New Rules on Equity Offerings: Lifting the Ban on China's Share Sales

The Measures repeal previous regulations applying to the issuance of shares by listed companies.² They add considerable precision to the general requirements and prudential conditions to be complied with by an issuer offering securities to the public. In particular, the Measures clarify the three general requirements found in Article 13 of the PRC Securities Law³ (中华人民共和国证券法) (Securities Law) regarding the issuer's compliance record, profitability and accounting reports:

i. regarding the issuer's compliance record, the issuer's directors, supervisors and senior management personnel must not have breached their fiduciary obligation and obligation of diligence, and must not have been sanctioned by the CSRC in the 36 months before the issuance, or publicly blamed by a stock exchange in the 24 months before the issuance;

ii. the issuer must have been profitable in the last three accounting years. The issuer's profitability must be assessed based on the lower of either the net profits, or the net profits less deduction of non-recurring profits and losses. If the issuer has publicly issued shares in the past 24 months, the issuer's

profits must not have dropped by more than 50% between the first year and the second year following the issuance, and

iii. in any of the issuer's financial accounting report of the past year, no certified public accountant audit report contained a qualified opinion, an adverse opinion or a 'disclaimer opinion' (that is, a statement that an opinion could not be made). The issuer must have a steady cash flow and for the past three years, cumulative allocated profits (in cash or shares) must have amounted to at least 20% of the average distributable profits of the past three years. The issuer's past 36 months financial and accounting documents are also subject to requirements.

The Measures only set restrictions on the maximum amount of shares to be issued in a follow-on public offering when the subscribers are existing shareholders of the issuer. In such a case, the value of the issued shares should not exceed 30% of the issuer's share capital.

Under the Measures, the market price serves as a basis to determine the price of the new shares. This represents a challenge for issuers and additional pressure for underwriters. The price of shares issued in a follow-on public offering must not be lower than the average price of the issuer's shares in the 20 trading days prior to the publication of the prospectus or on the last day prior to the publication of the prospectus.

On the same day the Measures were issued, the CSRC also promulgated revised versions of two guidelines on the format and content of application documents and prospectuses for public offerings of shares.⁴ All directors, supervisors and senior managers of the issuer must sign the prospectus and guarantee the accuracy of the information disclosed in the prospectus, and bear joint and several liability.

Despite opinions to the contrary amongst PRC legal commentators, current legislation does not clearly recognise shareholders' pre-emptive rights to subscribe to new shares in the context of follow-on offerings.⁵ Since the revision of the Listed Companies Articles of Association Guidelines,⁶ listed companies enjoy greater flexibility in adding tailor-made rules to their articles of association, which could eventually facilitate the granting of preferential subscription rights to existing shareholders in the articles of association. However, such rights can normally be waived at a shareholders' general meeting.

Private placements

Before the release of the Measures, PRC regulations provided limited guidance on private placements.⁷ In comparison with the stricter conditions applying to follow-on public offerings, the Measures subject registered issuers performing a private placement to more basic requirements.

In a private placement, a listed company issues shares to a limited number of designated investors. The private placement is not marketed to the public and no offer document is required. The terms of the placement are usually described in a 'private placement memorandum' prepared by the issuer and delivered to designated investors. The use of "announcements, public inducements or disguised public offer methods" is strictly prohibited in the context of private placements.⁸ An issuer publishing such marketing materials could be denied the 'safe harbour' of Part Three of the Measures and may be requested to comply with the more onerous requirements applying to public offerings.

The shareholders' general meeting of the issuer is vested with a right to designate the subscribers. However, under the Measures the issuer cannot privately issue new shares to more than 10 designated investors. This provision appears inconsistent with the Securities Law whereby an issuance of shares to less than 200 designated investors could, subject to additional conditions, be considered a private offer.⁹ As opposed to the situation prevailing in certain jurisdictions where only institutional or professional investors complying with onerous quantitative requirements can subscribe to private placements, designated investors to a private placement are not subject to any qualification requirements under the Measures. However, if the designated subscriber is a "foreign strategic investor" under the Measures for the Administration of Strategic Investments in Listed Companies by Foreign Investors¹⁰ (Strategic Investment Measures), the investor will have to:¹¹

i. comply with quantitative requirements (owning offshore assets of at least US$100 million or manage offshore assets of at least US$500 million);

ii. obtain an 'in-principle approval' from the Ministry of Commerce prior to subscribing to new shares issued by private placement, and

iii. satisfy a range of prudential conditions.

Under the Measures, new shares issued by private placement are subject to a one-year lock-up period. New shares subscribed by the controlling shareholder or the de facto controller (and any enterprise controlled by the controlling shareholder or the de facto controller) are subject to a lock-up period of three years.

The Measures do not specify any restrictions on the amount of new shares to be issued in a private placement, nor require any blackout period between two private placements. The price of the newly issued shares must not be less than 90% of the average price of the issued shares within the last 20 transaction days before the date of pricing.

Examination and approval process

The procedure for the examination and approval of listed companies' applications is a three-stage process (see Figure 1). The process is described in the Measures on the Public Offering Review Committee (Review Measures), issued by the CSRC and effective on May 9 2006. Under the Review Measures, an ad hoc issuance verification commission consisting of seven members (selected amongst a group of five CSRC officials and 20 external professionals or specialists) is in charge of examining the application documents prepared by the issuer, its accountants, financial advisers, legal counsel and valuation institution. Following the examination, the commission makes a recommendation to the CSRC and will approve or disapprove the application mainly based upon its opinion. The Review Measures subject private placements to slightly simplified approval procedures.

Role of commission members

Many of the provisions in the Review Measures aim at ensuring the commission's impartiality and the confidentiality of the examination process. Commission members are treated as 'insiders' and cannot directly or indirectly benefit from information obtained during the examination process. Commission members cannot hold shares of the issuer and are precluded from contacting the issuer. Members of the commission must report to the CSRC if the issuer attempts to contact commission members. A commission member is ineligible to take part in examination if he/she (or one of his/her family members) acts as a director (including acting as independent directors) or holds a management position in the listed company. If the issuer or any similar person believes a commission member is or may potentially be in a conflict of interest position, the issuer or a person related to the issuer may request the CSRC to ask the commission member to restrain from acting. The commission must ensure the confidentiality of the issuer's commercial secrets and must ensure that the deliberation and vote results do not leak out.

Occurrence of material event

If a material event occurs after the commission has made a recommendation to the CSRC but before the CSRC approves the issuance, the CSRC may request the commission to reconvene a meeting and re-examine the issuer's application. In case a material event occurs after the CSRC's approval but before the issuance, the Measures require the listed company to suspend the issuance and report to the CSRC. If the event impacts on the issuance, the issuance must be re-approved by the CSRC. However, neither the Review Measures nor the Measures provide guidance on the definition of what constitutes a "material event".

Listing on the stock exchange

After the issuance of new shares has been approved, the issuer can wait up to six months after the approval to proceed with the public offering. After the offering has been approved and the securities issued, the issuer may apply for the securities to be listed on an exchange.¹² The stock exchange (Shenzhen or Shanghai) is in charge of approving listings.¹³ The issuer and the stock exchange will enter into a listing agreement pursuant to which, the exchange will provide trading facilities and services for the trading of the issuer's securities, in consideration of the payment of a listing fee by the issuer.¹⁴ The listing agreement also describes the rules and procedures relating to temporary suspension and termination of listing.

Use of raised capital

The Securities Law and the Measures provide guidance on how issuers should use or invest the proceeds of an offering. These rules aim at deterring an observed practice consisting of using funds raised in offerings to speculate on stock or real estate markets. As a general rule, capital raised in an offering of securities should be used for the purpose described in the prospectus.¹⁵ In addition, the Measures require the raised capital to be used in compliance with relevant national industrial policy, environmental protection law, land administration law and "other laws and administrative regulations". Unless the issuer is a financial institution, it must not use the raised capital for the following purposes:

i. to purchase "tradable or sellable financial assets" (including securities);

ii. entrust financial management services;

iii. lend the raised capital to a third party, or

iv. invest (directly or indirectly) in a company whose principal business activity is selling or purchasing securities.

The Review Measures also introduce a rule according to which the completion of the issuer's 'investment project' must not generate competition between the issuer and its controlling shareholder (or effective controlling person) within a same industry, or influence the "independence of the issuer's production and operations".

The Guidelines for the Contents and Formats for Information Disclosures by Companies That Offer Securities to the Public (No.11): Prospectuses for Public Offers of Securities by Listed Companies, issued by the CSRC and effective May 8 2006 (Guideline No.11) requires the prospectus to indicate the amount of funds to be raised (which, under the Measures, must not exceed the funds needed for the project contemplated by the issuer). The prospectus must also describe the investment project, its timetable, the progress of approval and examination procedures. Guideline No.11 also prescribes specific content requirements depending on whether the funds are to be used to expand the production of existing products, produce new products or for developing a new business. If the funds raised are expected to be insufficient to complete the project, the prospectus must indicate how additional funds will be raised to complete the project. Under the Measures, if the raised capital is to be used by the issuer to purchase assets or equity in mergers and acquisitions (M&A) transactions, the issuer must also disclose, at the time of convening the shareholders' general meeting, details of the concerned assets or equity, the anticipated purchase price, the basis for valuation, and whether there are conflicts of interests with shareholders or connected persons.¹⁶

Change of control

The Measures state that in case the private placement causes a change of control of the issuer, the private placement is subject to relevant CSRC regulations, such as the Measures for the Administration of Acquisition of Listed Companies (Takeover Measures), effective since December 1 2002, which are currently being revised by CSRC. Under the draft version of the Takeover Measures (Draft Takeover Measures) released by the CSRC on May 22 2006 for comments, an investor holding more than 30% of the shares of an issuer as a result of a private placement must make a general offer to shareholders. The investor can be exempted from this general offer requirement by making a commitment not to transfer its shares during a three-year period. In addition, the shareholders' general meeting of the issuer must pass a resolution in favour of the exemption.

Involvement of sponsors and underwriters

In the context of public offerings, issuers are required to retain a qualified sponsor (a recommendation institution) whose duty is to provide the CSRC with an opinion assessing the compliance of the issuer's securities with the requirements for listing and trading on a stock exchange.¹⁷ After the issuance, the sponsor must guide the issuer in the fulfilment of its continuous obligations such as operations and information disclosure. For a private placement, issuers are generally not required to appoint a sponsor.¹⁸

The Measures and the PRC Company Law (中华人民共和国公司法) (Company Law) require shares offered to the public to be distributed by an underwriting agency (distributor), in accordance with a distribution agreement concluded with the issuer. Under the Measures, the underwriting agency and its representatives must sign the prospectus, guarantee the accuracy of the information disclosed in the prospectus and bear corresponding civil liability. The Company Law also requires the issuer to conclude an agreement with a bank for the collection of subscription funds.

Underwriting agencies will generally also be involved in the context of private placements. This requirement may increase issuance costs for the issuer (and underwriting fees for securities companies qualifying for underwriting work¹⁹). The Measures only allow the issuer to directly sell shares to designated shareholders without proceeding through an underwriting agency where all designated investors to the private placement figure amongst the 10 biggest shareholders of the issuer.²⁰ As a consequence, an issuer considering issuing shares to a foreign strategic investor by way of private placement will not be able to directly sell shares to the foreign investor and will need to proceed through a qualified securities company unless the strategic investor is already one of the top-10 shareholders of the issuer. This situation would only be possible if the foreign strategic investor has previously acquired the issuer's non-tradable A-shares by way of private agreement.²¹

PRACTICAL IMPLICATIONS

Together with other significant legislative efforts instigated by the CSRC in the past months, the Measures pave the way for the further development of China's capital markets. The issuance of the Measures confirms the progressive lift of a temporary ban on public offerings. In April 2005, the CSRC suspended public offerings while listed companies listed on the Shanghai or Shenzhen markets were invited to take part in a reform whereby their non-tradable shares were converted into tradable shares.²² From the point of view of domestic and foreign strategic investors, the Measures confirm the practical feasibility of private placement in the context of cross border M&A transactions, and significantly increase the transparency and predictability of rules applying to private placements by listed companies.

Endnotes

1 This article focuses on follow-on offerings of equity securities. Provisions specific to the issuance of convertible bonds by listed companies will not be addressed.

2 Prior to the promulgation of the Measures, the rules on the issuance and listing of shares by listed companies were mainly found in the Administration of Offerings of New Shares by Listed Companies Measures (issued by the CSRC and effective on February 25 2001) and the Circular on Matters Relevant to the Improvement of the Work Associated With Offerings of New Shares by Listed Companies (issued by the CSRC and effective on March 15 2001).

3 Issued by the National People's Congress (NPC) and effective on January 1 2006.

4 See the Guidelines for the Listed Companies Public Offerings Information Disclosure Contents and Formats Guidelines No. 10 and 11: Guidelines for the Contents and Formats for Information Disclosures by Companies That Offer Securities to the Public (No.10): Application Documents for Public Offers of Securities by Listed Companies, issued by the CSRC on May 8 2006 and Guidelines for the Contents and Formats for Information Disclosures by Companies That Offer Securities to the Public (No.11): Prospectuses for Public Offers of Securities by Listed Companies, issued by the CSRC on May 8 2006.

5 The PRC Company Law (Company Law) expressly recognises preferential subscription rights for shareholders of limited liability companies, but is silent as to whether shareholders of companies limited by shares enjoy similar pre-emption rights. Article 134 of the Company Law requires the shareholders' general meeting of the issuer to pass a resolution on the amount of new shares to be issued to existing shareholders. This provision is not a clear recognition of shareholders' pre-emptive subscription rights, because the amount of shares to be issued to shareholders should not be decided at the shareholders' general meeting but rather it should be determined pro-rata to existing shareholdings.

6 Issued by the CSRC and effective on March 16 2006.

7 The PRC Securities Law (issued by the NPC and effective on January 1 2006) requires the listed company making a non-public offer of new shares to comply with conditions specified by the CSRC and secure CSRC approval. Article 21 of the Listed Companies Articles of Association Guidelines (issued by the CSRC and effective on March 16 2006) states that listed companies may increase their registered capital by way of private issuance of shares.

8 Article 10 of the Securities Law.

9 Ibid.

10 Jointly issued by the Ministry of Commerce (MOFCOM), the CSRC, the State Administration of Taxation, the State Administration of Industry and Commerce and the State Administration of Foreign Exchange on December 31 2005 and effective on January 30 2006.

11 These prudential conditions are: "having financial stability and be of good standing"; "having conducted operations in a lawful way"; having established "complete corporate governance and internal control systems", and having "no record of material penalty being imposed by any regulatory authority" either in its domestic jurisdiction or any other jurisdiction during the three years preceding the investment.

12 See Part Three of the Securities Law, the Shanghai Stock Exchange Share Listing Rules (issued on May 18 2006) and in the Shenzhen Stock Exchange Share Listing Rules (issued on May 18 2006). See also page 22 in this issue of China Law & Practice for a detailed discussion of these rules.

13 Article 48 of the Securities Law.

14 Article 53 ibid.

15 Article 15 ibid.

16 Article 53 ibid.

17 The rules applying to the operations and duties of sponsors (or recommendation institutions) are set out in the Measures on Stock Issuance and Listing Recommendation System Interim (issued by the CSRC on
December 28 2003 and effective on February 1 2004).

18 Article 11 of the Securities Law.

19 In addition to the Securities Law, requirements for securities companies to carry on underwriting business activities are mainly set in the Administration of Share Distribution by Securities Firms Measures, (issued by the State Council Securities Commission and effective on June 17 1996). To act as underwriters, securities companies must comply with capitalization, staffing and track records requirements and hold a "share distribution business qualification certificate".

20 The requirement to proceed through an underwriting agency for private placements did not appear in the draft version of the Measures released for comments by the CSRC in April 2006 (Draft Measures) and must have been added as a result of lobbying by securities companies during the comment period following the release of the Draft Measures.

21 Prior to the issuance of the Strategic Investment Measures, foreign investors not holding a qualified foreign institutional investor status could only acquire A-shares of listed companies by privately purchasing non-tradable A-shares under the Matters Relevant to Foreign Investment in Listed Companies Several Opinions (jointly issued by the CSRC and the MOFCOM's predecessor, the Ministry of Foreign Trade and Economic Cooperation, effective on
November 8 2001) and the Circular on Matters Relevant to the Transfer of State-owned Shares and Legal Person Shares in Listed Companies to Foreign Investors (jointly issued by the CSRC, the Ministry of Finance and the State Economic and Trade Commission, effective on November 1 2002).

22 On April 29 2005, CSRC launched a pilot reform according to which non-tradable shares in selected companies were floated on stock exchanges in Shanghai and Shenzhen as tradable shares held by public shareholders. On September 4 2005, CSRC issued the Administration of Listed Companies Stock Right Allocation Reform Method, extending this reform to all listed companies.