Authors
Hayden Flinn  (范凱敦)
Partner

Richard Mazzochi  (馬紹基)
Partner

Anne Louie  
Senior Associate

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Richard Mazzochi
(馬紹基)
Partner
T +852 3443 1046

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Hong Kong
Hayden Flinn  (范凱敦)
To be completed

Sydney
David Friedlander  
To be completed

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On 22 September 2006, the Hong Kong Securities and Futures Commission (SFC) published its conclusions on possible reform to the law relating to the public offering of shares and debentures. The conclusions follow a consultation process that began in August 2005. The SFC’s response is clearly based on the majority response to its consultation paper. There will be important changes to some current market practices. Proposed legislative amendments will follow in due course.

You can view a summary of the SFC’s consultation conclusions here. The following paragraphs focus on the critical changes in the SFC conclusions paper.

A unified offering regime?

There was widespread public support for the proposition that the provisions of the Companies Ordinance (CO) relating to the public offering of shares and debentures be transferred to the Securities and Futures Ordinance (SFO). More difficult is how to make that regime “fit” with the existing investment advertisement regime already set out in the Securities and Futures Ordinance.

The SFC’s proposal is to regulate the offering of shares and debentures as a discrete part separate from the regulation of investment advertisements. The question is what difference will this make (other than to have the regulation of all types of securities in one piece of legislation)?

The SFC accepts the creation of a unified offering regime is a bridge too far. There was widespread support for harmonising the treatment of investment arrangements and instruments having the same characteristics. However, there was no broad consensus as to whether the offering of shares and debentures should be regulated in the same way as advertisements for securities.

Underlying the lack of consensus is a concern that a unified approach may distort the level of disclosure required for different types of offers. Based on our experience in other leading markets, it is possible to create a harmonised regime whilst giving due recognition to the significant differences in the nature of the disclosure required - for example, on an issue of shares as opposed to an issue of a highly structured security whose return is linked to the performance of another asset. Without informed debate about these issues, the reform risks simply moving the regulation of shares and debentures from the Companies Ordinance into the Securities and Futures Ordinance as a discrete part. The danger of this being that it would have no due regard to the overlap with the regulation of securities, collective investment schemes and regulated investment agreements.

Structured products

A significant proposal is to:

• carve out “structured products” from the definition of “debentures”. A structured product is a product which “in addition to exposure to the credit or default risk of the issuer (or guarantor), contains an exposure to an underlying asset, opportunity or risk that is usually unrelated to the issuer or the guarantor”; and
• formulate non-statutory product codes or guidelines tailored for products with similar characteristics.

Structured products will be regulated under the Securities and Futures Ordinance investment advertisement regime.

This proposal reflects the regulatory arbitrage that exists between:

• warrants - regulated by the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (HKSE Listing Rules);
• retail bonds linked to an underlying asset such as a share, a basket of shares, index, credit etc - regulated by the Companies Ordinance; and
• equity linked instruments also linked to an underlying asset - regulated by the Securities and Futures Ordinance (as a “security”).

This proposal will remove that arbitrage (there is no suggestion of any change to the regulation of warrants by The Stock Exchange of Hong Kong Limited (Hong Kong Stock Exchange), although amendments were recently made to some aspects of the HKSE Listing Rules that apply to warrants).

How will this affect you?

Significantly, this means a prospectus will not be required for the issue of structured retail bonds. Instead, the offering material will be regulated by the SFC under the Securities and Futures Ordinance. This means much more flexibility in the approval process including the ability to issue structured retail bonds on a “tap” basis under programs approved by the SFC annually, rather than on each occasion that a bond is to be issued (much in the same way as equity linked instruments are currently issued). This will remove much of the delay experienced by issuers under the existing debenture regime.

Plain vanilla offers of bonds and shares will remain subject to the prospectus regime.

Focus of prospectus regime to move from a document-based approach to transaction-based approach

This proposal was widely endorsed in submissions to the SFC and is a sensible development. The SFC has acknowledged the need for changes to the safe harbours to reflect this change.

The most significant type of transaction that will require a safe harbour after this proposal is implemented is “top up placings”. These are currently implemented with oral offers that fall outside the prospectus regime. The existing “professional investors” safe harbour will need to be closely examined to determine if it provides sufficient protection for top up placements.

Offer to the public concept is retained

The SFC proposes to retain the concept of offer to the public. We maintain that this concept is uncertain and would be redundant if proper safe harbours for all types of offers are provided.

Disclosure standard

The SFC is pursuing its proposal to move the overall disclosure standard into the body of the legislation adjacent to the liability provisions and supplement this standard with prescribed content requirements in subsidiary legislation. The majority of respondents supported this proposal but there is a general concern that if the disclosure standard is too vague, issuers may be advised to insert so much information into a prospectus with the result that the prospectus becomes difficult to read.

The SFC does not agree that a general disclosure standard is necessarily unclear and comments that similar standards exist in other international markets such as Australia, Singapore and the UK. In Australia the disclosure standard is complemented by the statutory requirement that any disclosure document should be “worded and presented in a clear, concise and effective manner”. Earlier this year, the Australian regulator published a draft policy statement on “Better prospectus disclosure” commenting that a prospectus should be as short as possible and that a long and complex prospectus is not an effective way to communicate information. The Australian regulator also suggested that certain information should be incorporated by reference (see below “Incorporation by reference” section).

The SFC has commented that it intends to consult the public about whether to require a prospectus to be worded and presented in a clear and concise manner. It also intends to encourage “plain English” to be used in preparing a prospectus. We support the use of plain English having developed the drafting of plain English disclosure documents in Australia.

There is support for the overall disclosure standard to be supplemented with subsidiary legislation containing prescribed content requirements that apply to different types of debt and equity offerings. It is important that flexibility is built into the subsidiary legislation to differentiate between all types of debt and equity products and to allow for the development of new products. We suggest the content requirements should be generic rather than a detailed checklist that results in formulaic disclosure.

The SFC is to further consult the market on the specific content requirements.

Incorporation by reference to encourage shorter prospectuses

To encourage shorter prospectuses the SFC will permit “incorporation by reference” of certain information but proposes to limit it to information filed with the relevant regulatory authority and displayed on that regulator’s website. The SFC proposes to invite public comment on what information should be incorporated by reference.

Incorporation by reference is permitted in many jurisdictions. In Australia, the information must be lodged with the Australian regulator and investors must be able to obtain a copy of the information free of charge during the application period. ASIC (Australian Securities and Investments Commission) has suggested in its recent draft policy statement on prospectus disclosure, that technical and detailed financial information should be incorporated by reference. It is on a drive to have issuers incorporate by reference to a greater degree.

In the UK, information that can be incorporated by reference includes: annual and interim financial information, constitutional documents and circulars to security holders. Before the Prospectus Directive was introduced, in the UK an issuer was able to incorporate financial statements that were not in existence at the time a prospectus was published. The Prospectus Directive prohibits this. Now only information that is in existence at the time the prospectus is published and which has been approved or filed with the competent authority that is responsible for the approval of the prospectus may be incorporated by reference. Each prospectus must contain a summary that, briefly and in non-technical language, conveys the essential characteristics of, and risks associated with, the issuer, any guarantor and the securities to which the prospectus relates. That summary may not incorporate information by reference.

We also suggest that certain relatively standardised sections, eg the summary of the issuer’s constitution, the difference in laws between the place of incorporation of the issuer and Hong Kong, could be incorporated by reference.

This is a welcome development and should lead to shorter and more reader-friendly prospectuses.

Prospectus liability and reasonable belief defence

The SFC proposes that the scope of the prospectus liability regime will be expanded to include issuers and/or offerors of shares or debentures, and each person who accepts, and is stated in the prospectus as accepting, responsibility for the prospectus. The SFC also proposes that, “promoters” and people who “authorise the issue of a prospectus” will no longer be subject to prospectus liability provisions. These amendments will clearly help to clarify who will be subject to the prospectus liability regime.

The SFC also proposes to modify the due diligence defence so that it only applies if all reasonable enquires have been carried out. This change may alter issuers’ approaches to due diligence and verification. It may be necessary to establish a fully documented due diligence enquiry process for any public offer of shares or debentures. The proposed provision is conceptually similar to the corresponding provisions in Australia. The practice in Australia is for law firms to design a due diligence enquiry process that will satisfy the due diligence defence requirement. At the end of the process, law firms formally sign off that the due diligence process is sufficient to establish the due diligence defence.

In the consultation paper the SFC proposed that sponsors will be subject to the prospectus liability regime. The SFC has decided not to implement this proposal. The liability regime for sponsors remains a mixture of common law (in particular negligence), non-statutory duties under the Listing Rules and general securities laws provisions.

Pre-IPO research - a sensible starting point

The SFC received substantial comments on its proposal and this was, as expected, the most controversial topic in the consultation paper.

The SFC reiterated its policy concerns on pre-deal research reports by connected analysts, namely:

• the potential inequality of information due to their “connection” with the issuer; and
• inaccurate information contained in pre-deal research reports, which may be used by issuers as an alternative “selling document” without being subject to the same scrutiny (and liability) as prospectuses.

At this stage, the SFC does not propose to ban pre-deal research. Although all deal-related research poses regulatory challenges, recent global independence protocols go a long way to addressing the issues. The SFC will instead extend (and expand, where appropriate) the scope of the Code of Conduct for Persons Licensed by or Registered with the SFC to:

• ensure independence and objectivity of analysts concerning pre-IPO research;
• prohibit analysts from obtaining any forward looking information (both qualitative and quantitative forecasts) about the issuer and any material information not already contained in the draft prospectus or in the public domain. Subject to compliance with internal control and compliance procedures, the SFC has given the green light for an advanced draft prospectus to be provided to selected analysts (which may include connected analysts) for the purposes of preparing the research report.

A sponsor may be required to be present at all meetings between the listing applicant and analysts and confirm that no forward looking information, or material information not already contained in the draft prospectus, has been disclosed or provided to analysts at these meetings.

To “level the playing field”, the SFC also proposes to require that the red-herring (generally referring to a draft prospectus that is very close to the final document) be made available to the public after the relevant listing application has been heard and the in-principle approval has been granted by the Listing Committee of the Hong Kong Stock Exchange. The SFC will liaise with the Hong Kong Stock Exchange on the mechanisms for implementing this proposal and will also invite the market to comment on a draft bill consultation paper.

Lastly, the SFC does not propose to treat pre-deal research for a follow-on offering in the same way as pre-IPO research. Any new rules to be introduced about pre-IPO research pursuant to the consultation conclusions would not apply to follow-on offers.

Overall, with one exception, we believe that the SFC’s revised approach to pre-deal research is a sensible one. We were concerned about the proposals in the SFC’s consultation paper. However, our previous concern about “connected analysts” being placed at a disadvantage by the SFC’s initial proposal would appear to have been addressed. At this stage, it is unclear from the SFC’s consultation conclusions if the prohibition on forward-looking information would apply to any forward-looking information to be included in the prospectus. We believe the better approach would be to allow the issuer to give forward-looking information to analysts as long as that same forward-looking information is included in the red-herring (and the final prospectus) to be made available to the public.

In Australia, the Corporations Act currently allows a developed draft of the prospectus to be made available to sophisticated investors and to professional investors prior to the offer period. This arrangement recognises that this interaction with the market is useful and necessary for the price discovery process and for building up sub-underwriting and book-building interest in the offer. The draft is generally not as developed as a typical US red-herring. To date, this arrangement has not given rise to any significant regulatory implications in the Australian market.

Making the red-herring available to the public?

The SFC’s proposal would take the arrangement a step further by making a red-herring available not only to sophisticated and professional investors, but also to the general public. The SFC seems to be happy for a “pathfinder” to be provided to analysts whilst requiring a red-herring to be given to the public. If this is the case, we believe this is a good outcome and subject to our comments below, we do not see any reason why a red-herring should not be provided.

We must wait for the draft bill to see if the SFC is referring to a draft prospectus that substantially is the final prospectus without any offer price information. It will be interesting to see what safeguards will be proposed to ensure that the red-herring is subject to the full rigour of a prospectus verification process (but hopefully without extending the current prospectus liability framework to such draft prospectuses). How the public will be informed of material amendments to the red-herring as compared with the final prospectus will need to be carefully considered. Also would the issuer have to comment on market speculation or rumours reported by the media based on the red-herring?

A straightforward and systematic approach to dealing with these issues must to be taken to make sure the public is not subject to “information overload” just prior to the actual opening of the offer (which could take away from the effectiveness of the prospectus itself) and that the marketing of the offer is conducted smoothly.

Anti-avoidance

The SFC’s anti-avoidance proposal was received with mixed views by the market. Some of the main concerns expressed, as expected, were the extension of the time period from 6 to 12 months, the use of the on-sale offeror’s intention as a trigger for the application of the rule and the potential result of requiring an offeror in an on-sale, who may not be as familiar with the issuer’s business, to prepare a prospectus.

In light of the market’s response, the SFC has decided to reconsider its approach and to retain the anti-avoidance provision set out in section 41 of the Companies Ordinance for now. This is sensible as no global regulatory system has yet found an effective way to deal with secondary sale issues that solve more issues than they create.

From a policy perspective, the SFC noted that the prospectus exemptions most open to potential abuse are the “private-placement - offers to no more than 50 persons” exemption and the “small-scale offers - HK$5 million” exemption.

With that in mind and looking to the approaches adopted in Australia and Singapore, the SFC has decided to introduce an aggregation provision whereby:

• “closely related offers” made within 12 months (even if not by the same entity) will be aggregated when determining the offeree/size limits; and
• the SFC will be empowered to aggregate “closely related offers” within that period when determining whether the particular safe harbour has been abused.

The criteria for determining whether offers are “closely related” will be set out in SFC guidelines to be issued. The SFC will invite the public to comment in a draft bill consultation paper.

In Australia, ASIC has similar aggregation powers. ASIC’s power has rarely been, or needed to be, used.

Advertising to remain subject to vetting

The SFC issued marketing guidelines for listed structured products in September 2006. These were widely accepted by the market.

However each advertisement concerning unlisted structured products still needs SFC approval.

Despite the acceptance that listed and unlisted structured products are commercially similar, there is no proposal to unify the approach taken to marketing materials. We understand this approach is taken because advertisements for collective investment schemes are also vetted.

Next steps

The next step is for the SFC to issue a draft bill consultation paper that sets out the proposed draft amendments. The timing for that paper is unknown. With many of the proposals, the actual drafting is likely to raise contentious issues that will need to be carefully considered.