The regulators tighten regulations on GEM IPOs

Introduction

On 20 January 2017, the Securities and Futures Commission (SFC) and The Stock Exchange of Hong Kong Limited (Exchange), issued a joint statement (Joint Statement) to express grave concerns over the price volatility of stocks listed on the Growth Enterprise Market (GEM) of the Exchange. On the same day, the SFC also issued a guideline (Guideline) to provide guidance to sponsors, underwriters and placing agents on the standards of conduct that is expected of them in the listing and placing of GEM initial public offering (IPO) stocks.

Joint statement

Regulatory concerns

Almost all GEM IPOs were conducted by way of placing only. Many listed GEM stocks have highly concentrated shareholdings and a small shareholder base. The SFC has observed that, in a number of placings, (a) the allocation of a substantial majority of the offered shares were attributable to a small proportion of the placing agents involved in the transaction, who placed those shares to a small number of placees (top placees), while (b) the remainder of the offered shares were placed in small quantities (usually one or two board lots) to a large number of placees. While the number of placees exceeded 100, the final allocation was substantially similar in effect to a placing of the offered shares only to the top placees and resulted in a high concentration of shareholdings among the top placees. In addition, the SFC has observed that a handful of investors repeatedly appeared as the top placees in otherwise unconnected GEM IPOs. The SFC and the Exchange consider that some market practices may not enable an orderly, informed and efficient market for such securities to develop.

Adequate spread of holders

The SFC and the Exchange are of the view that where the securities in the hands of the public are overly concentrated, the conditions for an open market may not exist even if such securities are held by 100 holders, being the minimum number of placees under Rule 11.23 of the Rules Governing the Listing of Securities on GEM (GEM Listing Rules). Nominees, who take up or hold securities in a placing on behalf of other persons who are the ultimate beneficial owners, cannot be regarded as distinct placees. This should be taken into account when assessing the adequacy of spread of holders of these equity issues.

Shares “in public hands”

The SFC and/or the Exchange, where appropriate, will take appropriate actions with respect to any proposal, arrangement or agreement whereby one or more persons (a) takes up securities in a placing on behalf of, (b) holds securities on behalf of, or (c) otherwise acts in accordance with the instructions of, any director, chief executive or substantial shareholder of such issuer or any of its subsidiaries or a close associate of any of them (for PRC issuer, promoter and supervisor in addition to the aforesaid persons), with a view to avoiding the application of any GEM Listing Rule.

Preferential treatment

With regard to any securities proposed to be placed by a new applicant, no preferential terms or treatment as to price or otherwise may be afforded to any placee unless adequate disclosure of such terms or treatment is made in the listing document. The Exchange reserves the right to reject any such proposed arrangements.

Preferential terms or treatment may include a guaranteed allocation, an unusually large allocation, an agreement to allocate securities in another IPO, a waiver or rebate of brokerage commission, a put option or offer to repurchase the offered securities after the listing or any other arrangement entered into on a non-arm’s length basis in exchange for placees taking up the offered securities.

Role of new applicants, sponsors and underwriters/placing agents

Due care should be taken by the new applicant to decide, in consultation with the sponsor, among other things, the method of listing, the target investor type and placee mix, the overall strategy and allocation basis and any preferential treatment (financial or otherwise) afforded to placees and the relevant disclosure in the listing document. The new applicant is expected to seek assistance from the underwriters and placing agents to adopt an appropriate strategy and allocation basis with a view to achieving an open market and avoiding any undue concentration in the holdings of its shares. The prospectus should list all the underwriters and placing agents appointed and their contact details to provide additional information to investors about available distribution channels.

Proper records must be kept by each of the sponsors, underwriters and placing agents documenting their respective involvement in the placing process, including, where applicable, a record of (a) all notifications to clients, (b) all orders received, (c) the rationale for allocation of the securities as well as the reasons for rejection of orders, and (d) the list of placees submitted to the Exchange.

Potential consequences

The SFC or the Exchange may reject allocations of securities, make enquires on the allocation of securities and where appropriate, take action against those new applicants, sponsors and underwriters or placing agents who fail to have appropriate policies and procedures to ensure that any GEM IPO placing is conducted in a fair and orderly manner.

Guideline to sponsors, underwriters and placing agents involved in the listing and placing of GEM stocks

Guidance to sponsors

A sponsor is expected to use all reasonable efforts to:

• Advise the new applicant on the following:
  • the relevant regulatory requirements and the potential consequences for non-compliance
  • the method of listing, in particular, whether the new applicant should adopt an offer for subscription by or sale to the public in addition to a placing tranche
  • the target investor type and placee mix
  • the overall strategy and allocation basis with a view to achieving an open market and an adequate spread of shareholders, and to ensure that the percentage of shares in public hands meets the relevant requirements under the GEM Listing Rules (as supplemented by the Joint Statement)
  • the proper disclosure of any preferential treatment (financial or otherwise) afforded to any placees in the new applicant’s listing document, where applicable, and
  • the retention of proper documentation by the new applicant.
• Retain proper documentation to demonstrate that the sponsor has used all reasonable efforts to discharge all of its obligations.

Guidance to placing agents

Placing agents must have a robust marketing and placing strategy and allocation basis with a view to achieving an open market in the offered securities, including an adequate spread of shareholders. In particular:

• Placings should be conducted with sufficient senior management oversight.
• Placing agents should put in place appropriate policies and procedures to avoid any undue concentration of shareholdings and to maximize the likelihood of an open, fair and orderly market in the securities at the time of listing.
• “Know your client” procedures must be conducted properly. Placing agents are required to take reasonable steps to establish the identity of the client and to confirm whether a client intending to subscribe is the beneficial owner of the client’s account (ie not a nominee of some other person) and is independent of the new applicant, its controlling shareholders and directors.
• Sources of funding for the subscription of placing shares should be established before any acceptance of the client’s subscription using a risk-based approach.
• Save for nominee companies, subscriptions should be rejected where there is a suspicion that the client may be a nominee of some other person whose identity the placing agent is unable to ascertain or the acceptance of subscriptions will result in an inadequate spread of shareholders.
• Proper records must be kept so that the placing agents can demonstrate compliance with the Guideline throughout the entire placing process.

Potential consequences

A failure to comply with any of the requirements of the Guideline by a sponsor or placing agent (and their representatives) may reflect adversely on its fitness and properness and may result in disciplinary action. The SFC will adopt a pragmatic approach taking into account each firm’s particular circumstances when assessing a sponsor’s or placing agent’s compliance with the Guideline.

Conclusion

This is a long-awaited step to address the undesirable features that may exist in the distribution of securities in the context of IPOs, in particular, GEM listings. The Guideline in essence consists of general statements or principles of conduct expected of the sponsors, underwriters and placing agents. Without introducing concrete or specific regulatory regime or requirements in this regard, it remains to be seen how the SFC would effectively enforce the Guideline. It seems that the SFC and the Exchange will further tighten the regulation on GEM as they contemplate to work on a broader GEM reform. In the meantime, firms that act as GEM IPO sponsors, underwriters or placing agents should ensure due compliance with the requirements under the Joint Statement and the Guideline to avoid delay in the IPO process and/or disciplinary action to be taken against them.