REGULATIONS
Unclogging China's Stock Exchanges
July 31, 2006
Jean-Marc Deschandol, Norton Rose

Until recently, only a fraction of Chinese listed companies' shares could be traded on China's stock market. Most of a company's other shares were non-tradable and owned by the state, state-owned enterprises and other legal entities. When the Shanghai and Shenzhen stock markets were established in 1990 and 1991 respectively, most issuers were state-owned enterprises. Their share capital was divided into tradable and non-tradable shares in order to preclude changes of ownership occuring via the stock market. In principle, holders of tradable and non-tradable shares have the same rights to receive dividends and to vote at the shareholders' general meeting. This 'segmented share structure' inherited from the early days has now become an embarrassing feature that prevents necessary reform to China's stock exchanges and results in severe liquidity constraints for listed companies. 

On 29 April 2005, the China Securities Regulatory Commission (CSRC) launched a pilot reform according to which non-tradable shares in selected companies were listed on stock exchanges in Shanghai and Shenzhen as tradable shares held by public shareholders (the reform). On 4 September 2005, the CSRC extended the reform to all listed companies.

Floating Procedures

The decision to take advantage of the reform rests with the listed company's holders of non-tradable shares. At least two-thirds of holders of non-tradable shares must put forward a joint motion requiring the company's board of directors to convene a shareholders' meeting. The decision to float the company's non-tradable shares must then be approved by at least two-thirds of all shareholders (including two-thirds of holders of tradable shares) attending the shareholders' meeting. 

For holders of non-tradable shares, access to liquidity has a cost. In practice, they must compensate holders of tradable shares in order to secure their consent. The compensation package usually consists of non-tradable shares and a dividend paid by the company. As an incentive to these transactions, the compensation is exempted from stamp duty and enterprise and individual income tax. Furthermore, new rules issued in July 2005 now make it possible to include warrants in the compensation package. 

Safeguards Against Market Over-reaction

The reform is not the first attempt at reducing high state ownership in listed companies. Similar trials were initiated in 1999 and 2001 but failed as a result of negative reaction from the stock market. The lesson was well learned, as the new measures provide safeguards preventing the market from overreacting and ensuring the floating of non-tradable shares is phased in over time. Listed companies must suspend the trading of their shares while deciding on the implementation of the float. After becoming tradable, the shares are subject to a lockup period of at least 12 months. At the end of that period, further restrictions apply to the volumes of shares that can be traded by shareholders. 

New Opportunities for Foreign Investors

Before the reform, tradable A shares of listed companies could only be acquired by foreign investors holding a qualified foreign individual investor (QFII) status. Non-QFII foreign investors could acquire a stake in listed companies by purchasing non-tradable shares through private agreement, or tradable B shares issued by only a small percentage of the companies listed on China's stock exchanges.

Shortly after the reform was introduced, the Ministry of Commerce (MOFCOM), the CSRC and other government departments jointly issued the Foreign Investors Strategic Investment in Listed Companies Administrative Measures (the strategic investment measures) on 31 December 2005, which came into force on 30 January 2006. The strategic investment measures target a totally different type of equity investment from the comparatively short-term share, trading under the existing QFII scheme. Furthermore, the strategic investment measures also subject strategic foreign investments to much lower entry requirements and to fewer investment restrictions than QFIIs.

Under the strategic investment measures, foreign investors may acquire, by way of private agreement or private placement, a minimum of 10 per cent of issued shares in listed companies that have implemented the reform. The strategic investment measures do not set a foreign shareholding cap on strategic investments, but as a general requirement, strategic investments must comply with the Foreign Investment Industrial Guidance Catalogue as well as with the ceiling percentages set out in any industry-specific regulations. To qualify as strategic investors, foreign investors must comply with a range of prudential conditions and own offshore assets of at least US$100m or manage assets of at least US$500m.

Impact on Acquisition Projects

One of the objectives of the reform is to release large-scale state-owned assets from state ownership and control. In this respect, state-owned shareholders of listed companies implementing the reform are required to reduce their shareholding to 'the greatest extent possible'. Consequently, control is likely to change hands in the case of most selected listed companies currently controlled by state-owned shareholders. Foreign strategic investors considering acquiring a stake in a Chinese listed company may have to be prepared for possible changes in target listed companies' shareholding structure. Concurrently, as the state gradually relinquishes management control, the board of directors at many listed companies will eventually be reshuffled.

Vulnerability to Takeovers

The reform lays the groundwork for hostile takeover bids. Currently, the China's securities law subjects investors holding more than 30 per cent of the shares of an issuer to a general offer obligation. With a greater percentage of their shares being publicly tradable, listed companies will have to develop anti-takeover strategies and defence mechanisms. However, under current laws and regulations, listed companies are vulnerable in defending hostile takeover bids. For instance, under Article 33 of the Administration of Listed Company Takeover Measures (issued by the CSRC on 28 September 2002 and effective as of 1 December 2002), the issuer's management is forbidden to take any active anti-takeover action, such as issuing new shares, repurchasing shares or disposing of major assets after a takeover offer has been launched on the company.

According to the draft version of the Acquisition of Listed Companies Administrative Procedures (draft takeover code), released by the CSRC on 22 May 2006 for comments, after the launch of an offer and until the offer expires or the acquisition is completed, the target company can only continue normal business operations and implement resolutions already passed at the shareholders general meeting, and the target company's board of directors cannot pass resolutions on the transfer of the company's assets, perform investments, provide loans or guarantees, change the company's business activities, or take any action that would have a material effect on the company. This would mean that an anti-takeover 'crown jewel defence' involving the spin-off of the target company's main assets would require shareholders approval. Directors of the target company are also precluded to resign during the duration of the offer (no 'people pills'). It remains to be seen if these restrictions will survive the comments period and be found in the final version of the takeover code expected to be issued before the end of this year.

Control Dilution Remedies

State-owned shareholders controlling listed companies may manage to maintain their control through the combination of share buyback and share increase schemes. In order to mitigate share dilution effects and to ensure market stability, on 16 June 2005 the CSRC issued regulations allowing listed companies to implement share buyback plans for the purpose of reducing their registered share capital. Holders of tradable shares are, if they so wish, free to take part in the buyback. On the same day, the CSRC issued regulations allowing controlling shareholders of a listed company to increase their holding of tradable shares after the 12-month lock-up period without triggering the mandatory general offer requirement. 

Looking Ahead

Although the fragmented nature of laws and regulations in this area means that there are a number of important issues which need to be clarified and resolved and represents a challenge to foreign investors, the reform and the strategic investment measures are undoubtedly a step in the right direction. The reform means that there will be greater liquidity in China's stock markets and the strategic investment measures will considerably boost cross-border merger and acquisition activity involving target Chinese-listed companies. It is indeed expected that the greater involvement of foreign investors will lead to better corporate governance that, in turn, will lead to greater investor confidence.

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