New restructuring rules for backdoor listings

In September 2016, the China Securities Regulatory Commission (CSRC) issued its Decision on Amending the Administrative Measures for Material Asset Restructurings of Listed Companies and additionally made revisions to three complementary documents: the Interim Provisions on Strengthening the Oversight of Irregular Stock Transactions Relating to Material Asset Restructurings of Listed Companies; the Provisions on Several Issues Concerning the Regulation of Material Asset Restructurings of Listed Companies; and the Opinions on the Application of Articles 14 and 44 of the Administrative Measures for Material Asset Restructurings of Listed Companies. This follows upon the previous revision of the acquisition and restructuring measures in November 2014.

Background of new rules. A backdoor listing constitutes a material asset restructuring of a listed company, and article 13 of the Administrative Measures for Material Asset Restructurings of Listed Companies (the measures) expressly addresses the criteria for recognizing a backdoor listing. In August 2011, the measures specified for the first time that restructuring listings will be subject to more stringent oversight, requiring them to dovetail with IPOs; and in November 2013, they further provided for equivalence with the criteria for IPOs. The CSRC requirements on backdoor listings are hence much more stringent than those for other material asset restructurings.

In recent years, with the increasingly serious IPO blockage, backdoor listings have shown a growth trend. However, both listed companies and restructurers have done their best to avoid triggering the backdoor listing conditions, thereby sidestepping the CSRC’s regulation. Large quantities of financing have been used to purchase shells, resulting in an explosion in their price. Such unreasonable acts have seriously distorted the optimal allocation of resources by the market.

Multidimensional regulation. The most recent revision of the measures aims to wrap a secure “fence” with the systems and criteria, reduce the heat of speculation on shells, and promote the rational repair of the market valuation system. Pursuant to the previous version, satisfaction of two conditions – “change in control” and “the total amount of the assets acquired by the listed company exceeding the total amount of its existing assets by 100%” – constituted a backdoor listing, whereupon carrying out of the strict review procedure for an IPO became mandatory. But the above-mentioned criteria for a backdoor listing can now easily be circumvented.

The latest revision improves the criteria for determining a restructuring listing in three aspects. First, it provides greater detail on the criteria for determining a change in control by adding one circumstance – “where the equity is dispersed, but the directors and senior management can direct the material financial and operating decisions of the company, it will nevertheless be deemed to have control” – thereby allowing resolution of a situation where a backdoor listing could be circumvented due to the subject assets or equity being dispersed and there being no actual controller.

Second, it improves the criteria for determining the scale of the purchased assets, by revising the original single indicator of “total amount of assets by 100%” to five indicators (total amount of assets, operating revenue, net profit, net assets, and share capital), such that if any one of the indicators reaches the 100% threshold, a backdoor listing is constituted. The CSRC has also retained a relatively high degree of discretion.

Finally, the new regulations expressly provide that the period for the first accumulation principle is 60 months from the date on which the change in control occurs. Accordingly, an asset injection occurring beyond 60 months, even it reaches any of the above-mentioned indicators, will not be determined to be a backdoor listing, and will instead be deemed a conventional material asset restructuring. Complementary regulatory measures to restrain speculation on shells are also improved. The specific measures include prohibition of ancillary financing with a restructuring listing. This will severely limit the practice of the original actual controller of the listed company increasing his or her shareholding percentage through a subscription for ancillary financing and thereby avoiding a backdoor listing being constituted; also, this will greatly increase the cost of a backdoor listing, and shrink the space for arbitrage on the primary and secondary markets, putting a squeeze on short-term speculation.

Besides, the lock-up period for new, old, large and small shareholders is extended, providing greater detail for the transfer of old shares and imposing sales restrictions. According to the new regulations, the share lock-up period for new and old large shareholders is 36 months; additionally, to prevent the listed company’s original controlling shareholder, actual controller and their connected persons from evading sale restriction obligations by transferring shares to other specific parties, the measures further specify that “specific parties that directly or indirectly acquire shares of the listed company from such entities in the course of the transaction” are also required to publicly undertake to not transfer such shares for 36 months. The lock-up period for new small shareholders is increased from 12 months to 24 months. The new rules on the lock-up period are conducive to restricting the original controlling shareholder and new small shareholders from divesting through the restructuring listing, resulting in a market-oriented mechanism where new and old shareholders mutually constrain each other.

The constraints are also increased on companies that have committed violations of laws or regulations, or integrity-damaging acts. If a company has violated laws or regulations in the past three years, was reprimanded by the exchange in the past year, or committed a major integrity-damaging act, it will not be permitted to sell a shell, further tightening shell supply.

The “cold period” is also shortened for terminating the course of a material asset restructuring, from three months to one, to encourage listed companies to effect acquisitions and restructurings through healthy means to enhance the quality of listed companies and guide more funds toward investment in the real economy. Finally, the revised measures have strengthened the responsibilities of listed companies and intermediaries, strengthened accountability and intensified during-the-fact and after-the-fact oversight of intermediaries.

The particularities of China’s capital markets have made backdoor listings an area in which the conflict between supply and demand, rules and innovation have been the most concentrated, and either overly stringent or overly lax regulation affects the normal expression of the basic function of the capital markets. With the implementation of the new regulations, the circumvention in bad faith of regulation of backdoor listings may become a thing of the past.

Jiang Fengtao is the managing partner and Liu Bing is a partner at Hengdu Law Firm