Unloading State-owned Shares: Another Trial Under New Rules

The differential pricing between tradable shares and non-tradable shares is caused quite naturally by the relative liquidity of the shares. Non-tradable shares are bought and sold at a substantial discount to the tradable shares of the same company due to the challenging government approvals that are required in order to resell those shares. The differential pricing between the tradable shares listed in the PRC (generally referred to as 'A Shares') and tradable shares listed in Hong Kong (generally referred to as 'H Shares') is due to the limited supply of tradable shares in quality companies in the PRC. This limited supply of shares for purchase by investors in China has caused the price to earnings ratios of many companies listed on PRC stock exchanges to vastly exceed international norms. As a result, for those companies that are dually listed on a PRC stock exchange and the Hong Kong Stock Exchange, their common stock typically trades at much higher prices, on an equivalent currency basis, on the PRC stock exchange versus the Hong Kong Stock Exchange (HKEx).

Differential pricing has recently caused difficulties in the simultaneous listing of companies on both the HKEx and the Shanghai or Shenzhen Stock Exchanges. Such difficulties are due to requirements under PRC Company Law(中华人民共和国公司法) that shares offered at the same time must be sold at the same price. It was hoped that this year there would be one or two companies able to accomplish such a simultaneous dual listing. But due to the recent decreases in the PRC stock exchange indexes, in part because of the Circular, it is now understood that these potential companies are pursuing initial listing only in Hong Kong, to be followed later by potential listings in Shanghai or Shenzhen.

The differential pricing of A shares and H shares for those companies that are already dually listed is also a hurdle to acquisition transactions. There have been a few instances where takeovers of such dually listed companies have apparently been abandoned due to difficulties in justifying paying a price to all shareholders that represents a premium to the A share price.

The differential pricing of tradable shares and non-tradable shares has also caused difficulty in connection with acquisitions of non-tradable shares. This has come about as a result of the mandatory general offer rules under the PRC Takeover Code (Administration of the Takeover of Listed Companies Procedures). In connection with the acquisition of any shares (whether tradable shares or non-tradable shares) representing 30% or more of a company listed on the Shanghai or Shenzhen Stock Exchanges, the acquirer is required under the PRC Takeover Code to make a general offer to acquire all of the outstanding shares of such a company at a price no less than a specified minimum price.

For tradable shares, the minimum price is the greater of either the recent purchase price by the acquirer, or 90% of the 30-day trailing average market price for the shares on the Stock Exchange. The CSRC has apparently been deluged with requests for exemption from this requirement because 90% of the 30-day trailing average of the market price of the tradable shares is generally in vast excess of the purchase price of the non-tradable shares purchased by the acquirer. Potential acquirers have apparently indicated to the CSRC that if they are required to make a general offer for the tradable shares at such a higher minimum price, then they cannot afford to acquire the non-tradable shares.

PREVIOUS ATTEMPTS TO IMPLEMENT THE SEGMENTED SHARE STRUCTURE

As a result of the negative effects discussed above, as well as others, the PRC government has been seeking avenues to integrate the segmented share structure for some time. Unfortunately, each previous attempt has been halted due to concerns related to the negative impact on the prices of the tradable shares.

The Circular is the third policy trial after the abandonment of two previous trials in 1999 and 2001. In December 1999, the CSRC launched the first trial to unload non-tradable shares by offering such shares to public investors at a price range set between the net asset value per share, and 10-times the earnings per share.

The two pilot companies, China Jialing Industrial and Guizhou Tyre Company, both priced their non-tradable shares at 10-times their respective average earnings per share for the preceding three years. The share prices of these two companies' tradable shares plunged after the announcement and the offerings of non-tradable shares were not fully subscribed by investors. As a result, the first trial was abandoned.

After the failure of the first trial, the State Council issued the Administration of Reduction of State Share Holdings to Raise Funds for Social Security Tentative Procedures (Tentative Procedures) to launch a modest program to reduce state share ownership in June 2001. Section 5 of the Tentative Procedures required that SOEs launching IPOs sell 10% of their state-owned shares to public investors at the listing price. Subsequent to this announcement, major indexes on the Shanghai and Shenzhen Stock Exchanges fell substantially to finish significantly down by October 2001. On October 22 2001, the CSRC announced that Section 5 of the Tentative Procedures would be suspended while a new proposal for reducing state-owned shares was being worked out.

In January 2002, the Development Research Center of the State Council unveiled a new proposal to grant holders of tradable shares of PRC listed companies the right to purchase non-tradable shares in such a company at "fair value" (which may be less than the market price of the tradable shares). Even though the PRC government emphasized that this was merely a proposal, its existence contributed to the perception that the implementation of a plan to sell non-tradable shares was imminent and thus contributed to a significant downward trend in the relevant indexes. From January 2002 to the end of June 2002, the Shanghai Composite Index dropped 39% and the Shenzhen Composite Index fell 44%.

In June 2002, the State Council announced a halt to the sale of State-owned shares on domestic stock markets, excluding State-owned companies seeking listing overseas.

NEW RULES

The Circular sets out a procedure by which listed companies participating in the pilot programme (trial companies) may apply for a percentage of the non-tradable shares held by their controlling shareholders to be reclassified as tradable shares. The procedure requires, among other things, the approval of the shareholders of the relevant trial company. In connection with the issuance of the Circular, the CSRC has also raised the possibility of eliminating the separation between tradable and non-tradable shares in connection with future IPOs.

The Circular provides, among other things: (i) a selection of the trial companies; (ii) information disclosure requirements for the trial companies; (iii) procedures for the extraordinary meeting of shareholders to adopt plans to reclassify non-tradable shares as tradable shares; and (iv) lock-up restrictions on the sale of non-tradable shares that have been reclassified as tradable shares through the pilot programme. The Circular also emphasizes protection of the rights of tradable shareholders.

Selection of Trial Companies

Section 1 of the Circular provides that the CSRC will choose the trial companies based on (i) the expressed interests, if any, of the shareholders of listed companies to engage in the pilot programme; and (ii) the recommendations of sponsors. The shareholders of each trial company shall decide and adopt their own plan for reclassification of non-tradable shares.

Information Disclosure

Section 2 of the Circular sets forth information disclosure requirements for each trial company in connection with the pilot programme.

· A trial company must disclose its participation in the pilot program upon such confirmation from the CSRC. The trial company must also apply for a suspension in trading of its tradable shares.

· Within two business days from the adoption of the board resolution to reclassify non-tradable shares as tradable shares, a trial company must publicly announce: (i) the board resolution; (ii) the description of the reclassification plan; (iii) the opinions of independent directors; (iv) the recommendations of the sponsors; and (v) the notice of the extraordinary meeting of shareholders. At the same time, a trial company is required to apply for the resumption of trading of its tradable shares on the business day immediately following the announcement.

· A trial company shall apply to suspend trading of its tradable shares before the extraordinary meeting of shareholders. The suspension shall last from the day following the recorded date of the extraordinary meeting of shareholders to the announcement of the resolutions of such a meeting.

· A trial company must publicly announce the resolutions of the extraordinary meeting of shareholders within two business days and apply for a resumption in trading of its tradable shares.

Extraordinary Meeting of Shareholders

Section 3 of the Circular provides that shareholder approval, including public shareholders' approval, is required for the adoption of any share reclassification plan for a trial company.

· In connection with the extraordinary meeting of shareholders of a trial company, the public shareholders of the trial company shall be informed of their rights and the conditions and procedures of exercising such rights.

· The notice of the extraordinary meeting of shareholders shall be published at least three times prior to the shareholders' meeting. An online voting system shall also be provided to facilitate the shareholders' exercise of their voting rights.

· The independent directors of the trial company shall collect proxies from the public shareholders for the voting of the reclassification plan.

· The reclassification plan shall be approved by more than (i) two-thirds of the voting rights held by all shareholders who are present in person or by proxy and (ii) two-thirds of the voting rights held by the public shareholders who are present in person or by proxy.

If the disposal of non-tradable shares of a trial company is required to be approved by relevant regulatory authorities, such regulatory approvals must be obtained and announced before the extraordinary meeting of shareholders. Such approvals are required for transfers of shares of companies in various regulated industries, such as the banking or insurance industry.

Lock-up Restrictions

Section 5 of the Circular provides the following requirements for the gradual release of the non-tradable shares into the stock market, after being reclassified as tradable shares.

· Within 12 months of the reclassification of non-tradable shares into tradable shares (lock-up period), the holders of such newly transformed shares may not sell or transfer their transformed shares through stock exchanges.

· After the expiration of the lock-up period, a holder of non-tradable shares holding more than 5% of the total issued share capital in a trial company may not sell, through public transactions on the stock exchange: (i) more than 5% of the company's total outstanding shares within 12 months; or (ii) more than 10% of the company's total outstanding shares within 24 months.

· When total sales of shares previously classified as non-tradable, by any holder through public transactions over a stock exchange, reaches 1% of the total outstanding shares of a trial company, the selling shareholder must make a public announcement of such a fact within two business days of its occurrence.

Sponsors and Stock Exchanges

The Circular requires that trial companies engage sponsors to conduct due diligence, issue recommendations in connection with reclassification plans, and assist in the implementation of such plans. Each sponsor is required to designate three representatives for such an engagement.

The Circular provides that the stock exchanges shall review the application documents submitted by the trial companies relating to reclassification plans and monitor the sales of transformed shares and related information disclosure. The Circular also instructs the stock exchanges and securities depositary and clearing entities to adopt practice guidelines to govern the pilot program. To this end, the Shanghai Stock Exchange, Shenzhen Stock Exchange and China Securities Depository & Clearing Corporation jointly issued, on May 8 2005, the Pilot Reform Projects Regarding Separation of Equity Ownership and Trading Rights of Listed Companies Operational Guidelines.

Future Initial Public Offerings

Although the Circular does not address the issue of whether companies that offer their shares publicly in the future will continue to carry the distinction between tradable and non-tradable shares, the CSRC spokesman has indicated that, subject to market conditions and a relatively stable pricing environment, the regulator will choose "an appropriate time" to eliminate the distinction between tradable and non-tradable shares for future IPOs.

MARKET REACTION TO THE NEW RULES

On May 9 2005, the CSRC announced that four listed companies had been selected for participation in the pilot program. The four companies include the Shanghai Zi Jiang Enterprise Group, Sany Heavy Industry, Tsinghua Tongfang and the Hebei Jinniu Energy Resources Company. These companies have a combined market capitalization of about US$2.4 billion, or about 1% of China's total.

The announcement of the trial project was made before the start of trading on May 9. News of the event sent the Shanghai and Shenzhen Stock Exchanges to a string of new six-year lows. Although the proposed reclassification plans published by the four selected trial companies offered various cash and/or stock compensation packages to their tradable shareholders, the market reacted negatively as investors' again feared substantial dilution of their tradable equity. Within two weeks from the announcement of the four selected trial companies, the Shanghai Composite Index and Shenzhen Composite Index tumbled 7.5% and 7.9%, respectively.