CSRC's New Circular Puts Spin-off Listings in the Spotlight

All such merits have caused a number of A share-listed companies to formulate their own spin-off plans. As early as July 2000, Beida Jade Bird Universal (08095, HK) was separated from its A share-listed parent company, Beijing Tianqiao Beida Jade Bird (600657, SH), and made its listing on the GEM board of the Hong Kong Stock Exchange. Tong Ren Tang Technologies (08096, HK) followed suit, separating from Beijing Tongrentang Ltd (600085, SH) and making its IPO in Hong Kong in 2004. Other spin-off cases include Chengdu Top Tech (08135, HK), Shanghai Fudan Microelectronics (08102, HK) and Lianhua Supermarket (00980, HK). Lianhua's listing is the first spin-off of an A share-listed company that has been listed on the Hong Kong Stock Exchange's Main Board. More A share-listed companies' spin-off plans are reportedly in the works.

However, there are potential negative side effects to an Offshore Spin-off Listing. In the eyes of the investors of the parent company, a spin-off could dilute their shareholding value in the spun-off subsidiary. But an even greater concern focuses on the parent company's ability to retain a "critical mass" of operations and assets that will be able to support its separate listing status after it spins off its core business for an offshore listing. There is a risk that such a spin-off would seriously erode the interests of its shareholders. It has been proven that an existing listed company's announcement for a proposed spin-off usually leads to a sharp decline in its share price. Most capital markets regulators across the world have therefore issued special regulations to enhance supervision over spin-off actions to protect the interests of public shareholders.

For many years, the CSRC treated applications for Offshore Spin-off Listings filed by A share-listed companies on a case-by-case basis. There has been considerable speculation in the market as to what constituted the CSRC's bottom line in making a decision on spin-off applications. Trying to anticipate what the CSRC's ultimate criteria would be loomed large when it came time for listed companies, as well as the professional counsel they engaged, to determine and design their spin-off plans. The CSRC has never publicly addressed this issue. Such discretionary standards applied to spin-off listing applications have been so unclear that many A share-listed companies have been baffled. Many A share-listed companies eagerly hope for the cloud of uncertainty and obscurity around spin-off applications to be finally lifted.

New Criteria and Supervisory Requirements

The long-expected Circular finally released by the CSRC only sets out a general framework in the Offshore Spin-off Listing field, making it likely that the CSRC will be providing further explanations or elaborations in the future.

Application of the Circular

Section 1 of the Circular first specifies that the Circular is applicable to the Offshore Spin-off Listings by enterprises controlled by existing domestically listed companies (Controlled Subsidiaries). The Circular is silent on the definition of "control", which definition shall be subject to further clarification as to whether it means more than 30% shareholding, 50% shareholding or the single biggest shareholding, although the Circular appears to exclude its application to any other entities in which a domestically listed company (Listed Parent Company) has an equity interest, but over which it has no control. It appears that the requirement set out in Section 1 may be avoided if a Listed Parent Company restructures its shareholding in the subject entity to terminate its "control" in order to carry out an offshore spin-off listing that will not be subject to the Circular. However, under the Circular, it is unclear if a non-controlled entity of a Listed Parent Company that may or may not meet all the qualifications as set out below is entitled to conduct an Offshore Spin-off Listing.

Qualifications of a Listed Parent Company for the Purpose of an Offshore Spin-off Listing

Section 2 of Circular provides eight qualifications that a Listed Parent Company must meet in order for its controlled enterprise to offer and list its public shares on an offshore stock exchange. In these conditions the CSRC emphasizes the following:

(i) the Listed Parent Company must have been profitable in the past three years before the spin-off;

(ii) the contribution made by the Listed Parent Company to the registered capital of its controlled enterprise in the past three fiscal years shall not have been in the business and assets attributive to the use of proceeds received from the public offering by this Listed Parent Company in China;

(iii) entitlement of the Listed Parent Company to the distribution of the net profit of the Controlled Subsidiary as per equity interest (as reflected in the consolidated financial statements of the Listed Company for the most recent fiscal year) shall not account for 50% or more of the total net profit of the Listed Parent Company reflected in its consolidated financial statements;

(iv) entitlement of the Listed Parent Company to the net assets of the Controlled Subsidiary as per equity interest (as reflected in the consolidated financial statements of the Listed Parent Company for the most recent fiscal year) shall not account for 30% or more of the [total] net assets of the Listed Parent Company reflected in its consolidated financial statements;

(v) the Listed Parent Company must not compete with the Controlled Subsidiary in the same line of business, and each must have separate assets and financial accounts, with no management personnel in one entity allowed to serve concurrently in the other;

(vi) shareholding by the directors, officers and other related persons of the Listed Parent Company or the Controlled Subsidiary in the Controlled Subsidiary shall not account for 10% or more of the total share capital of the Controlled Subsidiary immediately prior to the offshore listing;

(vii) there must exist no circumstance where the capital or assets of the Listed Parent Company is appropriated by any individual, legal person, or other organization or related person who actually controls the Listed Parent Company, nor any major connected deal that undermines the interest of the Listed Parent Company; and

(viii) the Listed Parent Company must have committed no substantial irregularities in the past three years.

Among the above criteria, without doubt the most compelling are items (iii) and (iv). The once only rumoured CSRC "30% bottom line" has now been given an express clarification. Item (v) of this Section aiming to maintain independent operations between the Listed Parent Company and the spun-off subsidiary stresses the clear separation of assets, financial accounts and management between the Listed Parent Company and its subsidiary. Furthermore, item (vi) has been employed to avoid involvement of personal interests of the management of the Listed Parent Company or the Controlled Subsidiary in pursuing a spin-off project.

Approval Mechanisms

The Circular further adopts a set of mechanisms to ensure the independent listing status and continuous profitability of the listed parent company after the spin-off.

Resolutions of the Board of Directors and Shareholders Meeting Required

According to Section 3, the board of directors shall adopt resolutions to transact matters such as compliance with the Circular by the proposed Offshore Spin-off Listing, the scheme for the proposed listing, a commitment to maintain the independent listing status of the Listed Parent Company, and statements and prospects for the continuous profitability of the Listed Parent Company. Such details of the proposals submitted by the board of directors shall later be transacted and voted on an itemized basis at the shareholders' meeting. The above requirements of Section 3 may have been influenced by the Listing Rules of the Hong Kong Stock Exchange in this respect.

Moreover, if the directors and senior executives of the Listed Parent Company may hold shares in the Controlled Subsidiary pursuant to a share option scheme, the independent directors should first solicit the votes attributive to the holders of tradable shares (i.e., shares held by the general public). Following this, the share option scheme shall be subject to approval by half of the votes represented by holders of tradable shares present at the shareholders' meeting.

Introduction of a Financial Advisory System

Section 4 of the Circular has mandated the set up of a financial advisory system that will effectively reinforce control over the Listed Parent Company. According to Section 4, the Listed Parent Company shall engage a securities firm, which is registered with the CSRC and in the roster of qualified sponsor institutions, as its financial advisor for the purpose of maintaining its continuous listing status. The financial advisor bears a lasting responsibility for overseeing the continuous listing status and operational ability of the Listed Parent Company upon the offshore listing of the Controlled Subsidiary, from the spin-off application to the expiration of the remaining time of the Offshore Spin-off Listing and the following full fiscal year. The fact that the financial advisor will subsequently be required to submit a report to the CSRC and the stock exchange will make it a watch dog of the post-spin-off compliance by the Listed Parent Company.

Information Disclosure

Section 5 also sets forth certain information disclosure requirements for the Listed Parent Company with respect to the offshore listing of its Controlled Subsidiary. The financial advisor is responsible for ensuring that the Listed Parent Company honours its information disclosure obligations when certain significant financial events occur.

Supervision of the Financial Advisor

Section 6 requires that a financial advisor shall be honest and trustworthy, diligently fulfil his duties, faithfully discharge his duty to issue relevant financial advisor's reports, and supervise and guide, on an ongoing basis, the Listed Parent Company to maintain its independent listing status after the spin-off. The performance of these duties shall be subject to CSRC supervision.

CSRC Approval

CSRC approval for such an Offshore Spin-Off Listing has been emphasized in Section 7 of the Circular.

Exclusion of the Circular's Application

Section 8 of the Circular further clarifies that it shall not be applicable to domestically listed companies that simultaneously issue A shares and B shares.

The Circular's Likely Influence

The Circular may affect the progress of some A share-listed companies in their attempts to list their subsidiaries' offshore, as they have to adjust themselves to meet the new standards. But a number of A share-listed companies may well continue unimpeded with their spin-off efforts.

Moreover, the Circular only governs domestic A share-listed companies making Offshore Spin-off Listings, and thus does not affect the offshore spin-offs conducted by red chips or offshore listed companies spinning off domestic businesses to be listed at the Shanghai or Shenzhen stock exchanges. Such a spin-off normally would be subject to the corresponding supervision authorities' regulations where such parent company is listed.

It is certainly an improvement for the China's securities regime to increase transparency and predictability and the Circular will prove most welcome to practitioners and market watchers. As with most new rules, especially those that lack detailed provisions, time will be required to identify issues and to await further elaboration on the Circular provided by market watchers.

For example, some may suspect that the reason that TCL received the CSRC's approval, despite the seemingly high proportion of profits contributed by its mobile handset unit, is attributable to the fact that the financial statements submitted by the parent and the subsidiary were not consolidated. This indicates a possible defect in the Circular. In addition, the 50% and 30% limits for net profits and net assets, respectively, laid out by the Circular may be dodged by crafty arrangements in the financial operations of the group companies for containing the Controlled Subsidiary within the permitted ceilings to avoid these restrictions. Therefore, the actual effects of the new Circular will be subject to further testing of complex capital market practices.

Nevertheless, the Circular is an active response to changes in the Chinese capital market and it does provide the market with some clear instructions on spin-off listings. At the very least, although more is obviously hoped for, it will help to curb irregularities seen in existing listed companies' subsidiary listings, and give domestic investors more certainty in evaluating and planning their investments.