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Hong Kong Listing Rules Update: Revised Connected Transaction Rules to Take Effect on July 1, 2014

June 26, 2014

 

Introduction

Chapter 14A of the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (the “Listing Rules”) contains rules regulating connected transactions. On March 21, 2014, the Hong Kong Stock Exchange (the “Exchange”) published its consultation conclusions on the proposals to amend the connected transaction rules and align the general definitions of “connected person” and “associate” in the Listing Rules. The amendments to the Listing Rules will take effect on July 1, 2014 (the “New Rules”). The following section highlights some of the key changes made and their implications.

 

Key Changes to the Connected Transaction Rules

 

1. Facilitate easier understanding of the new rules

In order to simplify the language of the connected transaction rules, the existing Chapter 14A will be replaced by the plain language Guide on Connected Transactions Rules previously issued by the Exchange in April 2012. The Exchange has also published a new series of Frequently Asked Questions on “Rule Requirements Relating to Connected Transactions” (FAQ Series 28) to assist with understanding of the New Rules.

 

2. Amendments to the definition of connected persons

a. Rule 14A.101 exemption for transactions with connected persons at the subsidiary level

The definition of connected person currently includes persons connected at the subsidiary level (i.e. a director, chief executive or substantial shareholder of any subsidiary of the issuer or an associate of any of them).

The Listing Rules will be amended to exempt transactions with persons connected only at the subsidiary level from the shareholders’ approval requirement if:

  • the transactions are on normal or better commercial terms;
  • the transactions are approved by the issuer’s board of directors; and
  • the issuer’s independent non-executive directors confirm that the terms of the transaction are fair and reasonable, and they are on normal commercial terms and in the interests of the issuer and its shareholders as a whole.

Also under the New Rules, the shareholder approval exemption for qualified property acquisitions with connected persons at the subsidiary level will be removed since it will be redundant in light of the new exemption under Rule 14A.101 which applies to all transactions with connected persons at the subsidiary level.

b. Excluding “persons connected with an issuer’s insignificant subsidiaries” from the definition

The Listing Rules currently exempt transactions between the issuer group and persons connected with the issuer’s insignificant subsidiaries, subject to a 10% restriction on the consideration test for any capital transaction between an insignificant subsidiary and the person connected with that subsidiary. An “insignificant subsidiary” is a subsidiary of the issuer whose total assets, profits and revenues are less than: (i) 10% under the percentage ratios for each of the three preceding financial years; or (ii) 5% under the percentage ratios for the latest financial year. Instead of exempting transactions between the issuer group and persons connected with the issuer’s insignificant subsidiaries as provided under the current Listing Rules, these persons will be removed from the definition of connected persons under the New Rules. This also means that the issuer will no longer need to maintain a list of persons connected with insignificant subsidiaries.

 

3. Amendments to the definition of associates

a. Exemption for trustee interests

The current definition of “associate” includes trustees of any trust of which a director, chief executive or substantial shareholder (or, if such person is an individual, any of his immediate family) is a beneficiary.

Under the New Rules, trustees of an employee share scheme or occupational pension scheme will be fully exempt from the Chapter 14A requirements provided that both of the following conditions are satisfied:

  • the scheme is established for a wide scope of participants; and
  • the connected persons’ aggregate interests in the scheme are less than 30%.

It should be noted that this new exemption from Chapter 14A requirements only applies to trustees of the scheme. If the transaction is between the issuer and any participant who is a connected person in an individual capacity, the exemption will not apply.

b. Clarification on the scope of associates

Under the current rules, the definition of “associate” includes an entity in which a connected person has a 30% or more direct or indirect interest. An exemption is available where such 30% interest in an entity is held by a connected person through the issuer. However, the current rules do not specify whether the exemption would still apply if the connected person has a direct interest in the entity in addition to the indirect interest held through the issuer. To clarify the position, Rule 14A.14 of the New Rules clearly states that the exemption will apply if the connected person and his or its associate’s interests in the entity (other than those held indirectly through the issuer) are together less than 10%.

 

4. Exclusions of transactions with third parties

Under the current rules, transactions between an issuer group and third parties may also be classified as connected transactions if they confer benefits on connected persons. The New Rules have provided new exclusions of the following transactions with third parties:

  • any disposal of interests in the target company to a third party where a controller at the issuer level is the target company’s substantial shareholder;
  • any acquisition/disposal of interests in the target company from/to a third party where a controller at the subsidiary level is the target company’s substantial shareholder; and
  • transactions with third parties described in paragraphs (ii) to (iv) of current Rule 14A.13(1)(b). These relate to transactions involving the issuer (or its controller) acquiring interests in a target company in specific circumstances where the controller has or will have an interest of less than 10% in the target company.

 

5. Exemptions for connected transactions

a. Increase of monetary threshold for fully exempt connected transactions

Under current rules, the de minimis exemption exempts a connected transaction from all reporting, announcement and shareholders’ approval requirements of Chapter 14A if all of the percentage ratios are:

  • less than 0.1%; or
  • less than 1% for transactions with persons connected with the issuer’s subsidiary only; or
  • equal to or more than 0.1% but less than 5% and the total consideration is less than HK$1 million.

Under the New Rules, the monetary limit for this exemption is being increased to HK$3 million. This should ease the compliance burden for issuers when carrying out smaller transactions.

b. Relaxation of provision/receipt of consumer goods or services

Under the current rules, provision or receipt of consumer goods to, or services from, connected persons are exempt from all the connected transaction requirements, provided that they satisfy certain conditions. One of the conditions is that the goods and services must be of a total consideration or value that is less than 1% of the total revenue or purchases of the issuer as provided for in its latest audited accounts. Under the New Rules, this 1% cap has been removed.

c. Codified exemption for directors’ indemnities/insurance

Where an issuer grants an indemnity against any claim that may arise from the proper discharge of his/her duties, such grant is regarded as a connected transaction. The Exchange’s past practice was to exempt such indemnities from connected transaction requirements on a case-by-case basis. Such practice has now been codified. The New Rules exempt from the connected transaction rules the provision of an indemnity to, or the purchase of insurance for, a director of the issuer or its subsidiaries if:

  • the indemnity/insurance is for liabilities that may be incurred in the course of the director performing his duties; and
  • the indemnity/insurance is in a form allowed under the laws of Hong Kong, and, where the company providing or purchasing the insurance is incorporated outside Hong Kong, the laws of the company’s place of incorporation.

For example, if under the terms of a director’s service contract, a listed company will indemnify him against liabilities to the listed company arising from negligence, default and breach of duty by the director, the listed company will not be able to rely on the new exemption for directors’ indemnities because the Companies Ordinance does not allow a director to be indemnified against negligence, default or breach of duty in relation to the company. Nor can the listed company rely on the existing exemption for directors’ service contracts under Rule 14A.95 in respect of a director’s indemnity or insurance which is not exempt under Rule 14A.91 or 14A.96 (No. 18 and 19 of FAQ Series 28).

 

6. Option arrangements

Currently, the termination of an option is a transaction for the purposes of the connected transaction rules but the Listing Rules do not specify how the size tests should be calculated.

The New Rules treat the termination of an option in the same way as the transfer or non-exercise of an option. This means that the termination should be classified as if the option is exercised, unless the issuer has no discretion over the termination, for example if it is triggered by an event specified in the original agreement and is beyond the control of the issuer.

Further, Rule 14A.79(4) of the New Rules provide alternative classification tests based on the asset and consideration ratios and calculate on the higher of:

  • (for a put option held by the issuer’s group) the exercise price over the value of the assets subject to the option, or (for a call option held by the issuer’s group) the value of the assets subject to the option over the exercise price; and
  • the consideration or amount payable or receivable by the issuer’s group.

However, the alternative classification tests can only be applied if the value of the option assets is readily ascertainable and the issuer is able to provide:

  • a valuation of the option assets prepared by an independent expert using generally acceptable methods; and
  • a confirmation from the issuer’s independent non-executive directors and an independent financial adviser that the transfer, termination or non-exercise of the option is fair and reasonable and in the interests of the issuer and its shareholders as a whole.

An announcement of the transfer, termination or non-exercise of the option must be made by the issuer, and such announcement must include the views of the independent non-executive directors and the independent financial adviser.

 

7. Codified auditor’s confirmation on continuing connected transactions

Under current rules, an issuer must continue to engage its auditors to perform an annual review of its continuing connected transactions each year. The auditor’s confirmation on continuing connected transactions has been modified in the New Rules to align with the guidance in Practice Note 740 “Auditor’s Letter on Continuing Connected transactions under the Hong Kong Listing Rules”. This amendment codifies the current practice of the Exchange in accepting auditor confirmation letters which are prepared in accordance with Practice Note 740.

 

8. Independent advice on connected transactions

Where a connected transaction requires shareholders’ approval, the issuer is required to set up an independent board committee and appoint an independent financial adviser. The New Rules clarify that the independent board committee’s opinion on a connected transaction must, in addition to specifying whether the terms of the connected transaction are fair and reasonable, in the interests of the issuer and its shareholders as a whole and how to vote on the transaction, also advise whether the transaction is on normal or better commercial terms and in the issuer’s ordinary and usual course of business.

 

Other Changes to Definitions of Connected Person and Associate

Application of Chapter 14A definitions of “connected person” and “associate” to other parts of the Listing Rules

The terms “connected person” and “associate” are defined in Chapter 1 of the Listing Rules. Chapter 14A also uses these definitions for its connected transaction rules but extends them to cover wider scope of persons.

The following are the extended definitions of “connected person” and “associate” under Chapter 14A which are not covered in Chapter 1:

  • "connected persons": any former directors of the issuer or its subsidiaries in the last 12 months and their associates
  • "associates": extended family members of a connected person who is an individual. These include any person cohabiting with him as a spouse; his or his spouse’s children of age of 18 years or above; his parents; his siblings; and companies controlled by them.

The Exchange is of the opinion that the extended definitions of “connected person” and “associate” should be used in certain other provisions of the Listing Rules as well. The following is a non-exhaustive list of areas in which the Chapter 14A definitions of “connected person” and “associate” will be used instead of the Chapter 1 definitions under the New Rules:

  • the reverse takeover rules in Chapter 14 which will apply to significant acquisitions from the incoming controlling shareholder and his/its associates;
  • significant corporate actions, spin-off proposals and directors’ service contracts that require shareholders’ approval, where the controlling shareholders or directors and their associates may not vote;
  • grant of share options to connected persons under Chapter 17;
  • sponsor’s confirmation on whether it is a connected person of the new applicant (in the case of new listing applications);
  • independent financial adviser’s confirmation on whether it is, or holds more than 5% interest in, an associate of the counterparty of a transaction (in the case of a connected transaction by an issuer); and
  • other Listing Rules where the use of the Chapter 14A definitions of connected person and associate are a result of the connected transaction requirements.

 

Renaming the definitions in Chapter 1 of the Listing Rules

The New Rules also rename the definition of “connected person” and “associate” in Chapter 1 as “core connected person” and “close associate”, respectively.

In light of the above, when the rule changes take effect on July 1, 2014, issuers and market practitioners will need to check which definitions are being applied to a particular rule. The Exchange has published tables setting out where the Chapter 14A definitions will be applied under the New Rules. The New Rules also clarify that a person may be deemed as a connected person for the purposes of Chapter 14A only.


This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. David J. Johnson Jr., an O'Melveny partner licensed to practice law in California, Washington D.C., New York and Hong Kong, Gigi Woo, an O'Melveny partner licensed to practice law in Hong Kong and England & Wales, and Joyce Tung, an O'Melveny counsel licensed to practice law in Hong Kong, and Wendy Kan, an O'Melveny trainee solicitor, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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