Convertible Bonds: Will the Market Respond?

WHAT'S NEW ?

Further to the Tentative Procedures, the Implementing Procedures set out the particular requirements and procedures for the issue of convertible bonds by listed companies, including:

a) basic requirements on the issuer;

b) application and approval procedures;

c) issue and underwriting;

d) redemption, sell-back and conversion of the bonds issued;

e) disclosure of information; and

f) legal liabilities for violation.

Scope: Who is the Issuer?

The Company Law provides that "a listed company may issue corporate bonds convertible to shares," but falls silent on whether an unlisted company can issue convertible bonds. Article 2 of the Tentative Procedures stipulates that convertible bonds issued in Rmb in the PRC by listed companies and "Important State-owned Enterprises" are covered by the Tentative Procedures. The Implementing Procedures provide that they are applicable to the issue and listing of convertible bonds issued in Rmb in the PRC by listed companies. Therefore, unlisted companies, including unlisted "Important State-owned Enterprises," are out of the scope of the Implementing Procedures.

Requirements on the Issuer

In addition to the general requirements set out in the Company Law and the Tentative Procedures, the lead underwriter is required to examine a number of aspects of the issuer and reflect on its findings in the recommendation to the CSRC. Notably, the lead underwriter should review:

a) the distribution of dividends in cash over the past three years;

b) whether the core business of the issuer is competitive in the relevant industry and has growth potential;

c) whether the issuer has a good corporate governance structure;

d) whether the issuer's operations are independent from its related parties, such as controlling shareholders;

e) whether the issuer's assets have been misused by any related parties, and whether there are any material connected
transactions that are detrimental to the interest of the issuer;

f) whether there has been any material restructuring or change of capital over the previous one year period;

g) whether there has been any violation of regulations on the disclosure of information over the past
three years.

We can find similar requirements in a draft directive published by the CSRC on the restructuring of companies intending to go public. In view of the various problems of many listed companies on China's stock markets, exemplified by the growing number of loss-making listed companies and the well-publicized and

first de-listing of a listed company in April 2001, the CSRC is placing more emphasis on the quality of the issuer. This is an encouraging sign for investors, especially individual and non-professional investors.

The Underwriter's Role

One notable provision of the Implementing Procedures is that the issuer's lead underwriter will be responsible for recommending the issuer to the CSRC and submitting the application materials. The lead underwriter is also required to verify the issuer's application internally before submitting the recommendation and application, following the procedural requirements on verification for share issues. This reflects the developments over the past two years, namely that the CSRC examination procedures for listing applications have been gradually standardized and that the underwriters are given more and more responsibilities in the application process. Not surprisingly, Article 14 of the Implementing Procedures provides that the examination and approval procedures of the CSRC for the issue of convertible bonds will also follow the CSRC procedures for examining and approving share issue application.

Provisions on Issue and Trading

Of the 59 articles contained in the Implementing Procedures, 28 of them address the issue, redemption, sell-back, and conversion of the convertible bonds of listed companies.

Article 20 provides that conversion of the convertible bonds may occur six months after the date of issue. However, this is slightly different from the stipulation of the Tentative Procedures, which state that conversion may happen six months after the "completion" of the issue.

The Implementing Procedures require the issuer to enter into a security contract with a guarantor, who must provide a full guarantee covering the repayment of the principal and interest, penalties, damages, and expenses with respect to the convertible bonds to be issued. However, the Implementing Procedures give CSRC the discretion to waive such a requirement in accordance with "other regulations of the CSRC," which are unknown at this stage.

As to the redemption rights of the issuer and the sell-back rights of the investors, the issuer can redeem issued convertible bonds once in a given year, and investors can only sell the convertible bonds they are holding back to the issuer once in a given year.

Disclosure of Information

Disclosure of information is a very important aspect for securities regulation, and the CSRC is also moving in the direction of monitoring the market through improving disclosure by listed companies. In addition to the general disclosure requirements applicable to listed companies, the Implementing Procedures require the issuer to disclose information on all material changes in connection with its issued convertible bonds in its annual reports, interim reports, and extraordinary reports.

Similar to the disclosure requirements on major shareholders of a listed company, the Implementing Procedures require any investor holding 20% of the total issued convertible bonds of a listed company to report to the CSRC and the stock exchange and to make public announcements within three days of occurrence of the fact, as well as any subsequent change in the holding of 10% of the total issued convertible bonds of the listed company.

Liabilities for Violation

A notable provision in this section concerns the liabilities for violation by the issuer when the issuer cannot live up to its profit forecast. It has not been uncommon in the past for newly listed companies to perform badly on their profit forecast, or even to post losses in the first year after their initial public offering. In a move to curb the practice of inflating profit forecasts and to prompt the issuer to be more responsible for its promises, the Implementing Procedures stipulate that in certain cases where actual profit is lower than forecast profit, the issuer should give reasonable explanations and public apologies, and the CSRC will criticize the issuer in public. In cases of posting losses in the year the convertible bonds are issued, the CSRC will criticize the issuer and, for a period of two years, suspend the acceptance of any application from the issuer for the issue of securities.

IMPACT

If the Tentative Procedures can be seen as forming the skeleton of the laws regulating convertible bonds, then the promulgation of the Implementing Procedures can be regarded as adding flesh to the bones. Together with the three standard formats promulgated by the CSRC at the same time, the Implementing Procedures provide the detailed guidelines and instructions for prospective issuers that are easy to put into practice. This emphasizes the CSRC's efforts in improving standardization and transparency in market regulations.

Although the promulgation of the new regulations will enhance predictability of the approval process, which may attract interests from some listed companies, it is not the time to get optimistic about convertible bonds taking a greater share in China's securities market.

The lack of detailed, practical rules and guidelines, as well as the lack of transparency in governmental approval criteria and procedures, has not been specific to convertible bonds regulations. Two years ago the pace of the CSRC's legislation works began to accelerate and despite the lack of clarity in China's regulation of the securities market, hundreds of companies have been listed in the past few years. In contrast, the convertible bonds market has been particularly quiet.

China's stock market has been highly speculative, and poorly performing listed companies are very common. The public debt market, which has not been appealing to the issuers, is underdeveloped. Both the market condition and the high threshold set by the government may have contributed to the market's lack of interest in convertibles bonds. However, as the market grows and becomes healthier, the flexibility of convertible bonds may attract more issuers in the future. To that end, the Implementing Procedures have paved the way for future interested issuers. Just a few weeks after the promulgation of the Implementing Procedures, two listed companies announced that they planned to issue convertible bonds on the market. Will there be more? It is still early to tell.

END NOTES:

1 [Standard Formats of Information Disclosure by Companies Publicly Issuing Securities, No. 12: Application Documents for the Issue of Convertible Bonds by Listed Companies]: Chinese title: 公开发行证券的公司信息披露内容与格式准则(第12号)-上市公司发行否可转换公司债券申请文件 [Standard Formats of Information Disclosure by Companies Publicly Issuing Securities, No. 13: Prospectus for the Issue of Convertible Bonds]: Chinese title: 公开发行证券的公司信息披露内容与格式准则(第13号)-可转换公司债券募集说明 Standard Formats of Information Disclosure by Companies Publicly Issuing Securities, No. 14: Listing Announcement for the Issue of Convertible Bonds]: Chinese title: 公开发行证券的公司信息披露内容与格式准则(第14号)-可转换公司债券上市公告书