Preferred shares give priority profit distribution, fewer rights

Since last year, the author has provided a full suite of legal services to a certain listed state-owned enterprise under the central government (A+H) for its private offering of preferred shares (PS). This is the first PS offering in China by a listed company not in the financial sector.

PS are still new thing to China. They are a type of share regulated separately from the common class of shares under general provisions of the Company Law. PS holders have priority over common shareholders in the distribution of the company’s profits and remaining property. However the rights of PS holders, such as participation in the company’s decision-making and management, are subject to restriction. Their main legal bases include the Company Law, the Guiding Opinions of the State Council on the Launch of a Pilot Project for Preferred Shares (No. 46 [2013]) and the Measures for the Administration of the Pilot Project for Preferred Shares (Order No. 97, issued 21 March 2014; the measures).

In general, PS holders, unlike common shareholders, do not participate in the day-to-day operation and management of the company. In normal circumstances, they do not participate in votes at shareholders’ general meetings.

As noted above, PS holders enjoy priority in the distribution of the company’s profits and remaining property, but do not have the rights to, e.g., returns on the assets or to participate in material decisions.

Dividends on PS are generally fixed. In particular, where PS subject to mandatory dividend clauses are concerned, dividends should be paid to the PS holders in the specified amount so long as the company has profits to distribute. In contrast, the dividends to common shareholders are not fixed, being dependent on company’s profits and the specific distribution policy during the year in question.

The price volatility of PS on the secondary market is relatively small and the scope for making a profit based on the bid-ask spread is also relatively narrow. In contrast, for common shareholders, price increases on the secondary market are also an important source of earnings in addition to dividends.

A company may specify in its articles of association the conditions, price and percentage of conversion of PS to common shares and the buyback of PS by the issuer. In contrast, common shareholders may not request the buyback of their shares, their only option being realization on the secondary market to achieve divestment.

General conditions for PS offering

1. Independent personnel, assets, financial and business affairs and corporate organization.
2. Sound internal control systems.
3. Average annual distributable profits for the most recent three fiscal years which have not been less that one year’s dividends on the PS.
4. Cash dividends in the most recent three years which have been compliant with the company’s articles of association and the relevant China Securities Regulatory Commission (CSRC) regulatory provisions.
5. No major violations of accounting regulations during the reporting period.
6. A clear purpose for the offering proceeds has been set out.
7. Outstanding PS not exceeding 50% of the company’s total common shares, and proceeds not exceeding 50% of the net assets prior to the offering.
8. Identical terms for all of the PS in a single offering. An additional offering cannot be made until the previous offering is completed.

Special provisions

1. A listed company that wishes to make a public offering is required to satisfy one of three circumstances.

   i. Its common shares are a component of the SSE 50 Index;

   ii. The public offering is to serve as the payment method for the acquisition or merger by absorption of another listed company;

   iii. PS may be publicly offered as the payment method where a common shares buyback is to be carried out to reduce registered capital. Alternatively, following the completion of a buyback plan, there may be a public offering of PS not exceeding the capital reduction amount.

2. The listed company should have been continuously profitable during the most recent three fiscal years.
3. During the prior 12 months, neither the company, nor its controlling shareholder, nor its actual controller should have breached public undertakings given to investors, etc.

Targets and procedures

The PS offering may only be targeted at qualified investors as specified in the measures. The targets of any single offer may not exceed 200, and the aggregate number of targets for PS with identical terms may not exceed 200.

To offer PS, the board of directors first discloses the PS offering proposal and adopts resolutions on such matters as the offer plan in accordance with the law. Where a private offering is to be made and the offer targets have been determined, the listed company and relevant offer targets then execute a preferred share subscription contract the entry into effect of which is subject to certain conditions.

After that, the independent directors of the listed company issue an opinion on the impact that the contemplated offering will have on the rights and interests of each class of shareholders of the company, and the opinion is disclosed with the board’s resolution.

Following the board’s resolution, the shareholders’ general meeting of the listed company subsequently deliberates on the PS offering. The sponsor acts as sponsor and declares its sponsorship to the CSRC. The CSRC then conducts its review and, if the offering passes, renders its approval. Finally, the offering is made on the stock exchange.

Further, pursuant to the measures, unlisted public companies (more commonly referred to as companies listed on the New Third Board) may also offer PS. The PS offering conditions for unlisted public companies include possessing lawful and compliant operations and a sound mechanism for corporate governance.

The same PS offering provisions for listed companies apply to the targets for the PS private offerings by unlisted public companies, e.g. the purpose of the proceeds, the offer quantity and amount of proceeds, face value, etc.

Finally, the issuer is required to engage professional lawyers to do legal due diligence on the issuer, participate in the deliberations on the offer plan and issue a legal opinion on the lawfulness and compliance of the contemplated offering.

Cao Chunfen is a partner at Zhonglun W&D Law Firm