The Stock Exchange of Hong Kong Limited (the “Exchange”) published a Guidance Letter HKEX-GL97-18 (the “Guidance Letter”) on 6 July 2018 for listing applicants in the internet technology sector or that have internet-based business models (the “IT Sector”), setting out the Exchange’s approach towards such companies to facilitate their listing within the existing regulatory framework.
3 major issues faced by the listing applicants within the IT Sector
The listing applicants within the IT Sector often face the following issues:
- These companies, in particular the internet-based companies, have a high degree of reliance on the internet platforms operated by their parent companies or major suppliers, which may lead to extensive connected transactions under the Listing Rules;
- These companies often place greater emphasis on retaining and incentivizing talented persons and staff through the grant of share option schemes, which may find the existing threshold for share option under the Listing Rules to be unduly restrictive and burdensome; and
- These companies may find it difficult in demonstrating compliance with relevant laws and regulations when the laws and regulations are yet to be fully established.
The Guidance Letter
High degree of reliance
The Exchange normally considers reliance to be a disclosure issue and requires a new applicant to disclose details of its reliance upon a substantial shareholder, connected persons, a major supplier or a major customer in its listing document. However, where the degree of reliance is extreme, the Exchange may have a concern on whether the applicant is suitable for listing.
Whilst there is no bright line test to determine whether an applicant’s reliance on a single major supplier or customer is an extreme case which impacts on suitability for listing, the Listing Decision HKEX-LD107-1 sets out factors which the Exchange considers in assessing whether an applicant’s reliance on a major customer or supplier is so material as to impact suitability:
- whether the applicant’s business model can be easily changed to reduce the level of reliance;
- whether the level of reliance is likely to decrease in the future;
- whether the whole industry landscape is dominated by a few players making it unlikely for companies in the same line of business to break off the reliance;
- whether the applicant can demonstrate that the reliance is mutual and complementary; and
- whether the applicant is able to maintain its revenue in the future in light of the reliance.
Furthermore, the Exchange is now prepared to allow a higher level of reliance on their parent companies, connected persons, major suppliers and major customers, and place less emphasis on the need to demonstrate a reduction in reliance if the applicant is able to demonstrate the following:
- the whole industry landscape is dominated by a few players that may or may not be the applicant’s parent company (or other connected persons / major suppliers / major customers);
- it is difficult for the new applicant to use the services of an alternative provider to reduce the level of reliance as the services that the applicant relies on are provided by a small number of dominant major providers in competition with each other;
- there were legitimate commercial reasons for the applicant and its parent company (or other connected persons / major suppliers / major customers) to enter into the transactions, and these were on normal commercial terms in the ordinary course of business of the issuer as well as the parent company (or other connected persons / major suppliers / major customers), and will (in the case of transactions with a connected person) be subject to continuing connected transaction requirements under the Listing Rules after listing; and
- there are long term agreements in place between the applicant and the parent company (or other connected persons / major suppliers / major customers) to provide continued access to the parent company’s (or other connected persons / major suppliers / major customers) platform or services.
The applicant would also be required to disclose the following information in its listing documents:
- the areas of reliance and the reason for the applicant’s business model that results in the reliance;
- details on the arrangements (including fees and charges) for the services rendered by the parent company/connected persons/major suppliers/major customers;
- details of any mitigating factors to reduce the risk of reliance; and
- risks associated with such reliance, including a description of the “worst case scenario” if the services are no longer available.
The Exchange would evaluate connected transactions carefully on a case-by-case basis and it has the discretion to decide if the applicant is unsuitable for listing even if it meets all the factors as set out above.
Quantifying caps for continuing connected transactions
For applicant who has a short operating history or is in a growth phase, it may be difficult to accurately estimate the amount of payment required under a cooperative agreement for the use of the platform of the applicant’s parent company or another connected person. Accordingly, to impose an arbitrary monetary cap may be unduly burdensome and not in the interests of the new applicant’s shareholders after listing.
In light of the aforesaid, the Exchange proposes to grant waivers from strict compliance with the requirement to set a monetary annual cap under the Listing Rules 14A.53, and allow the annual cap to be set as a formula on a case by case basis. The applicant would have to demonstrate the necessity for such an arrangement and that the formula to be adopted is in line with historical and prevailing commercial practices. The issuer will also have to demonstrate that it merits the continuing connected transaction at the time it is to be renewed and that the circumstances continue to justify the granting of the waiver.
Extensive use of share incentive scheme
Companies in IT Sector often retain and incentivise talented persons through the grant of share options, which may find the existing 10% overall cap and the one percent cap on individual participants under Listing Rule 17.03 to be unduly burdensome. The limit of ten years for the securities under the option to be taken up may also be considered as too restrictive.
The Exchange may, at its discretion and on a case-by-case basis, grant or reject a waiver from strict compliance with (i) the percentage cap requirement on outstanding share options under a share option scheme and allow a higher cap to be set; and (ii) the ten-year limit within which securities must be taken up under the option and allow a longer period to be set.
An applicant should demonstrate the necessity for a higher cap / longer option period in its case. The listing documents should also include the material terms of the scheme and the circumstances when it may grant options beyond the 10% cap under the Main Board Rules.
Unestablished regulatory environment
Companies in IT Sector often operate in sectors for which local laws and regulations are still evolving, and are still being drafted. This creates uncertainty and difficulties for applicants to prove its compliance given the evolving regulatory environment in which they operate.
If the relevant laws and regulations applicable to an applicant are still developing and are not expected to be promulgated in the near future, the Exchange would normally expect disclosure of the associated risks in the listing document to be sufficient. In these circumstances, a legal opinion would not be required to cover compliance with the unimplemented laws and regulations.
However, if it is clear that draft regulations affecting the applicant’s business will be promulgated in the near future, the applicant would have to demonstrate, with the support of a local legal opinion, that it is able to comply with the requirements of the draft regulations in the event that the draft regulations are promulgated in the form as set out in public notices of the regulations.
In gist, the Guidance Letter is the Exchange’s response to calls for adaptations to the Listing Rules to suit the particular characteristics of companies of the IT Sector. Based on the Guidance Letter, listing applicants of the IT Sector may:
- list with a higher level of reliance on parent companies/connected persons/major suppliers/major customers if they fulfill certain criteria;
- provide the annual caps for continuing connected transaction in form of a formula instead of a monetary cap;
- seek waiver to allow: (i) a higher percentage cap on outstanding share options to be granted; and (ii) a period longer than the permitted 10 years for securities to be taken up under options; and
- not be required to provide a legal opinion to support its compliance of laws and regulations that are still developing and are not expected to be promulgated in the near future,
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This article does not constitute legal advice or a legal opinion on any matter discussed and, accordingly, it should not be relied upon. It should not be regarded as a comprehensive statement of the law and practice in this area. If you require any advice or information, please speak to practicing lawyer in your jurisdiction. No individual who is a member, partner, shareholder or consultant of, in or to any constituent part of Interstellar Group Pte. Ltd. accepts or assumes responsibility, or has any liability, to any person in respect of this article.