New Disclosure Standards for FICLS Prospectuses

- risks arising from reliance on overseas suppliers of raw materials, overseas customers and overseas technical services;

- risks arising from possible changes in PRC laws, regulations and policies granting preferential tax treatment to foreign investment enterprises;

- risks arising from possible changes in laws and regulations of the country or place of domicile of foreign investors relating to foreign investment in or technology transfer to the PRC;

- risks arising from changes in foreign currency exchange rates;

- details of laws and regulations on foreign investment in, and technology transfer to, the PRC of the country or place of domicile and headquarters of each foreign investor¹that has a 5% or greater shareholding in the issuer;

- details of any restriction on transfers of shares contained in the issuer's articles of association;

- details of connected transactions with foreign investors. The Provisions require disclosure of connected transactions between the issuer and each of its foreign investors during the three years prior to issue of the prospectus, together with details of applicable pricing standards. In addition, the prospectus must contain an opinion from the issuer's current auditors as to whether the connected transactions have been carried out on a fair basis, as well as details of specific measures adopted by the issuer to ensure fairness of connected transactions. The management discussion and analysis section of the prospectus must also disclose the total expected volume of connected transactions in the coming year;

- details of the principal contents of any market segmentation agreement entered into between the FICLS and any of its foreign investors; and

- various personal details of the foreign directors and senior management personnel, including positions held by them in other domestic and overseas organizations.

Consultation Period

The final promulgation of the Provisions was preceded by a ten-day public consultation period in which the CSRC invited comments on the draft regulations. The final Provisions differ from the consultation draft in a few respects. Most notably, the consultation draft required disclosure of the details of any project undertaken outside the PRC for which the proceeds of a domestic public offering would be used. Presumably that specific requirement has been omitted on the basis that under existing CSRC disclosure regulations, every prospectus must contain details of all principal uses of proceeds, regardless of where they are to be invested.

Scope of Application

The Provisions impose additional disclosure requirements on FICLS in addition to the general provisions of the Securities Law and the CSRC on the contents and form of prospectuses issued by domestic companies. FICLS established by investors from Hong Kong, Macau and Taiwan are also subject to the Provisions.

While not specifically stated in the Provisions, it seems implicit that they are intended only to apply to prospectuses to be issued by FICLS that are either already listed or preparing to list on a domestic stock exchange (and would not therefore apply in relation to FICLS that are listed on overseas exchanges). For this purpose, the Hong Kong Stock Exchange is an overseas exchange.

Issues Raised by the Provisions

Different Standards for FICLS

It is not clear why the CSRC has determined that FICLS should be subject to additional prospectus disclosure obligations beyond those that apply to PRC issuers generally. In principle, existing domestic prospectus disclosure requirements should be adequate for FICLS, as application of those requirements, and general disclosure principles, should dictate that information material to the issuing FICLS' operations or financial performance will in any event be disclosed in the prospectus. For example, in the absence of the Provisions, we would still expect risk factors covering those summarized above to be included in a domestic prospectus where they are significant to a particular issuer or offer. Equally, it is difficult to rationalize why, under existing PRC regulations, matters such as restrictions on share transfers and details of market segmentation agreements, which may also be relevant to non-FICLS issuers, are not required to be disclosed in prospectuses issued by those companies.

Equality of Disclosure

The Provisions principally require disclosure of information in relation to the foreign investors in a FICLS, and any transactions entered into by them with the issuer. No explanation is provided as to why disclosure of the same information is not required in respect of the issuer's domestic shareholders when the information might be relevant. As a FICLS and its public shareholders may be equally affected by transactions entered into between the issuer and its domestic shareholders, it would have been preferable for the Provisions to have required equal disclosure in relation to all shareholders holding above a stated minimum interest in the issuer.

Materiality and Discretion

Except as summarized above in Key Provisions, the Provisions also do not impose any materiality threshold in relation to disclosure. As a result, a FICLS may be required to disclose some specified information in relation to foreign shareholders who have very small shareholdings. Strict application of the Provisions may also lead to disclosure of information that is of no material significance to the issuer's business or financial results. For example, if a foreign shareholder in a FICLS does not have any obligation to transfer technology to the company, disclosure of the laws and regulations of the domicile of the foreign investor in relation to technology transfer to the PRC will have no bearing on the company.

It is hoped that in applying the Provisions, the CSRC will exercise its discretion so as to avoid disclosure of immaterial matters. One way of achieving this aim is for the CSRC to accept disclosure to it on a confidential basis of information that is not sufficiently material to warrant inclusion in the prospectus.

Connected Transactions

The additional disclosure requirements for connected transactions may cause concern for both issuers and their auditors. Existing CSRC regulations require disclosure of the financial impact on the issuer of connected transactions entered into during the three years prior to the issue. However, the Provisions would appear to require disclosure of details of all connected transactions entered into between the issuer and its foreign shareholders during the past three years, irrespective of their impact on the issuer.

In addition, the issuer's auditors are required to issue a fairness opinion in respect of those transactions. Fairness opinions of auditors are not required in respect of connected transactions entered into by other issuers under existing PRC securities regulations, and auditors may in particular cases be reluctant or unable to comply with this requirement. Forming an opinion on the fairness of transactions will generally involve consideration of various factors, including the normal market terms for each category of transaction, which the auditors may not be in a position to assess, particularly in relation to past transactions. Auditors are also likely to be concerned about the potential liability that may attach to fairness opinions.

A preferable way of dealing with such connected transactions would be to follow the Hong Kong approach, which involves the issuer's sponsors commenting on the fairness of ongoing connected transactions, with the auditors providing annual confirmations that the transactions have been entered into in accordance with the terms governing them and that they are in accordance with the issuer's pricing policies (if the transactions involve the supply of goods or services).

The Provisions give no guidance as to the consequences of any inability of auditors to issue a fairness opinion, either in respect of past or continuing connected transactions. In this case, clarification would be required from the CSRC; it may be that an issuer would need to amend the terms of any agreement in respect of which its auditors are unable to issue a fairness opinion. Clearly, this would not be possible in respect of transactions done prior to the issue.

Conclusion

The Provisions subject FICLS to additional prospectus disclosure obligations over and above those that apply to domestic listed companies. They offer no explanation as to why different disclosure standards should apply to FICLS, or why they target disclosure of matters relating to an FICLS' foreign investors, and not its domestic investors. The Provisions also impose additional obligations on FICLS in relation to connected transactions entered into with foreign investors, most significantly by requiring an issuer's auditors to issue fairness opinions in relation to such transactions. Accountants may have difficulty in complying with this requirement, and may also be concerned with potential liability issues. It is likely that not until the next listing or public securities issue by a FICLS will some of these issues be resolved.

Endnote

1 It is not clear from the text of the Provisions whether laws and regulations on foreign investment in, and technology transfer to, the PRC of both the domicile and the headquarters (which may be different jurisdictions) of the foreign investor are required to be disclosed.