procurement.
If the listing applicant is materially dependent on a Relevant Counterparty, the Exchange will assess the sustainability of the relationship between the listing applicant and the Relevant Counterparty by taking into account the following non-exhaustive factors:
a) whether the Relevant Counterparty is mutually dependent on the listing applicant; and
b) whether the listing applicant has an established relationship or long-term agreement with the Relevant Counterparty.
A listing applicant’s material reliance on a Relevant Counterparty is only a matter of disclosure if, absent red flags to indicate otherwise, (i) the relationship with the Relevant Counterparty is unlikely to materially adversely change or terminate; or (ii) the new applicant is/ will be able to effectively mitigate its exposure to any material adverse changes to or termination of its relationship with the Relevant Counterparty.
Another key consideration that will be taken into account by the Exchange is where the listing applicant receives material financial assistance (such as loans, guarantees or other forms of collateral or security) from the Controlling Shareholder Group (the “Financial Support”). Due to the practical difficulty in assessing to what extent the Controlling Shareholder Group’s incentive to provide Financial Support will be reduced after listing, the Exchange will presume, in the absent of evidence to the contrary, such Financial Support will be withdrawn upon listing.
In order to demonstrate that its business is sustainable without the Financial Support, listing applicants may choose to settle all loans or release all guarantee from the Controlling Shareholder Group at listing. Nevertheless, settlement of the Financial Support is not a mandatory requirement. The Exchange will also take into account the following non-exhaustive factors to assess whether the listing applicant’s business will be sustainable without the Financial Support:
a. whether the listing applicant is able to obtain independent financing on comparable terms; or
b. whether the listing applicant has sufficient liquid assets on hand to meet its financial needs.
(iii) Competing businesses between listing applicant and its controlling shareholder
Competition between the listing applicant and its controlling shareholder, including any business in which the controlling shareholder has an interest in (other than the listing applicant and its subsidiaries) is not prohibited by the Exchange, however certain disclosure and compliance requirements must be satisfied by the listing applicant.
Pursuant to Rule 8.10 of the MB Listing Rules (Rule 11.04 of the GEM Listing Rules), where a listing applicant has a controlling shareholder with an interest in a business apart from the listing applicant’s business which competes or is likely to compete, either directly or indirectly, with the listing applicant’s business (the “excluded business”):
a. the listing document must prominently disclose the following:
c. all connected transactions between the excluded business and the listing applicant after listing must strictly comply with the requirements of Chapter 14A of the MB Listing Rules (Chapter 20 of the GEM Listing Rules).
While competition between the listing applicant and the Controlling Shareholder Group is normally a disclosure issue, in extreme cases in which 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 would assess its impact on the listing applicant’s suitability for listing.
A common approach to resolving the competition issue for the controlling shareholder to:
(a) enter into a non-competition undertaking in favor of the listing applicant, pursuant to which the controlling shareholder would undertake not to compete with the listing applicant in the manner as specified in the undertaking;
(b) grant a right of first refusal to the listing applicant if it is aware of a new business opportunity relating to the listing applicant’s business or intends to dispose of the competing business; and/ or
(c) to grant a call option to the listing applicant to acquire the competing business in the future.
The above undertakings are not mandatory but are usually provided in practice as they may be helpful to ensure continued delineation of the Controlling Shareholder Group from the competing business or limit the extent of competition between the listing applicant and the Controlling Shareholder Group after the listing. Details of such undertakings would be required to be disclosed in the listing document.
To further assist listing applicants to better understand how conflicts of interest can be managed, some non-exhaustive examples of conflict of interest management measures are set out in the Guidance Letter HKEX-GL100-19 (“GL100-19”):
a. restricting the members of senior management of the listing applicant from participating in the management of the competing business, and vice versa;
b. limiting the number of overlapping directors holding executive roles in both the listing applicant and the Controlling Shareholder Group;
c. having a sufficient number of independent directors, who have requisite knowledge, industry experience and expertise, on the listing applicant’s board to advise on the conflicted transactions and business decisions, as overlapping directors would abstain from voting; and
d. engaging additional independent consultants to provide advice to the independent non-executive directors where needed.
Further, GL100-19 provides that if the businesses of the Controlling Shareholder Group are clearly delineated from those of the listing applicant, there will be no competition and the risk of potential conflicts of interest will be comparatively low. The following are some non-exhaustive examples of how listing applicants could distinguish themselves from the excluded business(es) of the Controlling Shareholder Group:
a. different business models under which the listing applicant and the Controlling Shareholder Group sell the same or similar products but to different customers;
b. produces non-substitutable products or provides non-substitutable services in the same industry (e.g., highly specialised bespoke products vs. mass-produced standardized products; foundation construction company vs. decoration and fitting out company); or
c. operates in different geographical locations.
 Rule 8.05(1)(c) of the MB Listing Rules or Rule 11.12A(2) of the GEM Listing Rules.
 Paragraph 27A in Appendix 1A to the MB Listing Rules and the GEM Listing Rules, Rule 8.10(1)(a) of the MB Listing Rules and Rules 11.03 and 11.04 of the GEM Listing Rules in respect of such controlling shareholder(s).
 Rule 8.04 of the MB Listing Rules (Rule 11.06 of the GEM Listing Rules).
 Rule 8.04 of the MB Listing Rules (Rule 11.06 of the GEM Listing Rules).