Member Article

INTRODUCTION Recent trends Over the past decade, the Hong Kong Special Administrative Region of the People's Republic of China ("Hong Kong" and the "PRC" respectively) has experienced an increase in merger and acquisition activity. We expect this to continue, with more overseas companies investing in Hong Kong, which is now well established as the main financial and services hub for the PRC's economic development, and the economy of which has undergone substantial recovery since the post-1997 deflationary era. Over the next 18-24 months we also expect to see consolidation in certain specific sectors discussed at the end of this brochure. An attractive market In general, at least from a legal perspective, post-1997 Hong Kong is still an attractive and open market for foreign investors for a number of reasons, including the following: • the Hong Kong dollar is (and is expected to remain) fully convertible and accordingly there are no foreign exchange controls to complicate cross-border mergers and acquisitions; • subject to certain exceptions, it is relatively simple to set up, acquire or dispose of businesses in Hong Kong; • in respect of unlisted companies, there is minimal regulatory interference concerning merger and acquisition activity, except in certain industries such as insurance, banking, and telecommunications; • in relation to listed companies, there is greater regulatory involvement including the need to comply with the rules of The Stock Exchange of Hong Kong Limited (the "Stock Exchange"), the provisions of The Codes on Takeovers and Mergers and Share Repurchases (the "Code") and legislation regarding insider dealing and disclosure of interests. The central principles reflected in these provisions would be familiar to most international investors; • with limited exceptions there are no minimum local shareholding requirements or restrictions on foreign ownership of shares or assets. The exceptions include restrictions on the exercise of voting control by non-residents in certain circumstances in respect of some types of licences in the broadcasting industry; • Hong Kong does not have any general competition legislation (although it does have substantial sectorial legislation governing anti-competitive behaviour in both the telecommunications and broadcasting industries); and • Hong Kong's low tax regime is simple and transparent, and does not include any capital gains or (with a limited exception) withholding taxes. Mergers and Acquisitions The terms "merger" and "acquisition" have no legislative interpretation or meaning in Hong Kong. While defined by statute in a number of jurisdictions, "merger" is not a legal term of art in Hong Kong and, used generically, can have any number of meanings, many of which are indistinguishable from acquisitions. "Acquisition", of course, has a more generally accepted meaning and can encompass a number of methods by which a party acquires whole or partial ownership of a business enterprise or shares in a target company. For the purposes of this brochure, certain aspects of mergers and acquisitions which are peculiar to Hong Kong law in the context of an acquisition of the share capital of a Hong Kong company and the acquisition of the assets and liabilities of a Hong Kong company are considered. This brochure also gives a broad overview of the principal regulatory framework governing the acquisition of shares in public companies, particularly those listed on the Stock Exchange. PRIVATE AND PUBLIC COMPANIES Application of the Companies Ordinance The Companies Ordinance applies to all companies formed and registered under that ordinance. Certain of its provisions apply to overseas companies with a place of business in Hong Kong and registered as such under Part XI of the Companies Ordinance. Broadly speaking, the Companies Ordinance sets out the general rules and regulations governing Hong Kong companies and the conduct of their affairs. It also contains a number of specific provisions relating to matters which may impact upon mergers and acquisitions and how they can be structured, including the following: • the prohibition on a company giving financial assistance for the purchase of its own shares; • rules relating to the issue of new shares at a discount to their par value; • restrictions on the methods whereby a company can reduce its share capital or vary the rights attaching to a particular class of shares; and • restrictions on the amounts which can be distributed by way of dividend. Public or private company? An important distinction is drawn in Hong Kong between private and public companies. While the Companies Ordinance contains no definition of what constitutes a public company, it prescribes that a private company must: • restrict the right to transfer shares - this restriction is contained in a company's articles of association and particular care must be taken to avoid the company being permitted to issue bearer shares (which are regarded as freely transferable); • limit the number of its members to no more than 50 (subject to an exception for employees); and • prohibit any invitation to the public to subscribe for shares in or debentures of the company. Any companies not meeting the above criteria will be deemed to be public companies (whether or not they are also listed on the Stock Exchange). The great majority of companies incorporated in Hong Kong are private companies. One advantage of private companies incorporated in Hong Kong is that they are not required to disclose their key financial information when filing annual returns. Public companies are subject to further regulatory regimes (notably the Code and, if listed on the Stock Exchange, the Rules Governing the Listing of Securities on the Stock Exchange (the "Listing Rules")) described in more detail below. TYPICAL DOCUMENTATION Core documentation involved in a sale and purchase of a business or a company in Hong Kong typically includes the following: • a confidentiality letter in which the parties undertake to keep confidential the actual transaction and any information they may obtain during the due diligence process. In some cases, it may include a provision for exclusive negotiations for a particular period so that the purchaser knows that there will be no dual negotiations or auction type process; • a due diligence questionnaire and report in relation to the business or company; • a sale and purchase agreement that specifies the obligations and liabilities of each party in relation to the sale. This normally includes detailed representations and warranties regarding the business or company. The form of the sale and purchase agreement will depend largely upon whether shares or assets are being acquired. In a share purchase, all the company's obligations and liabilities will move across with the target company whereas in a business sale, subject to the Transfer of Business (Protection of Creditors) Ordinance ("Transfer of Business Ordinance"), the purchaser will normally be able to pick and choose which assets and liabilities it wishes to purchase; • a disclosure letter in which the seller makes disclosures against the representations and warranties given by it to the purchaser in the sale and purchase agreement; • share transfer forms where the sale and purchase involves the sale of shares, and bought and sold notes if these are shares in a Hong Kong company; • a notice under the Transfer of Business Ordinance in the case of the sale of a business; • other documentation may be required, such as a press announcement, and, possibly, a circular to shareholders, if the sale or purchase is by, or involves, a company listed on the Stock Exchange (or one of its group companies); • disclosures to the company and the Stock Exchange of the acquisition of shares in a case where the target company is listed; and • if the Code applies and a general offer is made, then offer documentation would need to be produced in compliance with the Code. DUE DILIGENCE Matters investigated In any M&A transaction, as well as financial due diligence, legal due diligence in some shape or form is normally undertaken by the purchaser. Reports on title are sometimes prepared in relation to properties owned by the target company, and with regard to other non-financial due diligence, the main items commonly investigated include, amongst other things, the statutory books, major contracts, plant and machinery leases, service agreements, loan details and particulars of litigation. Extent of legal due diligence Over the last decade, a US-style approach towards due diligence has become almost standard practice, whereby a questionnaire is submitted to the target company, teams of lawyers filter through the documents and an accountant-style report is prepared. This is a more expensive approach than the traditional method of simply reporting on disclosures made against warranties given in the contractual documentation. However, multinational corporations will now often proceed with acquisitions only after completing formal legal as well as financial due diligence on the target. In addition, when the target has operations or assets in mainland PRC, a greater degree of proactivity in due diligence is usual and prudent. EMPLOYEES AND CREDITORS Issues on business acquisitions In the context of transactions involving the purchase of the assets and liabilities of a company, i.e. business rather than share acquisitions, issues arise in relation to the transfer of employees to the purchaser and in respect of liabilities to creditors of the target, both of which are governed by Hong Kong legislation. Employees Hong Kong does not have regulations which specifically effect the transfer of employment of employees in connection with a business acquisition. Under Hong Kong law, all existing contracts of employment have to be terminated and (if applicable) new contracts of employment offered to those employees who are being transferred. In circumstances where termination is connected with the disposal of the business for which the employees were previously employed, redundancy issues may arise and the old employer may be liable to make severance payments and provide other statutory benefits. The Employment Ordinance provides a specific exemption in the case of a business transfer in cases where the new owner of the business makes an offer to re-employ the employees on no less favourable terms and conditions at least seven days before the previous employment terminates: no liability to make severance payments arises if that offer is unreasonably refused (although there may still be residual liabilities to make long service payments). If the employees accept the offer, then they achieve continuity of employment for the purposes of the Employment Ordinance so that eventual liability for redundancy benefits is rolled over to the new employer but by reference to the total period of employment. TRANSFER OF LIABILITIES The Transfer of Business Ordinance provides that whenever a business is transferred, the acquiror shall, notwithstanding any agreement to the contrary, become liable for all the debts and obligations arising out of the carrying on of business by the seller unless the procedures set down in that ordinance are followed. These procedures require the parties to publish a notice of transfer (setting out prescribed particulars of the transfer) not more than four months but not less than one month before the date the transfer takes place. Effectively, the purchaser ceases to be liable for all such obligations of the seller with effect from the date on which the notice of transfer becomes complete, which occurs upon the expiration of one month after the date of the last publication of the notice, unless within that period a creditor effects proceedings against the seller in respect of any liability of the seller arising out of the carrying on of the business. Under the Transfer of Business Ordinance, the purchaser is entitled to be indemnified by the seller for all amounts for which the purchaser is made liable under that ordinance and for which it would not otherwise be liable, although in most cases an express indemnity provision is also included in the contractual documents between the parties. LANDLORDS Hong Kong real estate leases are almost invariably not assignable without in each case the consent of the landlord. It is also very often the case that consent of the landlord will be required for any change in control of the tenant. Failure to obtain consent will usually give rise to a right of termination of the lease. Thus in most merger and acquisition transactions where there is Hong Kong property under lease and that lease is to be transferred to the purchaser (in a sale of business) or to move across with the target (in a sale of shares), the landlord's consent will be required for the transaction. Obtaining consent is not necessarily a formality and will not necessarily be done quickly. The landlord will invariably look to the financial strength of the acquiring group and may well seek to renegotiate the rent if the contractual rent is below the market rent. To avoid problems in a transaction where the target business or company has real estate leases, the question of approaching landlords should be addressed as early as possible. TAX AND STAMP DUTY The tax regime As mentioned above, local tax considerations play a subsidiary role in the structuring of mergers and acquisitions in Hong Kong, due to the simplicity and transparency of the tax regime. Some of the principal features of the Hong Kong tax regime which distinguish it from other jurisdictions are: • Hong Kong does not recognise the concept of taxing capital gains on the disposal of assets (including property and shares); • there is no withholding tax payable in respect of distributions to shareholders by way of dividend; and • dividends are not taxable income. Stamp duty Stamp duty is charged on the sale of shares in Hong Kong incorporated companies. The rate has been reduced in recent years. Currently the rate is calculated at the rate of 0.2% on the higher of the amount of the consideration paid and the value of the shares being transferred and is normally paid in equal proportions by the seller and the buyer. Relief is available (subject to certain conditions) in respect of intra-group share transfers between associated companies (90% ownership is the applicable threshold) and there are a number of methods that can be used to minimise (and sometimes even eliminate) the stamp duty charge, although for some time there has been uncertainty as to the effectiveness of some of these methods. Stamp duty, at varying rates up to 3.75%, is also payable on the acquisition of immovable property in Hong Kong. This charge may be a material factor in the transfer of a business owning immovable property. The convention is that the purchaser will pay stamp duty on a transfer of immovable property. Associated company relief may be available. ACQUISITION ACCOUNTING This is a detailed area beyond the scope of this brochure, but suffice to note that there have been fairly recent changes both to the Hong Kong Statements of Standard Accounting Practice (to prevent writing off of goodwill against reserves) and the Companies Ordinance (to provide relief in certain circumstances from the need to transfer premium arising on the issue of shares to a share premium account, which relief may facilitate future distributions). Where relevant, advice from auditors may be necessary. HONG KONG COMPANY LAW Statutory regulation Company law in Hong Kong has developed through the interaction and interdependence of case and statute law. The Companies Ordinance forms the core of the regulation of companies in Hong Kong. It is supplemented by subsidiary legislation. The Securities and Futures Ordinance, which came into force in April 2003, covers a number of securities law issues. These areas are beyond the scope of this brochure. In recent years there have been various proposals to amend company law in Hong Kong, notably to tighten up its corporate governance aspects. These proposals have been controversial and it is uncertain as to whether the proposals will be adopted. Should the proposals be adopted, the use of offshore companies could be expected to increase. Use of off-shore companies One factor which is quickly apparent to those conducting business in Hong Kong is the common use of offshore companies, incorporated in jurisdictions such as the British Virgin Islands. These companies are used for a number of reasons, including relative simplicity of maintenance, and the avoidance of Hong Kong stamp duty on share transfers (save as regards shares traded on the Stock Exchange, which are required to be registered on a Hong Kong branch register). It is also important to note that, on occasion, use of such companies can mitigate the application of some of the provisions of the Companies Ordinance. THE LISTING RULES Acquisition or disposal of shares in a listed company The Stock Exchange does not normally take a primary role in relation to the sale or purchase of shares in listed companies or in respect of takeover transactions. It may, however, investigate the listed company's suitability for listing following the takeover or merger. In particular, the Stock Exchange will be concerned to see that at least 25% of the share capital of the listed company (being the minimum public float, subject to exceptions) remains in the public's hands following the relevant transaction. In addition, the Stock Exchange will also scrutinise reverse takeovers or back-door listings. Acquisition or disposal of assets by a listed company Acquisitions and disposals by a listed company or one of its group members, and transactions with connected persons of a listed company, are primarily regulated by Chapters 14 and 14A of the Listing Rules respectively. The Stock Exchange has the responsibility of ensuring that all the requirements of the Listing Rules are complied with in this regard. Percentage ratios Under Chapter 14 of the Listing Rules, transactions are categorised in accordance with specified percentage ratios, and the consequences of a transaction depend upon the category into which it falls. There are five percentage ratios, which compare: • the total assets which are the subject of the transaction with the total assets of the listed group; • the net profit attributable to the assets which are the subject of the transaction with the net profit of the listed group; • the revenue attributable to the assets which are the subject of the transaction with the revenue of the listed group; • the aggregate value of consideration given/received with the total market capitalisation of the listed group; and • the value of any equity capital issued as consideration by an acquiring listed company with the value of its equity capital previously in issue. There are complex provisions relating to the tests and the calculations to be made, including a requirement for aggregation of transactions in certain circumstances and requirements where a company becomes or ceases to be a subsidiary or where a non-wholly owned subsidiary effects a transaction. CLASSES OF TRANSACTION AND RELEVANT REQUIREMENTS The classes of transaction and the relevant requirements are as follows: • reverse takeover: this is an acquisition of assets which, in the opinion of the Stock Exchange, constitutes, or is part of a transaction or arrangement which constitute, an attempt to achieve a listing of the assets to be acquired and a means to circumvent the requirements for new listings under the Listing Rules. The Stock Exchange will treat a company proposing a reverse takeover as if it were a new listing applicant, and the transaction must be made conditional upon approval by the shareholders of the company in general meeting. No written shareholders' approval will be accepted in lieu of holding a general meeting; • very substantial acquisition: this is an acquisition of assets where any percentage ratio is 100% or more. The acquisition must be made conditional upon approval by the shareholders of the company in general meeting. No written shareholders' approval will be accepted in lieu of holding a general meeting; • very substantial disposal: this is a disposal of assets where any percentage ratio is 75% or more. The disposal must be made conditional upon approval by the shareholders of the company in general meeting. No written shareholders' approval will be accepted in lieu of holding a general meeting; • major transaction: this is any acquisition or realisation of assets where any percentage ratio is 25% or more, but less than 100% for an acquisition or 75% for a disposal. It must be made conditional upon shareholders' approval, which may be obtained either by holding a general meeting of the company's shareholders or, if no shareholder is required to abstain from voting if the company were to convene a general meeting for the approval of the transaction, by written approval of a closely allied group of shareholders holding 50% or more of the nominal value of the company's voting securities; • discloseable transaction: this includes any acquisition or realisation of assets where any percentage ratio is 5% or more but is less than 25%; • share transaction: this is an acquisition of assets where all the percentage ratios are less than 5% but the consideration includes securities for which listing will be sought. Discloseable transactions and share transactions generally give rise to disclosure rather than shareholders' approval requirements; and • connected transaction: this includes widely drawn and complex provisions governing transactions with related parties. A connected transaction may require disclosure and also possibly shareholders' approval, depending on the circumstances. SECTION 155A OF THE COMPANIES ORDINANCE Hong Kong incorporated listed companies (which are now a minority of companies listed on the Stock Exchange) and their Hong Kong incorporated group companies must also take into account the provisions of Section 155A of the Companies Ordinance, which requires shareholders' approval for any disposals of any company's fixed assets where the value of the consideration in respect of that disposal, aggregated with any other disposal within the four months preceding it, exceeds 33% of the disposing company's fixed assets. This provision creates an unpleasant trap for the unwary. Mitigating factors are that it does not apply to non-Hong Kong incorporated companies, and that (where relevant) shareholders' approval is required at the level of the immediate company concerned (and therefore is likely to be a simple matter in the case of a subsidiary). GEM A second board has been established on the Stock Exchange in recent years, the Growth Enterprise Market ("GEM"). This is aimed at creating a market for technology and other higher risk enterprises. The track record and various other requirements of GEM differ from those of the main board, but most of the GEM Listing Rules are similar to the provisions of the main board Listing Rules. TAKEOVER CODE Scope of the Code Public companies in Hong Kong (whether listed on the Stock Exchange or not) fall within the regulatory framework of the Code. Private companies are exempt from its provisions. It largely resembles its English counterpart although there are significant differences. The Code is not legally enforceable, its purpose is to provide guidelines for companies and their advisers contemplating, or becoming involved in, takeovers and mergers affecting public companies in Hong Kong. The aim of the Code is to ensure fair treatment of shareholders affected by merger or takeover transactions. It requires the timely disclosure of adequate information to enable shareholders to make an informed decision as to the merits of any offer. Mandatory general offers The Code regulates acquisitions of shares in an offeree company which change its control, currently defined as a holding, or aggregate holdings, of 30% or more of the voting rights of a company, irrespective of whether that holding or holdings gives de facto control. This trigger level recently replaced the previous trigger level of 35% and grandfathering provisions were introduced in relation to existing holdings between the 30% and 35% level. The Code applies not only to the offeror and the offeree company, but also to those persons "acting in concert" with the offeror. Rule 26 of the Code requires the making of a mandatory general offer to all shareholders of the offeree company (unless a waiver has been granted by the executive director of the corporate finance division of the Securities and Futures Commission (the "Executive")), where a person or a group of persons acting in concert: • acquires control of a company (meaning 30% or more of the voting rights), whether by a series of transactions over a period of time, or not; or • when already holding between 30% and 50% of the voting rights of a company, acquires more than 2% of the voting rights in the target company in a 12-month period from the date of the relevant acquisition. This is known as the creeper provision. It was reduced (subject to certain grandfathering provisions) from 5%, at the same time as the trigger level was reduced from 35% to 30% (see above). Persons acting in concert In either case, an offer must be made to the shareholders for the balance of the shares of the public company. The offer must be in cash or accompanied by a cash alternative at not less than the highest price paid by the purchaser (or persons acting in concert with it) within the preceding six months. A group of persons acting in concert is, in general terms, regarded as being the equivalent to a single holder of voting rights. It is therefore important to understand the scope of acting in concert, which under the Code is wide and interpreted liberally. Persons acting in concert are persons who "pursuant to an agreement or understanding, actively co-operate to obtain or consolidate control of a company through the acquisition by any of them of voting rights of the company". The Code also describes classes of persons who are presumed to be acting in concert with others in the same class. The presumption that parties are acting in concert is a strong one and the Executive, who is responsible for the day-to-day management of the Code and the conduct of investigations, will draw the inference unless provided with clear rebutting evidence. Practically, this is one of the most contentious issues of the Code, particularly as the Executive is prepared to determine that a concert party exists where the evidence is primarily circumstantial. Waivers from the Code The Executive has wide discretion to grant waivers in respect of Rule 26 of the Code, subject only to his adherence to the spirit and general principles of the Code. In particular, when the issue of new securities as consideration for an acquisition, a cash subscription, or the taking of a scrip dividend would otherwise result in an obligation to make a general offer under Rule 26 of the Code, the Executive will usually waive the obligation if there is an independent vote, on a poll, at a shareholders' meeting (which is commonly known as the "whitewash" procedure). If the whitewash is obtained, the person or persons who otherwise would have been required to make the mandatory offer, are precluded from acquiring additional shares in the listed company for 12 months following the acquisition unless authorised by a separate vote. From a practical viewpoint, it is wise to seek clarification from, and the co-operation of, the Executive at the earliest stage possible if an application for a waiver is being considered. Sanctions for breach of the Code As the Code is voluntary, reliance is placed on directors and advisers of public companies to conduct themselves in accordance with the Code. The Code does not have the force of law, so fines or imprisonment cannot be imposed for breaches. However, the Listing Rules expressly require compliance with the Code by public companies listed on the Stock Exchange. Any breach of the Code will be deemed to be a breach of the listed company's listing agreement. In addition, if the Takeovers and Mergers Panel finds that there has been a breach of the Code it may impose a variety of sanctions ranging from private reprimand to a cold-shouldering order to the local securities industry, in respect of a person who has breached the Code. Peculiarities of the local market Hostile takeovers in Hong Kong have historically been rare occurrences, for the simple reason that most public companies have been closely controlled by the founding families. This is slowly beginning to change, both because family ownership is starting to move to the second and third generations and because of stresses on many companies and a necessity for restructuring, brought to a head by the Asian financial crisis. COMPETITION REGULATION Legislation has been enacted on a limited, sectorial basis, under the provisions of the Telecommunications Ordinance and the Broadcasting Ordinance. In both cases, there are general restrictions on licensees engaging in conduct that has the purpose or effect of preventing, distorting or substantially restricting competition in the relevant marketplace. These provisions draw heavily on Articles 81 and 82 of the Treaty Establishing the European Community, particularly in relation to prohibition of anti-competitive behaviour in general and abuse of a dominant position. In addition, the Telecommunications Ordinance prohibits misleading and deceptive conduct (drawing heavily from Section 52 of the Australian Trade Practices Act in this regard). Both pieces of legislation provide for penalties and enable third parties suffering loss or damage to seek remedies against licensees in breach. While these prohibitions are primarily aimed at anti-competitive day-to-day commercial behaviour, they are also clearly wide enough to include, and have been used in, the context of merger regulation. Most prominently, the Telecommunications Authority reviewed the PCCW HKT merger in order to determine whether such a merger would be generally anti-competitive. The Telecommunications Authority has also conducted a public consultation process regarding the desirability of introducing specific regulation dealing with mergers and acquisitions in the telecoms industry. Debate continues within government in Hong Kong as to whether or not more broadly applicable legislation should be introduced. The question of whether or not Hong Kong needs a general competition or anti-trust regime is now being actively considered. INDUSTRY TRENDS Hong Kong We anticipate some near-term consolidation in the insurance, banking and telecommunications industries in Hong Kong. In very general terms, the insurance and banking industries are likely to consolidate by reason of international trends towards globalisation so as to achieve worldwide customer service and critical mass, and towards consolidation of financial services industries. The insurance industry in Hong Kong is intensely competitive, with around 150 general insurers in the market. A particular problem in recent years has arisen with employee compensation insurance, where there has been significant excess capacity in a soft market, but with sharply increasing liabilities. Pressures to consolidate may be increased by the impact of recent catastrophes on parent company balance sheets. In the banking industry, factors pointing towards consolidation include increased competition for both deposits and mortgage business resulting from deregulation of interest rates. Longer term, increased dispersal of holdings within family controlled banks and pressures to offer more diversified services may lead to moves away from family control. The telecommunications industry has undergone significant liberalisation over the past 10 years. Factors which are likely to give rise to consolidation include: intense competition in the mobile sector, financial requirements for roll-out of new technology and traditional telecoms companies, cable TV companies, utilities and other entities competing aggressively for customers in both the domestic and international market. We have recently seen the takeovers of two smaller local mobile operators by the former monopoly telecoms operator (SUNDAY, by PCCW) and a PRC mobile operator (Peoples Telephone, by China Mobile) respectively, and the proposed merger of Telstra's CSL and New World Mobile. PRC Finally, looking over the border, it is worth mentioning developments in the M&A market in mainland PRC. This market was virtually non-existent 10 years ago. Since then, and particularly over the last eight years, the number and complexity of deals have grown exponentially, and the market has developed in a variety of directions. This trend is likely to accelerate, with deals arising out of both the state and private sectors as a result of mainland PRC's accession to the World Trade Organisation. Please refer to our separate brochure on "Mergers and Acquisitions in the PRC" (http://www.deacons.com.hk/eng/knowledge/knowledge_212.htm).