Switching to Hong Kong stocks, H-shares or red chips? (Previous article)

LABEL： Securities and Capital Markets ,

introduction

Since the release of the "Trial Measures for the Administration of Overseas Issuance and Listing of Securities by Domestic Enterprises" and its accompanying regulatory guidelines (collectively referred to as the "New Regulations on Overseas Listing") on February 17, 2023, the implementation of the filing process has become increasingly mature. Due to the advantages and convenience of Hong Kong, China in terms of political status, geographical location, bilateral agreements, etc., many domestic enterprises are considering listing on the Hong Kong Stock Exchange and have started preparations for listing on the Hong Kong stock market (see "Overseas Listing | Red Chip Structure Decryption: Red Chip Business Q&A Manual (III) - The First Change to be Made in Changing to Hong Kong Stock Market").

According to publicly available data from the Hong Kong Stock Exchange, the Hong Kong stock market has shown a clear recovery and activity since May of this year. Since the implementation of the new regulations for overseas listings, as of September 13, 2024, the China Securities Regulatory Commission has received a total of 195 applications from domestic companies to go public in Hong Kong, including 84 companies listed under the H-share model and 111 companies listed under the red chip model. It can be seen that both models have a substantial proportion in the listing of Hong Kong stocks, and the H-share model is no longer the exclusive path for a few large enterprises. At the same time, the red chip model slightly dominates.

After the introduction of new regulations for overseas listings, the direct listing (H-share) and indirect listing (red chip) models have been unified and included in the record management system, eliminating some unique institutional and regulatory requirements for H-shares. As a result, the H-share and red chip models seem to be gradually converging. In our practice, we are often asked about the difference between the two, and some companies even raise questions about the necessity of the red chip model and whether H-shares have more advantages. This article will be divided into two parts. In addition to macro factors such as industry and scale, it mainly focuses on the legal side. Starting from the fundamental differences in the underlying architecture of the two modes, it will provide readers with a specific analysis of the specific differences between the two methods in terms of listing review, foreign investment access, foreign exchange management, corporate control recognition, lock up period after listing, capital circulation, and financing repatriation for domestic use. The aim is to answer the above questions and provide readers with reference strategies for choosing.
1、 Overview of the main methods for listing in Hong Kong

The H-share model and red chip model are the two main ways for domestic enterprises to choose Hong Kong stock listing. (1) The H-share model refers to the issuance and listing of shares on the Hong Kong Stock Exchange by a limited liability company registered and established in mainland China as the listing entity; (2) The red chip model involves establishing domestic and foreign structures, including equity entities within China within the scope of consolidation with overseas entities such as Cayman Islands companies, and using overseas entities as listed entities to issue shares and go public on the Hong Kong Stock Exchange (specific steps for building the red chip structure can be found in our "Overseas Listing | Red Chip Structure Decryption: Red Chip Business Q&A Manual (2)"). The specific architecture diagram is as follows:

           

H-share model

           

Red chip model (including VIE architecture)

From the above figure, it can be seen that the underlying difference between the two models lies in the different issuing entities, which determines their differences in capital operation paths, foreign investment industry policies, control rights recognition, foreign exchange management, and listing verification. We will elaborate on this in the second part of the following text.
2、 What are the important differences between H-share and red chip listings during the listing stage

On the premise of complying with the above laws, regulations, and regulatory requirements, H-share companies and red chip companies have differences in registration location and applicable laws, reflected in different compliance requirements in foreign investment access policies, control rights recognition, employee equity incentives, and other dimensions. In terms of listing strategy and approach, the following differentiation factors should be considered to determine and optimize the listing path.
1. Capital operation paths such as "return to A"

Firstly, it should be mentioned that from the perspective of capital operation paths such as "returning to A", there are significant differences in the available paths and current regulatory practices between the two models.

(1) For red chip listed companies, in addition to dismantling the red chip structure and listing domestic companies on the A-share market, they can also choose to retain the red chip structure for listing on the A-share market, including listing overseas listed entities or spin off subsidiaries on the A-share market. On March 22, 2018, the China Securities Regulatory Commission issued the "Several Opinions on Pilot Projects for Innovative Enterprises to Issue Stocks or Depositary Receipts in China", which provides a policy basis for red chip enterprises to directly return to the A-share market, that is, red chip enterprises can complete listing through direct issuance of stocks or depositary receipts. Since then, red chip companies listed overseas have made many attempts to directly "return to the A-share market" through the above path, such as BeiGene [2] and SMIC [3], both retaining their overseas listing status and listing on the A-share market through direct stock issuance. However, as of now, due to the high requirements for the industry, market value, various financial indicators, compliance, and other aspects of red chip listed companies, as well as the volatility of domestic and foreign capital markets, only a small number of industry representative companies have ultimately achieved direct "A" through the above methods.

In addition, red chip companies can also achieve "return to A" by splitting subsidiaries, such as Shengmei Shanghai [4] and Weisheng Information [5]. This method of "returning to A" must meet a series of regulatory requirements both domestically and internationally, including listing period, independence of the issuer after spin off, financial indicators, internal and external approvals, and other multiple requirements.

(2) The operability of H-share companies' subsequent "A return" listing is more direct. The biggest advantage of H-share companies' "A return" listing is that the listing subject does not need to be adjusted, and the inquiries and focus points of regulatory agencies are mostly similar to those of A-share regulatory thinking. The specific practical path for H-share companies to complete domestic A-share listing includes the "H+A" model of directly issuing stocks for listing (including Junshi Biotechnology [6], Kangxinuo Biotechnology [7], etc.), spin off subsidiaries for A-share listing (including Xinmai Medical [8], Jinshan Office [9], etc.), and H-share delisting and conversion into pure A-share listed companies (including Luoxin Pharmaceutical [10], etc.).
2. Securities issuance and circulation

As mentioned earlier, the listing entities and equity structures of H-share and red chip models are different, resulting in significant differences in their securities issuance and circulation. Under the H-share model, the H-shares issued by companies planning to apply for H-share initial public offering belong to foreign shares and can be directly traded on the Hong Kong Stock Exchange. However, the shares held by their shareholders (whether domestic or foreign) before the initial public offering belong to unlisted shares and cannot be directly traded on the Hong Kong Stock Exchange. They must use the "full circulation" channel to convert them into H-shares for circulation on the Hong Kong Stock Exchange; Under the red chip model, all shareholders holding shares of the listed entity can directly circulate after listing on the Hong Kong Stock Exchange without the need for a "full circulation" application.

According to different application time points, the common "full circulation" mode can be divided into the following two types: one is "simultaneous application", which means that the proposed issuer applies for the conversion of domestic unlisted shares into H shares for listing and circulation on the Hong Kong Stock Exchange at the same time as applying for the initial public offering of H shares; The second is "follow-up application", which means that H-share companies apply to the China Securities Regulatory Commission and the Hong Kong Stock Exchange at a certain point after listing to convert their unlisted shares in China into H-shares for circulation. Please refer to Part 3, Point 1 below for specific verification points.
3. Restrictions on foreign investment access

The first problem encountered by overseas listed companies is the issue of foreign investment access policies. Companies should ensure that their business does not involve areas that are restricted or prohibited from foreign investment as listed in the "Special Management Measures for Foreign Investment Access (Negative List)". If their business involves these areas, they need to adjust their listing structure to meet the requirements of foreign investment access policies. Typical restricted businesses involved in overseas listed companies include value-added telecommunications services, with a foreign equity ratio of no more than 50% (excluding e-commerce, domestic multi-party communication, storage and forwarding, and call centers), and a foreign equity ratio of no more than 70% for Sino foreign joint venture medical institutions (the pilot areas for lifting foreign investment restrictions may vary). Based on the significant differences in the listing structure between the two models, there are also different focuses on the considerations of foreign investment access restrictions. Specifically:
(1) The listing and issuance of H-share companies will directly lead to an increase in the proportion of foreign shares, and they should continue to comply with foreign investment access policies before and after the issuance.

Under the H-share model, after listing and issuance, H-share shares issued in the secondary market will be recognized as foreign holdings, and after full circulation, the shares can be transferred to foreign shareholders. The proportion of foreign shares of subsequent issuers may increase significantly. Therefore, H-share companies should always pay attention to meeting the requirements of foreign investment access policies, including before listing, after listing, and after full circulation. According to the "Guidelines for the Application of Regulatory Rules - Overseas Issuance and Listing Category No. 2" ("Guideline No. 2") regarding the "Key Points for Special Legal Verification" and recent inquiries from the China Securities Regulatory Commission, issuers (including subsidiaries) using H-share mode whose business scope involves relevant areas of the "Special Management Measures for Foreign Investment Access (Negative List)" need to explain whether they continue to comply with the requirements of foreign investment access policies before and after this issuance and full circulation.

It should be noted that the "Special Management Measures for Foreign Investment Access (Negative List) (2021 Edition)" ("2021 Edition Negative List for Foreign Investment Access") clearly stipulates that "domestic enterprises engaged in investment areas prohibited by the" Negative List for Foreign Investment Access "that issue shares overseas and go public shall be subject to the approval of the relevant national regulatory authorities. Foreign investors shall not participate in the operation and management of the enterprise, and their shareholding ratio shall be implemented in accordance with the relevant regulations on domestic securities investment management for foreign investors" [11]; The relevant person in charge of the National Development and Reform Commission further clarified in their response to a reporter's question regarding the 2021 version of the negative list for foreign investment access that the "relevant regulations on the management of domestic securities investment by foreign investors" refer to the relevant regulations for foreign investors to invest in the domestic securities market through qualified foreign institutional investors (QFII), RMB qualified foreign institutional investors (RQFII), stock market interconnection mechanisms, and other means. The current regulations require that the investment ratio of a single overseas investor and its affiliates shall not exceed 10% of the total shares of the company, and the total investment ratio of all overseas investors and their affiliates shall not exceed 30% of the total shares of the company. For companies listed both domestically and internationally that engage in businesses prohibited by the negative list, overseas investors holding shares of the same company listed both domestically and internationally will be consolidated for calculation. At the same time, the Ministry of Commerce has clearly stated on its official website and in response to questions from the National Development and Reform Commission that the scope of application of Article 6 of the 2021 version of the negative list for foreign investment access is limited to domestic enterprises engaged in prohibited investment fields on the negative list directly listing overseas.

Based on the aforementioned regulations, the negative list for foreign investment access has reserved certain space at the regulatory level for domestic enterprises engaged in prohibited investment fields on the negative list to directly list overseas. However, the practical operation and implementation still need to be further verified by the market.
(2) Red chip companies often adopt VIE structure to cope with foreign investment access restrictions and should comply with the dual regulatory requirements of domestic and foreign regulatory agencies.

In the red chip model, issuers who build red chip structures usually use VIE structures to meet foreign investment access requirements, and the overseas parent company in the overseas structure is listed in Hong Kong as the listing entity. Due to the Hong Kong Stock Exchange's review requirements on whether the VIE structure of Greater China issuers complies with the "Narrowly Tailored" principle, listing applicants can only resolve any restrictions on foreign ownership through contractual arrangements when necessary. Otherwise, listing applicants must directly hold the maximum permitted equity of OPCO Company (i.e. the corresponding equity ratio allowed for direct shareholding under the foreign industry policy cannot be held in the form of VIE) (for an introduction to the VIE structure of Hong Kong stocks and the Narrowly Tailored principle, please refer to the previously published article "Overseas Listing | Red Chip Structure Decryption: Red Chip Business Q&A Manual (III) - The First Change Required for Switching to Hong Kong Stocks"). From the perspective of domestic supervision, since the official implementation of the new regulations on overseas listing, the China Securities Regulatory Commission will solicit opinions from relevant regulatory authorities and register VIE structured enterprises that meet compliance requirements for overseas listing. Therefore, the VIE architecture should comply with the regulatory rules of both the Chinese domestic and Hong Kong jurisdictions.

It is worth mentioning that on September 8, 2024, the Special Administrative Measures for Foreign Investment Access (Negative List) (2024 Edition) was released and will be implemented on November 1, 2024. The negative list restrictions on foreign investment access were reduced from 31 to 29, and the two items of "publication printing must be controlled by the Chinese side" and "investment in the application of processing technologies such as steaming, frying, roasting, and calcining of Chinese herbal pieces and the production of traditional Chinese patent medicines and simple preparations confidential prescription products" were deleted. The restrictions on foreign investment access in the manufacturing sector were "cleared". In addition, on September 7, 2024, the Ministry of Commerce, the National Health Commission, and the National Medical Products Administration issued a notice on expanding the pilot work of opening up in the medical field (the "Pilot Notice"), allowing foreign-invested enterprises to engage in the development and application of human stem cell, gene diagnosis, and treatment technologies for product registration, listing, and production in the China (Beijing) Pilot Free Trade Zone, China (Shanghai) Pilot Free Trade Zone, China (Guangdong) Pilot Free Trade Zone, and Hainan Free Trade Port; It is proposed to allow the establishment of wholly foreign-owned hospitals in Beijing, Tianjin, Shanghai, Nanjing, Suzhou, Fuzhou, Guangzhou, Shenzhen, and the entire island of Hainan (excluding traditional Chinese medicine, excluding mergers and acquisitions of public hospitals). The "Pilot Notice" undoubtedly brings good news for introducing foreign investment in the medical field, but the specific practice still needs to be implemented. Therefore, enterprises involved in the above-mentioned business areas should make adaptive adjustments or responses to their listing structure in a timely manner, taking into account changes and requirements in the shareholding ratio of foreign shareholders and foreign investment access policies.
4. Identification of controlling shareholder/actual controller

According to the requirements of the new regulations for overseas listings, in the filing documents, the issuer and its domestic lawyers need to identify the controlling shareholder and actual controller of the issuer, but the specific rules or basis for identification are not clear. There are also differences in the provisions and identification rules for controlling/actual controlling in company laws and securities regulatory rules in different regions. For red chip companies, under the common Cayman corporate structure, local laws do not have relevant provisions for controlling shareholders and actual controllers. Therefore, red chip companies listed on the Hong Kong stock market can be recognized in accordance with the Hong Kong stock listing rules; But for H-share companies, the issue of identification is relatively complex, and they not only need to comply with the Hong Kong stock listing rules, but also with specific rules within China.

Article 265 of the Company Law of the People's Republic of China stipulates that "the controlling shareholder refers to a shareholder whose capital contribution accounts for more than 50% of the total capital of a limited liability company or whose shares account for more than 50% of the total share capital of a joint stock limited company; a shareholder whose capital contribution or shareholding ratio is less than 50%, but whose voting rights based on their capital contribution or shareholding are sufficient to have a significant impact on the resolutions of the shareholders' meeting". The listing rules and related guidelines of the Hong Kong Stock Exchange ("HKEX Listing Rules") clarify the identification and responsibility of "controlling shareholders", namely (i) any person or group of persons who have the right to exercise or control the exercise of 30% or more of the voting rights at the issuer's shareholders' meeting; Or (ii) a person or group of persons who have the ability to control the majority of the members who make up the board of directors of the issuer.

It can be seen that the Company Law usually recognizes shareholders holding more than 50% of the voting rights as "controlling shareholders", and in most cases, it is one shareholder; The listing rules of Hong Kong stocks usually use a threshold of more than 30% of voting rights as the recognition of controlling shareholders, and there may be multiple controlling shareholders at the same time, without introducing the concept of "actual controller".

Based on market experience, H-share companies need to refer to the recognition approach of the Company Law for judgment, and their recognition results may differ from the conclusions under the Hong Kong Stock Exchange Listing Rules. However, these differences are mainly due to the application of rules and do not constitute substantive obstacles. There is no need to forcibly unify them, and they should mainly follow the Hong Kong stock listing rules, combined with the provisions of the Company Law, and provide reasonable explanations for the differences and recognition in the filing documents.
5. Compliance requirements for foreign exchange management

Due to the different equity structures of H-share companies and red chip companies, there are significant differences in compliance procedures for shareholders (including employee incentive targets) in overseas investments.
(1) Foreign exchange registration procedures performed by shareholders before listing

Red chip enterprises need to constantly pay attention to the compliance procedures of shareholders' overseas investments when building or restructuring red chip structures. For domestic natural persons, their holdings of shares in Cayman Islands companies or BVI entities overseas should be registered in accordance with the requirements of the "Notice on Foreign Exchange Management for Overseas Investment and Financing and Return Investment of Domestic Residents through Special Purpose Companies" (Huifa [2014] No. 37) ("Document No. 37 Registration"); For domestic legal entities that make direct investments overseas, they need to complete three compliance procedures ("ODI procedures"): approval or filing of overseas investment projects by the commerce department, the development and reform department, and bank foreign exchange registration.

For H-share companies, as they do not involve overseas holding rights of Chinese residents, shareholders of the company are usually not involved in the registration of Document No. 37 or ODI procedures before the initial public offering. However, domestic shareholders participating in the full circulation business should go to the local foreign exchange bureau within 20 working days after the reduction of holdings to complete the registration of domestic shareholder shareholding.
(2) Foreign exchange registration procedures related to employee incentive targets

Red chip companies usually use Cayman companies as the listing entities, which adopt the authorized share capital system, that is, the maximum number of shares that the company can issue is pre-set in the company's articles of association, and gradually issued through shareholder resolutions according to commercial needs and market conditions. Under the authorized share capital system, a portion of the share capital can be marked as reserved shares for equity incentives. These reserved shares are only marked for their intended purpose and do not need to be actually issued before employees exercise their rights. However, for H-share companies, domestic limited liability companies adopt a registered capital system, where the registered capital represents the actual capital that shareholders need to pay and be registered by the company. Therefore, the registered capital corresponding to equity incentives for H-share companies must be issued and paid in before listing, and the relevant shares must be held by the holding platform or employees.

Based on the differences in share capital systems between the two listing models mentioned above, there are also differences in corresponding foreign exchange regulatory registrations. This includes the red chip model, where the incentive objects are usually registered in accordance with the requirements of the "Notice of the State Administration of Foreign Exchange on Foreign Exchange Management of Domestic Individuals Participating in Overseas Listed Company Equity Incentive Plans" (Hui Fa [2012] No. 7) after the red chip enterprise is listed; However, in the H-share model, as the incentive targets/platforms and listed entities are generally domestic entities in China, the shares held usually do not involve special foreign exchange registration matters.
3、 Special verification requirements for H-shares under the new regulations for overseas listing

In addition to the important differences mentioned earlier, the new regulations for overseas listings also have specific regulatory verification requirements for the Hong Kong red chip model and the H-share model, including the application of special regulatory rules for the "full circulation" policy unique to the H-share model.
1. "Full circulation"

According to Guideline No. 2, when H-share issuers file with the China Securities Regulatory Commission, the commission has put forward verification requirements from two aspects: initial public offering and "full circulation" plan:

Regarding the initial public offering, in the special legal opinion, it is explicitly required that the issuer's lawyer verify whether the business scope of domestic enterprises (including subsidiary companies) involves the relevant areas of the "Special Management Measures for Foreign Investment Access (Negative List)" and whether they continue to meet the regulatory requirements after the initial public offering/"full circulation";

Regarding the "full circulation" plan, in the filing report and commitment, it is required to verify and explain the authorization documents of domestic unlisted shareholders and the commitment to compliance with stock acquisition, fulfill internal decisions and external approvals, and comply with the relevant regulations of the China Securities Regulatory Commission on "full circulation". In the special legal opinion letter, it is explicitly requested to verify whether the relevant domestic unlisted shareholders who apply for full circulation belong to the serious dishonest subjects stipulated in the "Guiding Opinions of the State Council on Establishing and Improving the Joint Incentive and Joint Punishment System for Creditworthiness and Accelerating the Construction of Social Integrity" (State Council Document [2016] No. 33).
2. Formulation of Articles of Association for H-share Listed Companies

In terms of corporate governance, according to the new regulations for overseas listings, H-share companies are required to comply with relevant rules such as the "Guidelines for the Articles of Association of Listed Companies" [12] issued by the China Securities Regulatory Commission for A-share listed companies. That is, H-share companies need to apply to a certain extent the regulatory requirements of the China Securities Regulatory Commission for A-share listed companies on the basis of complying with Chinese laws and regulations and Hong Kong stock listing rules. Red chip companies, on the other hand, are not restricted by these A-share guidelines and have higher autonomy in their corporate governance design.
3. Verification of issuing objects

H-share companies are subject to clearer rules and requirements in the selection of incentive targets. According to the new regulations for overseas listing, domestic enterprises that directly issue and list overseas and implement equity incentives or issue securities to purchase assets may issue securities to specific domestic targets that comply with the regulations of the China Securities Regulatory Commission. If H-share companies issue securities to specific domestic targets for equity incentives overseas, the specific domestic targets may include directors, senior management personnel, core technical personnel or core business personnel of domestic enterprises, as well as other personnel who the enterprise believes should be incentivized and have a direct impact on the enterprise's business performance and future development. However, the following individuals shall not be eligible for incentives: (i) those who have been subject to administrative penalties (including market entry bans) by the China Securities Regulatory Commission and its dispatched agencies for major violations of laws and regulations in the past 12 months; (ii) Those who are not allowed to serve as directors or senior management personnel of the company according to the provisions of the Company Law; (iii) Laws, administrative regulations, and relevant national provisions clearly prohibit participation in corporate equity incentives [13]. This regulation aims to maintain the fairness and rationality of equity incentives, ensure that incentive plans can truly benefit employees who have contributed to the company, and avoid potential conflicts of interest.

The new regulations for overseas listing stipulate special verification requirements for the equity incentive targets of H-share companies, but do not separately propose special requirements for the implementation of equity incentives for red chip companies. H-share companies and red chip companies need to follow the verification requirements for employee stock ownership plans and equity incentives mentioned in the second point of the "Verification Requirements for Equity Structure and Control Structure" in the attachment of Guideline No. 2.
4. Verification of the number of shareholders

H-share companies, as entities established within China, should comply with the provisions of the Company Law. When their shares are converted into "limited liability companies", the number of shareholders shall not exceed 200; Red chip companies are subject to the laws and regulations of their overseas establishment location. Taking the commonly used Cayman Islands exempted limited liability company as an example, the Cayman Companies Law does not have a clear limit on the number of shareholders.

The special verification points of the H-share model mentioned above do not imply any superiority or inferiority between the H-share model and the red chip model, but only the regulatory differences caused by the different models. During the filing and review process, targeted verification and response to inquiries should be paid attention to.

In addition to the main differences between the two modes mentioned above, the new regulations for overseas listing have put forward the same verification requirements for H-share mode and red chip mode. We will not repeat them here, and you can refer to our previous series of interpretation articles on the new regulations for overseas listing for details.
epilogue

The H-share model and the red chip model, as the two mainstream paths for Chinese domestic enterprises to list on Hong Kong stocks, each carry unique listing processes and capital operation logic. During the listing stage, the H-share model focuses on shareholding reform, while the red chip model tends to build a flexible overseas structure; There are also differences in the focus of review by domestic and foreign securities regulatory agencies, and companies need to make corresponding strategic adjustments and choices based on their own situation. After the listing and issuance, there are significant differences between the two models in terms of exit paths, trading methods, and fund repatriation in the later stage. We will continue to analyze and interpret them for readers in the next part of this article. Stay tuned.