Rewards and risks of financing through a HK reverse merger

By Jonathan Sun, Wang Junlu, Zhong Yin Law Firm

The term “reverse merger” means that the investor involved in a private placement (i.e. the acquirer) uses its assets to subscribe for the newly offered shares of the issuer (i.e. the target company) and, on this basis, injects the assets into the target company and secures a controlling interest, thereby realising the acquirer’s reverse merger.

 光汇石油曾通过注入客户而不注入资产的方法避免了资产注入被当做上市处理 孙健 Jonathan Sun 中银律师事务所 高级合伙人 Senior Partner Zhong Yin Law Firm
Jonathan Sun
Senior Partner
Zhong Yin Law Firm

Enterprises subject to restrictions on initial public offerings (IPOs) mainly opt for reverse mergers to achieve a listing, e.g. real estate enterprises and securities companies. After encountering obstacles to listing through such means as REITs, IPO and A-shares, Wanda successfully acquired a 65% stake in Hengli and completed a reverse merger in Hong Kong. A reverse merger can allow an enterprise to first secure control of a listed company, and then, depending on the actual degree of maturity, gradually inject business into it.

Why Hong Kong?

The main markets available to an enterprise for a reverse merger include the A-share market, Hong Kong Stock Exchange (HKEx), the Singapore Exchange and US exchanges. When considering which market to choose, the enterprise must, based on its own immediate interests, consider such factors as the price of the shell, how clean it is, follow-up fundraising capabilities, the speed at which the assets can be injected, shareholder tax planning, success rate, timing of the transaction, etc.

The advantages of Hong Kong lie in its world class market regulation and corporate governance structure making for relatively low risk in the shell’s contingent liabilities, and its globalised market and multitude of financing instruments giving enterprises relatively strong follow-up fundraising capabilities. However, asset injection may require more meticulous design.

王珺璐 Wang Junlu 中银律师事务所 律师 Lawyer Zhong Yin Law Firm
Wang Junlu
Zhong Yin Law Firm

The price of shells on the Hong Kong market is relatively steep, due on the one hand to the above-mentioned advantages, and on the other to the relative stability of the listing status of shell companies in Hong Kong. Unless a company goes bankrupt or becomes a pure cash company, very few are delisted.

Given that Hong Kong is close to the mainland, investors can more easily access the newest industry and company information, which is conducive to enhancing the degree of investment and transaction activity. This directly affects the rate of success of follow-up financing after a reverse merger.

Reverse mergers. The HKEx Securities Listing Rules specify that if any indicator of the assets cumulatively injected by the buyer within the 24 months after the buyer becomes a shareholder holding more than 30% of the common shares is greater than 100% of any of the five test indicators of the shell – i.e. revenues, market value, assets, profits or equity capital – such transaction constitutes a very substantial transaction, and such injection may require approval based on the same criteria as for an IPO application.

Brightoil’s strategy

This would defeat the purpose of the reverse merger. Brightoil Petroleum avoided its asset injection being treated as a listing by injecting customers rather than assets. Such a strategy can serve as reference.

Risk if percentage of equity acquired too small. The price for the acquisition of equity in a shell company is higher than that for the average tradable shares due to the addition of the shell price and control premium. Certain shell buyers hold the equity through an agent to reduce costs and circumvent such restrictions as the company being treated as newly listed, resulting in their being unable to vote when they subsequently wish to inject assets, being constrained by other small shareholders.

Buyers carrying out a takeover by this roundabout method need to be aware that this violates the regulation that shareholders are required to truthfully disclose their interests, and should the same come to light, they may be subject to criminal prosecution. Furthermore, the Securities and Futures Commission of Hong Kong (SFC) will pay attention to the arrangement of the original major shareholder of the listed company for the disposal of the remaining shares – for example, sale to other independent third parties – and will not permit the buyer to exercise control over these remaining shares.

Proof of funds

Takeover offer risk. Pursuant to the codes on takeovers and mergers and share repurchases, if a new shareholder holds more than 30% of the equity, it may be required to make a general takeover offer to all of the shareholders and show that it has the funds required for the takeover. Only where it can be shown that the shell company would face the prospect of being wound up, if not for the injection of funds by the buyer, can a general takeover offer be waived with the approval of the SFC, reducing the funding pressures.

Maintenance of listed status. To maintain its listed status, a company listed in Hong Kong is required to have genuine business, and may not be a pure cash company.

Shell resource risk assessment. The business assets of the shell will operate in such a way as to decide the difficulty and costs of clearance after acquisition of the shell by the acquirer. Shell companies involving large production-type machinery and equipment, inventory, accounts receivable and long product turnaround times are the most difficult to clear. Furthermore, if the asset swap of a shell with a large quantity of operating-type assets requires a long period of time, there is a risk of impairment of its business and assets, and the management of such assets requires professional skills, easily leading to operational difficulties.

Avoid cash payment

Easing of cash payment pressures. Regarding the large amount of funds needed in a reverse merger, the shell company should try to use a payment method other than cash. For example, consideration can be given to an equity swap to obtain equity in the shell company and then, to an asset swap, to strip away the non-performing assets of, and inject quality assets into, the shell company.

Furthermore, with a view to reducing cash expenditures, the buyer of the shell company can additionally consider first injecting funds into the shell company, and then having the shell company purchase quality assets from the buyer of the shell company, or first have the shell company take out a loan to acquire quality assets from the buyer of the shell, following which the buyer of the shell uses the proceeds from the asset transfer to acquire the shell company.




邮编: 100022

31 Floor, Jianwai SOHO A

Dongsanhuan Zhonglu 39, Chaoyang District

Beijing 100022, China

电话 Tel: 86 10 5869 8899

传真 Fax: 86 10 5869 9666

电子信箱 E-mail: