Consultation Paper on Offering Mechanisms

TABLE OF CONTENTS

• EXECUTIVE SUMMARY

1. Introduction

2. Principal Areas of Consultation

3. Consultation Period

• BACKGROUND

I. The 1994 Joint Policy Statement

II. Position since 1994 and Factors leading to the Public Consultation

III. Characteristics of the Combined Offering Mechanism

• AREAS OF CONSULTATION

I. Minimum size for the Subscription Tranche

II. The SEHK's discretion on the Use of Placing

III. Underwriters' discretion on the allocation of shares in the Placing Tranche

IV. Extent of Over-Allocation of Shares

V. Over-allocation between the Subscription Tranche and the Placing Tranche

VI. Flexibility in Adjusting the Price, Size and Timing of an Offer

VII. Eligibility to apply for shares in the Subscription Tranche and the Placing Tranche

VIII. Announcement of indications of interests in the Placing Tranche

• CONSULTATION

APPENDIX 1 : Joint Policy Statement on Offering Mechanisms (November 1994)

APPENDIX 2 : List of Global Equity Offerings (1993 - May 1997)

APPENDIX 3 : Joint Statement on Global Offering Mechanisms (July 1996)

APPENDIX 4 : Book-building: General Information

APPENDIX 5 : The Combined Offering Mechanism

APPENDIX 6 : Joint Announcement on Allocation of Shares in Initial Public Offerings (May 1997)

EXECUTIVE SUMMARY

1. Introduction

In response to developments in international markets and the resulting structure of initial public offerings ( "IPOs" ) in Hong Kong, the Securities and Futures Commission (the "SFC" ) and the Stock Exchange of Hong Kong Limited (the "SEHK" ) have reviewed the Joint Policy Statement on Offering Mechanisms issued in November 1994 (Appendix 1) . The factors leading to this consultation exercise are summarised in the section headed "Background" below. This Executive Summary highlights the principal areas of consultation and the recommendations currently proposed by the SFC and the SEHK.

2. Principal Areas of Consultation

The SFC and the SEHK invite the public to express views or comment on the following :

• (i) Minimum size for the public subscription tranche : As the main purpose of having the subscription tranche is to meet the demand of local investors who provide liquidity to the market, the SFC and the SEHK believe that a channel should be open for Hong Kong demand to be sufficiently met. The need to balance Hong Kong investor demand against the flexibility offered by the book-built placing method has always been in the fore-front of the regulators' priorities. Accordingly, whilst the SFC and the SEHK continue to hold the view that allocation of shares between the public subscription tranche and the placing tranche remains, to a large extent, a commercial decision for issuers and underwriters, it is believed that for the interests of the Hong Kong market as a whole, a minimum size of the subscription tranche should be specified. It is recommended that the initial size of the subscription tranche be set at a minimum of 10% of an issue, with a clawback provision allowing that tranche to be increased up to 30% of the total issue size if it is 15 times subscribed, and up to 50% of the total issue size if that tranche is 50 times subscribed. (Paragraphs 21 to 32).
• (ii) SEHK's discretion on the use of placing : The combined offering mechanism involving a public subscription tranche and a book-built placing tranche in an IPO was specifically approved for the purpose of facilitating large scale multi-jurisdictional equity offerings. It was not intended that such offering mechanism be used in all IPOs on the SEHK. Accordingly, the SEHK wishes to remind underwriters and issuers that it may, pursuant to Rule 7.10 of the Listing Rules, exercise its discretion not to allow, or impose restrictions on, any part of an issue to be offered by way of placing (Paragraphs 33 to 36).
• (iii) Underwriters' discretion on the allocation of shares in the placing tranche : Some market participants have expressed concerns that there is currently not sufficient transparency on how underwriters exercise their discretion in the allocation of shares in the placing tranche. The questions raised include whether underwriters should be required to disclose how discretion is to be exercised, and whether regulations should be introduced to prescribe how underwriters ought to exercise their discretion. Whilst the SFC and the SEHK expect underwriters to act fairly and in the best interests of issuers when allocating shares, it is not recommended that rules be introduced either to require detailed disclosure on how discretion is to be exercised or to prescribe how underwriters ought to exercise their discretion under the placing tranche of an offer (Paragraphs 37 to 40).
• (iv) Extent of over-allocation of shares : The creation of short positions by underwriters without the benefit of an over-allotment option, or creating short positions in excess of the limit under which shares could be allocated under such option will be subject to the scrutiny of the SFC under the relevant provisions of the Securities Ordinance which prohibit market manipulation activities (Paragraphs 41 to 47).
• (v) Over-allocation between the subscription tranche and the placing tranche : In order to maintain the balance between the public subscription tranche and the placing tranche, the SFC and the SEHK will require that over-allocated shares be divided in such a way that the total amount of shares ultimately allocated to the two tranches would bear the same ratio as that originally set between them before any over-allocation takes place (Paragraphs 48 and 49).
• (vi) Flexibility in adjusting the price, size and timing of an offer : The Companies Ordinance requires certain parameters to be specified in Hong Kong prospectuses. For global offerings where the book-building period remains open during the offer period of the subscription tranche, underwriters believe that the book-building process is, to a certain extent, limited by such parameters. As Hong Kong prospectuses are issued prior to the close of the "book", underwriters are seeking flexibility under the subscription tranche in adjusting the price range, the size and the timing of an issue prior to the close of the offer period. Whilst the SFC and the SEHK note that introducing greater flexibility in the areas mentioned above would help make Hong Kong more attractive to issuers, the whole question has to be considered with care, and the SFC and the SEHK believe that if any flexibility were to be allowed, the relevant legal issues must, in any event, have to be addressed and sufficient safeguards must be in place for the benefit of investors under the subscription tranche (Paragraphs 50 to 63).
• (vii) Eligibility to apply for shares in the subscription tranche and the placing tranche : Traditionally, the subscription tranche is intended for the participation of retail investors, and the placing tranche for institutional investors. However, it has been noted that high level of subscriptions by non-retail Hong Kong investors reduces the proportion of shares that could be allocated to retail investors. Over-subscriptions of IPOs have also caused imbalance in the supply and demand of funds in the banking system resulting, among other things, in the increase of short term interest rates on Hong Kong dollar. The SFC and the SEHK wish to seek the public's view on the approach that should be adopted to address these issues. Apart from maintaining the existing system, two possible approaches have been identified. Under the first approach, all investors are eligible to apply for shares under the placing tranche and the subscription tranche (with subscriptions for large and small amounts to be separated into two pools), but rules would be introduced to prevent investors who have applied for shares under one tranche from applying for shares under the other tranche. Under the second approach, participation in the subscription tranche would be limited to "retail" investors only; and participation in the placing tranche would be limited to "non-retail" investors only. An objective set of criteria would have to be established to define whether an investor would be regarded as a "retail investor", with the rest of the investors to be regarded as "non-retail investors" (Paragraphs 64 to 77).
• (viii) Announcement of indications of interests in the placing tranche : Certain sectors of the market consider that transparency of the placing tranche should be improved by requiring issuers and underwriters to disclose the extent of demand for shares under that tranche by describing the indications of interest expressed by investors in gross numerical terms. It is suggested that such disclosure should be made before the commencement of trading of the relevant securities in Hong Kong. This would also eliminate implications under the Securities (Insider Dealing) Ordinance when underwriters conduct short coverings or other dealings of the relevant securities in the Hong Kong market. (Paragraphs 78 to 86).

Consultation Period

The consultation period will end on 8 August 1997. Comments should be sent to :

The Securities and Futures Commission

12 Floor, Edinburgh Tower,

The Landmark, 15 Queen's Road Central, Hong Kong.

For the attention of the Secretary to the Commission.

Interested persons may also provide comments by E-mail to cf@sfc.hk.

This Paper is available at the offices of the SEHK (36th Floor, Jardine House, 1 Connaught Place, Central, Hong Kong) and the SFC (see above) as well as on the SFC Internet Home Page at http://www.sfc.hk, and on the SEHK Website at http://www.sehk.com.hk.

BACKGROUND

I. The 1994 Joint Policy Statement

1. Until 1993, the majority of new listings in Hong Kong were conducted through fixed price offers by subscription, with the remaining through a combination of the subscription method and the fixed price placing method, or by way of introduction.

2. The main features of a typical offer for subscription are that subscription of shares is fully underwritten, shares are offered at a price pre-determined by the issuers and the underwriters, and investors are required to pay in full for the total number of shares applied for by submitting, with the application forms, personal cheques or bankers' drafts. The Listing Rules require that issuers and underwriters must adopt a fair basis of allocation of shares on offer to the public. Therefore, underwriters normally allocate an equal number of shares to investors who applied for the same number of shares. In cases where the total number of shares applied for significantly exceeds the shares available, a ballot will be used to allocate shares to investors.

3. Beginning with the listing of the first batch of H shares on the SEHK in July 1993, global equity offerings which involve the raising of funds from both the Hong Kong market and the international markets have become more common. Accordingly, a Working Party comprising staff of the SFC and the SEHK was established in 1994 to review whether the fixed price public subscription method would disadvantage Hong Kong in participating in multi-jurisdictional equity offerings, and whether Hong Kong should adopt alternative forms of offering mechanisms. In pursuing this goal, the Working Party intended to introduce greater flexibility in the public distribution of securities in equity offerings, and at the same time ensure that the interests of local investors were not disadvantaged by any change in approach.

4. After consulting a number of merchant and investment banks which participated in global equity offerings in 1993/1994, the SFC and the SEHK issued a Joint Policy Statement on Offering Mechanisms on 4 November 1994 ( the "1994 Joint Policy Statement" ) (Appendix 1) . The principal conclusions of the Working Party which are relevant for the purposes of this Paper are summarised as follows:

• (i) The need to introduce alternative offering mechanisms was recognised. It was accepted that global equity offerings which involved the listing of large scale new issues on the SEHK raising funds from the domestic and international markets could be conducted by the simultaneous offer of shares in Hong Kong by way of the traditional public subscription method (which forms the Hong Kong subscription tranche) and the placing of shares to international investors by using the book-building method (which forms the international placing tranche).
• (ii) In respect of such global offerings, the Working Party believed at the time that the size of the subscription tranche and the placing tranche was a matter for the issuer and the underwriter to decide. The Working Party did not stipulate a minimum dollar value or percentage of a new issue that must be allocated for public subscription in Hong Kong. However, underwriters and issuers were expected to give due regard to the interests of local retail investors in developing offering mechanisms that would be suitable for their new issues.
• (iii) Inter-tranche flow of allocations between the Hong Kong and international tranche should be permitted so that securities may be allocated to markets where real demand lies. The objective was to facilitate optimal equilibrium between the primary market supply and demand and to minimise market imbalance.
• (iv) Where underwriters have over-allotted in an offering, genuine purchases in the secondary market effected solely for the purpose of covering such over-allotment would not of themselves infringe the relevant provisions of the Securities Ordinance which prohibit market manipulation in the form of pegging or stabilising the price of securities.

II. Position since 1994 and Factors leading to the Public Consultation

5. Since the issue of the 1994 Joint Policy Statement, the combined use of the public subscription method and the international placing of shares by way of book-building has become the norm in global equity offerings. These offerings involve shares being listed on the SEHK and in some cases, in the U.S. or in the U.K..

6. With a view to developing future policy initiatives on the area and in order to better understand how the two offering mechanisms operate and interact in practice, the SFC has, in the past two years, consistently reviewed underwriters' records relating to the book-building tranche with respect to each global offer. The SFC has also held discussions with market participants to understand how the book-building system is perceived to have operated in Hong Kong, and how the system works in overseas jurisdictions. Our study highlights certain policy issues that the Hong Kong market needs to further consider. These are summarised in paragraphs 7 to 19 below.

(a) Decrease in the size of the Subscription Tranche

7. The SFC and the SEHK noted that between 1994 and 1995, the size of subscription tranches decreased significantly notwithstanding that the IPO market was relatively weak in 1995 .

8. As expressly stated in the 1994 Joint Policy Statement, the initiatives in accepting alternative offering mechanisms in Hong Kong were targeted to "introduce greater flexibility for the public distribution of securities in equity offerings whilst ensuring that the interests of local investors are not disadvantaged by this approach ". The need to balance Hong Kong investor demand against the flexibility offered by the book-built placing method has always been in the fore-front of the regulators' priorities. With the decrease in size of the subscription tranches, the SFC and the SEHK were concerned that in developing offering mechanisms for new issues, issuers and underwriters had not given "due regard to the interests of local retail investors" as required by the 1994 Joint Policy Statement.

9. Accordingly, since the beginning of 1996, the SFC has taken on a more active role in approving that part of draft prospectuses which deals with offering mechanisms, in particular, the amount of shares proposed to be allocated to the subscription tranche. This explains the fact that commencing from 1996, there has been an increase in, and generally speaking, a standardisation of, the size of subscription tranches.

(b) Eligibility to apply for shares under the Placing Tranche

10. The Kwong On Bank listing in June 1996 highlighted the fact that some Hong Kong investors were able to obtain shares through the placing tranche as an alternative or additional route to applying for shares under the subscription tranche. It became known that some Urban Councillors obtained shares through the placing tranche which was understood to be for institutional investors. The case attracted considerable attention from the media and the Legco Financial Affairs Panel. The Panel regarded the fact that retail investors obtained allocations intended for institutional investors to be a "loophole". The Panel was concerned that there was no mechanism to prevent "unequal treatment" to investors under the two tranches of an IPO and asked the SFC and the SEHK to review this "loophole".

11. As a result of the Kwong On Bank case, the SFC and the SEHK issued a further statement in July 1996 ( the "1996 Joint Statement")(Appendix 3) to remind the market and the public of the objectives and the policy with regard to the combined global offering mechanism announced in 1994. Among other things, the 1996 Joint Statement emphasised that notwithstanding the flexibility afforded to underwriters in making allocations under the book-building system, they are expected to make decisions on allocation in the placing tranche impartially and based only on criteria which are in the best interests of the issuer and the general body of its investors.

12. To address concerns regarding the different treatment available to individual retail investors who may be able to obtain shares in the placing tranche, the SFC has, since July 1996, required underwriters to provide undertakings to the effect that individual retail investors are essentially excluded from the placing tranche. As part of this consultation exercise, the SFC and the SEHK are seeking the market's views on whether individual retail investors should be disallowed from participating in the placing tranche.

(c) Effect of over-subscription in the Public Subscription Tranche

13. The SFC and the SEHK note that a number of recent IPOs have been significantly over-subscribed. As a result, applications for smaller amounts of securities under the public subscription tranche have been scaled back and subject to balloting, whilst applications for larger amounts of securities have been scaled back by a factor which is approximately equal to the level by which an issue has been over-subscribed.

14. The current allocation procedures tend to encourage applicants to use bank credit to apply for large amount of stock. This greatly increases the demand for funds in the Hong Kong banking system, resulting in an increase of short term interest rates on Hong Kong Dollar. Both the SFC and the SEHK are concerned about the potential adverse impact which this might have on the Hong Kong market and the general economy as a whole.

15. In order to ensure that the issuance and marketing of securities is conducted in a fair and orderly manner and to maintain investor confidence in the market, the SFC and the SEHK issued a Joint Announcement on Allocation of Shares in Initial Public Offering in May 1997 which introduced interim measures to address the problem ( Appendix 6 ). At the time of release of this Paper, it is still too early to ascertain the exact effect that such interim measures might have produced on the system. In any event, it is believed that longer term measures should be put in place to address the problems caused by over-subscription of shares in IPOs.

(d) Whether flexibility of the combined offering mechanism should be further improved

16. Underwriters argue that there is an inherent contradiction between the book-building method which presumes that the price would not be fixed until the end of the book-building period, and the public subscription method which is based on a fixed price or price range. Thus, for offerings where the book-building period remains open during the offer period of the subscription tranche, underwriters consider that the subscription method has restricted the flexibility normally provided by the book-building system in adjusting the price range, timing and the size of an offer. The lack of such flexibility means that the objective of balancing supply and demand (which is supposed to be the principal advantage of using the book-building system) could not be properly achieved. The SFC and the SEHK would like to seek views on introducing more flexibility on adjusting these aspects of the subscription tranche.

(e) Whether more transparency should be introduced in the Placing Tranche

17. Discussions that the SFC had with a number of market participants including institutional investors who have participated in the book-building process, suggest that certain sectors of the market might want to have more information on:

• (i) how underwriters exercise their discretion when allocating shares to investors under the placing tranche; and
• (ii) the level of indications of interest expressed by investors under the placing tranche during the book-building period.

18. Whilst the first issue raises some fundamental questions on the flexible and non-binding nature of the book-building process, the second issue raises, among other things, legal implications under the Securities (Insider Dealing) Ordinance. These are issues on which the SFC and the SEHK wish to seek the public's views.

(f) Other factors leading to the Public Consultation

19. Apart from the above, the SFC and the SEHK believe that there are certain other issues in relation to the combined offering mechanism which should be clarified. These include, for example, clarification of the policy on whether underwriters should be allowed to create a short position on shares being offered by over-allocating shares above the level provided by the over-allotment option, and the SEHK's discretion on the use of placing as an offering mechanism under the Listing Rules.

III. Characteristics of the Combined Offering Mechanism

20. The principal features of a typical new issue which uses the traditional public subscription method and the book-built placing method are set out in Appendix 5 . The advantages of using the book-building method as opposed to the subscription method in the distribution of securities are summarised in Appendix 4 .

AREAS OF CONSULTATION

I. Minimum size for the Subscription Tranche

21. In the 1994 Joint Policy Statement, the SFC and the SEHK stated that the size of the subscription tranche and the placing tranche was a matter for the issuer and the underwriter to decide. However, the size of subscription tranches decreased significantly in 1994 and 1995 when issuers and underwriters were given full discretion in deciding the proportion of shares to be allocated to these tranches. As the main purpose of having the subscription tranche is to meet the demand of local investors, and these investors have consistently demonstrated their willingness to participate in global equity offerings, the SFC and the SEHK believe that a channel should be open for Hong Kong demand to be met on a basis proportionate to institutional demand.

22. Accordingly, whilst the SFC and the SEHK continue to hold the view that allocation of shares between the public subscription tranche and the placing tranche remains, to a large extent, a commercial decision for issuers and underwriters, we believe that for the interests of the Hong Kong market as a whole, there should initially be a minimum size of the subscription tranche in all issues. This approach would provide certainty and consistency in determining the initial size of the subscription tranche and the placing tranche, and would eliminate the need for underwriters and regulators to discuss the matter on a case by case basis.

23. In general, underwriters accept the need to balance the competing interests of retail and other Hong Kong investors and the need to maintain flexibility in the placing tranche. Some underwriters have suggested that a minimum of 10% of a typical US$300 million (HK$2.2 billion) offering (exclusive of securities which may be issued under an over-allotment option) be allocated to the Hong Kong market, which percentage could be increased by the issuer and the underwriters in their discretion. They have also lobbied for the percentage of the clawback not being set "too high".

24. Since 1996, the initial size of the subscription tranche has generally been set by underwriters at 10% of an issue, with a clawback provision allowing that tranche to be increased to up to 30% of the total issue size. The clawback provision is triggered when the subscription tranche is over-subscribed. Where the initial size of the subscription tranche is set at 10% of an issue, the clawback provision should operate to increase the initial size to 30% of the whole issue when the number of valid applications under the tranche amounts to 15 times its initial size. Where the initial size of the subscription tranche is set above 10%, the clawback provision should operate to increase the initial size to 30% of the whole issue when the number of valid applications under the tranche amounts to 150% or one and a half times of the whole issue size. The purpose is to maintain a one in five balance between supply and demand at the time the 30% clawback is triggered. The clawback provision also operates to re-allocate shares from the subscription tranche to the placing tranche in cases where the former tranche is not fully subscribed.

25. The SFC and the SEHK, however, note that in very popular issues, the 30% clawback of shares to the subscription tranche far from satisfies Hong Kong investor demand. When the number of valid applications received in these issues is compared to the number of shares available under the subscription tranche (even after the 30% clawback is taken into account), there is still a big disparity in the number of shares available for allocation, resulting in a considerable number of investors under the subscription tranche not being able to receive any shares. Accordingly, it is recommended that the size of the subscription tranche be set at a minimum of 10% of an issue, with a clawback provision allowing that tranche to be increased to up to 30% of the total issue size where the shares available under the tranche is 15 times subscribed; and up to 50% of the total issue size where the shares available under the tranche is 50 times subscribed. If, in a particular case, the issuer and the underwriters believe that lower percentages should be used, the SEHK's approval to a reduced size of the subscription tranche should be sought. In considering whether, and if so, how, a minimum benchmark should be set to determine the initial size of the subscription tranche, the SFC and the SEHK have considered the factors set out in paragraphs 26 to 32 below.

(a) Flexibility to respond to differences in supply and demand

26. Underwriters have represented that allocations requiring a substantial portion of the initial offering to go to the subscription tranche can impair their flexibility to respond to differences in demand in the Hong Kong and international markets, thereby reducing their ability to achieve an optimal distribution between these markets and the various kinds of investors. If demand for an issue is expected to come predominantly from overseas institutional investors, underwriters argue that they should have the ability to satisfy such demand at the highest possible price level, maximising the proceeds to be raised by the issuer. In such circumstances, there is a concern that if a fixed allocation to the subscription tranche is made, it would increase the probability that the tranche would be under or poorly subscribed, and increase the risk that the issue as a whole (including the placing tranche) would be perceived as being unsuccessful. That perception could, in turn, result in a "sell-off" in the after-market and weakening prices.

27. The proposal of setting the minimum initial size of the subscription tranche at 10% of an issue has taken into account these concerns. The 10% figure is supported by statistics - there has been no issue in the past four years which allocated less than 10% of the issue size to the subscription tranche initially, and during this period, the issue size ranged from a minimum of HK$206 million to a maximum of HK$3,934 million (see Appendix 2 ). The clawback provision is built in to ensure that shares could be re-allocated to markets where real demand lies. The 30% clawback has been applied to all global issues in the past nine months, and the proposed 50% clawback will only operate when the subscription tranche is very heavily subscribed.

(b) Possible impact on the "success" of an issue as a whole

28. Underwriters are concerned that by setting aside a fixed or high proportion of shares for the subscription tranche, the "success" of an offering might be affected. As the subscription tranche is dominated by retail investors, underwriters argue that increased participation of such investors in an offering (as opposed to institutional or professional investors) is likely to affect the price of the offer, the willingness of institutional investors to participate in the offer, and affect the general impression of the issuer or the market as to whether the offering is a successful one. The SFC and the SEHK are not persuaded by these arguments.

29. Underwriters argue that retail investors are generally perceived to be short-term holders or "flippers": they tend to sell or "flip" securities where the market price increases substantially after trading commences in order to secure a quick profit; and where the market price decreases in the after-market, they tend to "flip" to minimise loss immediately. Underwriters have suggested that such behaviour creates two problems with respect to the share price. First, it may create uncertainties for the underwriters in fixing the issue price, particularly if it is accepted that retail investors tend to be more easily moved by rumours or short-term market sentiments rather than focusing on the fundamentals of an issuer. Secondly, the after-market stability of the price may be affected by increased retail participation if assertions about their propensity to "flip" are accepted. These factors are said by underwriters to have an impact on the willingness of institutional investors to participate in an offer, but no clear evidence has been provided.

30. The SFC and the SEHK do not believe that retail investors are necessarily more likely to deal in securities immediately after trading commences than institutional investors. No underwriters have so far provided empirical studies to support their contention that the shares placed with institutions are less likely to be traded immediately after listing than shares sold to investors under the subscription tranche. Studies by the SEHK on the behaviour of placees in public offers in 1994 and 1995 concluded that behaviour of placees could not be inferred from market data with a significant degree of certainty. The studies showed that financial institutions disagreed as to whether institutional investors held shares for a longer period than ordinary investors. Commentary on the studies noted that the principal objective of all investors is to maximise profit. When there is a significant upward movement in the share price, institutional investors are as likely as retail investors to sell.

31. In the absence of any significant evidence that the shares placed to institutions are less likely to be traded immediately after listing, the SFC and the SEHK do not consider that a "successful" offering necessarily requires the size of the subscription tranche to be less than a 30% or a 50% clawback allocation (as the case may be). In any event, the 30% or 50% clawback provision would only come into operation when applications for shares under the subscription tranche is no less than 5 times the shares made available to investors (in the case of a 30% clawback), or no less than 10 times the shares made available to investors (in the case of a 50% clawback). As mentioned in paragraph 25 above, underwriters may, in exceptional cases, apply to the SEHK for a reduced size of the subscription tranche.

(c) Minimum dollar value as opposed to minimum percentage for the Subscription Tranche

32. It has been suggested that rather than setting the minimum size of the subscription tranche as a percentage of the total issue, the benchmark should be based on a minimum dollar value. It was suggested that a fixed dollar criterion would provide certainty to the market on the minimum initial size of the subscription tranche. The SFC and the SEHK believe that a minimum percentage figure makes more sense given the differing sizes of offerings. In our view, certainty to the market would not be affected by setting a minimum percentage figure as opposed to setting a minimum dollar value.

II. The SEHK's discretion on the Use of Placing

33. The use of the combined offering mechanism involving a subscription tranche and a placing tranche was approved for the purpose of facilitating large scale multi-jurisdictional equity offerings. It was not intended that the combined offering mechanism be used in relation to all IPOs to be listed on the SEHK.

34. Although offer for subscription and placing are both included in Chapter 7 of the Listing Rules as acceptable methods of listings on the SEHK, Rule 7.10 provides that "the Exchange may not permit a new applicant to be listed by way of a placing if there is likely to be significant public demand for the securities" .

35. The SFC and the SEHK wish to point out that the discretion in not permitting placing as an offering mechanism still rests with the SEHK, and in appropriate cases, the SEHK may disallow the use of placing pursuant to Rule 7.10.

36. The SFC and the SEHK consider that providing Hong Kong investors with access to new issues (whether in relation to global equity offerings or otherwise) continues to be one of their priorities. Accordingly, the SEHK wishes to clarify that where it considers that there is likely to be significant public demand for the relevant securities in the Hong Kong market, the SEHK may exercise its discretion not to allow any part of the issue to be offered by way of placing under Rule 7.10. Similarly, the SEHK may allow the use of placing in combination with the subscription method, but require a larger "clawback" or re-allocation of shares to the public subscription tranche. The SEHK may also exercise its discretion under Rule 7.10 not to allow placing if the issue is not part of a global offering.

III. Underwriters' discretion on the allocation of shares in the Placing Tranche

37. As mentioned in paragraph 17 above, some market participants have expressed concerns that there is currently not sufficient transparency on how underwriters/lead managers exercise their discretion in allocating shares to investors under the placing tranche. There are also complaints to the effect that book-building has worked against the interests of Hong Kong investors because underwriters or lead managers tend to favour investors or clients based in their own jurisdictions or those with whom they have a business or other relationship. The question is whether underwriters should be required to provide more disclosure on how discretion is exercised in relation to an offer, and/or whether regulations should be introduced to prescribe how underwriters ought to exercise their discretion in the allocation of shares in the placing tranche.

38. With respect to transparency, there are currently provisions in Hong Kong prospectuses which describe, in general terms, the criteria on which allocation of shares would be made under the placing tranche. Usually, these provisions state that allocation of shares is based on a number of factors including the level and timing of demand, total size of an investor's invested assets in the relevant sector, and whether or not it is expected that the investor is likely to buy further, hold or sell the shares after they are listed. Underwriters represent that the allocation criteria are normally set with the intention of establishing a more solid and stable institutional and professional shareholder base for the issuer.

39. Based on the review of underwriters' books between 1993 to May 1997, the SFC has noted a general tendency for underwriters/lead managers to allocate shares to clients originating from their own jurisdictions. However, this does not appear to be a tendency which overwhelms or dominates the allocation of shares in any particular issue to the exclusion of investors from Hong Kong or other overseas jurisdictions.

40. Whilst the SFC and the SEHK will encourage more disclosure in general and expect underwriters to act fairly and in the best interests of issuers when allocating shares under the placing tranche, we do not recommend introducing rules either to require more detailed disclosure on how discretion is to be exercised, or to prescribe how underwriters ought to exercise their discretion. The discretion of being able to choose investors for the issuer is a principal factor contributing to the attractiveness of the book-building system. Introducing rules to prescribe how the discretion ought to be exercised is likely to limit this flexibility which may disadvantage Hong Kong in participating in global equity offerings, and is inconsistent with the priority of the SFC and the SEHK to facilitate the efficiency of the distribution of Hong Kong securities to global markets. Accordingly, the SFC and the SEHK do not presently consider that there are persuasive reasons to regulate underwriters' discretion under the placing tranche. So far as Hong Kong investors are concerned, it is expected that genuine demand (especially retail investors' demand) would be satisfied under the public subscription tranche. The proposal to require a minimum size for the public subscription tranche (see section I above), the inclusion of clawback provisions which allow re-allocation of shares from the placing tranche to the subscription tranche (see section I above and Appendix 5 ), and the SEHK's discretion under Rule 7.10 of the Listing Rules (see section II above) are features which the SFC and the SEHK wish to maintain in order to ensure that Hong Kong investors have sufficient access to global equity offerings.

IV. Extent of Over-Allocation of Shares

41. The 1994 Joint Policy Statement provided as follows:

"As part of the study, the SFC has examined the need for rules permitting stabilisation during the initial public offering period in Hong Kong in the context of the Securities Ordinance and Hong Kong's participation in global offerings. The SFC's position is that where underwriters have over-allotted in an offering (with or without the benefit of an over-allotment option), genuine purchases in the secondary market effected solely for the purpose of covering such over-allotment (short covering) would not of themselves infringe the relevant provisions of the Securities Ordinance which prohibit market manipulation in the form of pegging or stabilising the price of securities. This means that an underwriter of a global offering, who is short shares in a new issue due solely to over-allotment, can cover its short position in the Hong Kong secondary market, even though the distribution might not be completed in other markets, so long as the underwriter's trading does not constitute manipulation as contemplated in the Securities Ordinance."

42. Although the above suggests that an underwriter may over-allot in an offering "without the benefit of an over-allotment option" , and purchases effected for the purpose of covering such over-allotment would not infringe provisions prohibiting market manipulation, subsequent to the announcement of the Joint Statement, it became apparent that such statement might have given the market an inaccurate impression of the SFC's position with respect to "naked shorts" and covering activities in relation to "naked shorts". Accordingly, the SFC wishes to clarify the position on the subject.

43. Section 135(1)(b) of the Securities Ordinance generally states that a person shall not intentionally create or cause to be created, or do anything with the intention of creating, a false market in respect of any securities listed on the SEHK. Section 135(2) provides that a false market is created in relation to securities when the market price of securities is raised, depressed, pegged or stabilised by various means.

44. Where short coverings are made with the benefit of an over-allotment option granted by the issuer, the SFC could readily see the commercial justifications for creating a short position by underwriters: if the share price falls below the issue price after trading commences, the underwriter can buy in the secondary market to cover over-allocations at less than the issue price and make a profit; if the reverse happens, the underwriter can exercise the over-allotment option at the issue price and break even. In such situations, there is a strong commercial logic for the short position to rebut the inference that it is designed to create a false market or manipulate the market. Where short coverings are made without the benefit of an over-allotment option, however, commercial justifications for creating the short position in the first place are not readily apparent or discernible. In those circumstances, it is not possible for the SFC to commit itself in advance of reviewing all related facts to the view that purchases effected to cover over-allocations would not constitute a breach under section 135 of the Securities Ordinance, and the SFC will need to carefully scrutinise the conduct of the parties concerned to determine if that section has been breached.

45. Thus, creation of short positions without the benefit of an over-allotment option, or creating short positions in excess of the limit under which shares could be allocated pursuant to such option is, prima facie, subject to the scrutiny of the SFC. The SFC would take necessary action should there be evidence of the creation of a false market. Hence, underwriters should restrict the extent of over-allocation of shares to the limit permitted under the over-allotment option (usually not more than 15% of the total issue size). With respect to genuine purchases in the secondary market solely for the purpose of covering over-allocations in cases where underwriters have the benefit of an over-allotment option, the position remains the same as stated in the 1994 Joint Policy Statement.

46. Some underwriters believe that the SFC's position with respect to "naked shorts" is unduly restrictive. In their view, over-allotting securities gives underwriters a "legitimate" and effective tool to assist in the creation of an orderly after-market to the benefit of all investors. They believe that the ability to over-allocate the securities in the initial distribution is important in offerings with a substantial retail component where a sizable portion of the initial subscription is typically resold immediately into the market. In such circumstances, it is in the interests of the market as a whole, and particularly for the retail investor, that the underwriters are in a position to take up the excess supply through market purchases to cover the over-allotment position. Furthermore, not all issuers are willing to grant over-allotment options.

47. The SFC has considered the views put forward by underwriters. However, for so long as Hong Kong law on the creation of false market remains unchanged, the SFC does not see any scope for more flexibility on short covering activities or stabilisation activities. The draft composite Securities and Futures Bill, if passed, will give the SFC authority to approve rules to provide stabilisation safe-harbours for underwriters. In the meantime, the SFC believes that clarification of the 1994 Joint Policy Statement as referred to above is necessary.

V. Over-allocation between the Subscription Tranche and the Placing Tranche

48. The majority of offering structures provide an over-allotment option to the underwriters, usually at 15% of the entire size of the offering (see Appendix 2 ). In order to maintain the balance between the subscription tranche and the placing tranche, the SFC and SEHK will require that except in exceptional cases, over-allocated shares should be divided in such a way that the total amount of shares ultimately allocated to the two tranches would bear the same ratio as that originally set between them before any over-allocation takes place. This means that if the initial size of the subscription tranche is set at 10% of an issue, with a clawback provision allowing up to 50% of the issue to be allocated to that tranche when it is 50 times subscribed, then if shares are over-allocated by the underwriters, and the subscription tranche is indeed 50 times subscribed, the underwriters would be required to increase the subscription tranche by allocating 50% of the additional over-allocated shares to that tranche. In this way, the original ratio of the size between the subscription tranche and the placing tranche would be maintained at 5:5.

49. The objective of dividing over-allocated shares between the two tranches is to ensure that the size of the subscription tranche relative to the size of the placing tranche would not be diluted by over-allocation of shares to the placing tranche. The rationale for this is explained in section I above.

VI. Flexibility in Adjusting the Price, Size and Timing of an Offer

50. One of the main objectives of the 1994 Joint Policy Statement was to introduce greater flexibility for the distribution of securities in global equity offerings. For offerings where the book-building period remains open during the offer period of the subscription tranche, underwriters believe that the subscription tranche has restricted the flexibility normally provided by the book-building system. This is because the price range, the size and the timing of an offer have to be specified in Hong Kong prospectuses prior to the close of the "book" so that the book-building process is limited by such parameters. Underwriters have asked that additional flexibility be allowed in the subscription tranche by permitting adjustment to these aspects prior to the close of the offer period. In this way, if underwriters note that indications of interest during the book-building process might require the original price range, size or timing of the issue to be adjusted, they could readily do so without having to change the Hong Kong prospectuses or cause disruption to the subscription process. Such additional flexibility, however, is not required in offerings where placement is completed before public subscription opens.

51. Whilst the SFC and the SEHK note that introducing greater flexibility in the subscription tranche in the scenarios mentioned above may achieve more efficiency in the distribution of securities, we believe that the question must be further considered with care. In seeking to introduce any flexibility in adjusting the price, timing and size of an offer, issuers and underwriters are, in any event, expected to comply with the applicable Hong Kong laws and have due regard to the interests of investors under the subscription tranche.

52. It should be recognised that during book-building, the position of investors under the subscription tranche is different to that of potential investors under the placing tranche. When investors submit applications forms and the requisite application moneys for shares under the subscription tranche, they are submitting "firm" indications of interest. Such indications of interest are binding on the investors (although not binding on the issuers and underwriters) as once submitted, they cannot withdraw the applications, and issuers and underwriters are entitled to present the cheques or bankers' drafts which represent the application moneys for clearance at the time the offer period closes. Hence, any flexibility for underwriters to adjust the price range, size or timing of an offer during the subscription period would potentially create more uncertainties for investors under the subscription tranche. Accordingly, the SFC and the SEHK would require adequate safeguards to be in place to ensure that any new features would not operate to the detriment of these investors. The adjustments that underwriters propose to introduce are discussed below.

(a) Flexibility in adjusting the price range

53. It is usual practice for Hong Kong prospectuses of global offerings to quote a price range for shares allowing adjustment to be made below (but not above) the original price range. Investors applying by way of subscription are asked to submit applications on the basis that the shares would be priced at the upper end of the range. Where shares are priced below the upper end of the range or below the original price range, investors are entitled to receive refund of the application moneys (generally see Appendix 5 ).

54. In support of the proposals that the issue price could be fixed above the original price range, underwriters have cited the following reasons:

• (i) Underwriters represent that at the time the Hong Kong prospectuses are completed, the book-building process has not yet been completed, hence, the price range is still indicative under the placing tranche. There is an increasing trend for demand in large and complex transactions to be indicated by investors only during the later part of the book-building period. However, as the mechanics of the Hong Kong offer have already set a "cap" on the share price, the flexibility to price above the original price range is limited. Underwriters believe that this limitation prevents them from achieving the optimal balance between supply and demand with respect to the securities concerned.
• (ii) Underwriters further represent that the alternative to adjusting the price above the indicative price range is for them to set a higher upper end limit to the price range when the Hong Kong prospectuses are printed. The price range quoted in recent prospectuses shows a spread of between 15% and 25%. If this spread were to be increased in all global offers in order to provide greater flexibility for pricing, investors under the subscription tranche would be unduly affected, as the difference between the issue price of the shares and the application price (at the upper end of the range) would increase, causing corresponding increase in the cost to investors under the subscription tranche.
• (iii) Underwriters have also stated that if they were to adjust the price range upwards, they would need to ensure that the new price range overlaps to a certain degree with the original range. As indications of interest received during book-building only relate to the initial quoted range, underwriters have to ensure that any new price range does not exclude indications of interest already received. Therefore, the lower end limit of any new price range should, in practice, be no higher than the upper end limit of the original range. Any upward adjustment, therefore, would not be materially out of context with the original quoted range.

55. The SFC and the SEHK do not, at present, see any difference between a reduction in the price below the original price range and an increase in the price above the original range. The present thinking of the SFC and the SEHK is that flexibility in adjusting the price range above or below the original price range should be limited to a range that is no wider in percentage terms than the original range. In addition, in the case of an upward adjustment, the lower end limit of the new range should not be higher than the upper end limit of the original price range; and in the case of a downward adjustment, the upper end limit of the new price range should not be lower than the lower end limit of the original price range.

(b) Flexibility in adjusting the size of an offer

56. Underwriters have advised that it is usual practice in the U.S. for issuers to be able to adjust the size of an offer during the book-building period. Adjustment to reduce the size is usually made where there is insufficient demand to take up the total number of shares offered at a price acceptable to the issuer, and reducing the price to increase demand would cause the issuer to withdraw the issue. To address the problem in these circumstances, underwriters would advise issuers to reduce the size of the offer. Adjustment to increase the size may also be made where demand is strong.

57. The SFC and the SEHK believe that changes in the size of an offer should only be allowed if the adjusted size would still meet the criteria for listing as set out in the Listing Rules (e.g. requirements with respect to minimum market capitalisation and public float). It is not recommended that underwriters be allowed to substantially increase or reduce the size of an offer. Any adjustment should preferably be made within a specified percentage of the original issue size, e.g. not more than 20% or 25%. In the case of a reduction in the issue size, the issuer would be expected to confirm or demonstrate that the reduced proceeds raised by the issue would still be sufficient to meet its funding needs or achieve the objective of its fund raising exercise. In the case of an increase in the issue size, the issuer would be required to state how the additional funds raised would be utilised.

(c) Flexibility in adjusting the timing of an offer

58. During the marketing period for an issue, underwriters hold roadshows to inform potential investors about the issuer and its business, and to obtain feedback on the likely demand for shares from investors. In some cases, underwriters may find it necessary to have a longer marketing period to solicit more demand and may wish to extend the offering time-table. In cases where a particular market event or condition has affected investor confidence, underwriters may wish to extend the time-table as an alternative to cancelling the issue or reducing the price or size of the issue. Underwriters have represented that the added flexibility in the timing of an offer would enable issuers to launch an offering at the time that is considered most suitable in light of demand and prevailing market conditions.

59. Concerns have been raised that an extension in the offering time-table might result in additional costs for investors applying for shares under the subscription tranche. In practice, the majority of applications under the subscription tranche are made on the last day of the offer period. Any extension of time should be announced prior to that day so that investors could delay submission of applications having regard to the revised time-table. In addition, receiving banks should not present for clearance any cheques received before the revised closing date.

60. If flexibility of extending the offering time-table were to be allowed, the present thinking is that the SFC and the SEHK would limit it to a single extension of up to seven days only.

(d) Safeguards for investors under the public subscription tranche

61. As mentioned previously, if issuers and underwriters wish to adjust the price, size or timing of an issue, they must ensure that the relevant legal aspects are addressed and sufficient safeguards are in place for investors under the subscription tranche.

62. It is recommended that safeguards that need to be put in place for the protection of investors under the subscription tranche should at least include the following:

• (i) Full disclosure in prospectuses of the possible changes that could be made - Prospectuses should include prominent disclosure of the risks that the price range, size and/or the timing of an issue may be changed, and that in the event of a change in any of these matters, any investor who has already made an application may withdraw the application and if he so wishes, submit a new application. Prospectuses should also include details as to how and when shareholders will be advised of any change and what steps, if any, need to be taken by investors in respect of their applications if a change does occur. In addition, the issuer should display a prominent warning next to all boxes for application forms stating that changes to the price range, size and/or timing of an issue may be made, and if such change does take place, the latest date on which an announcement would be published and in which newspapers, to inform the market of the change. On the day immediately after an announcement of change is made, the issuer should also display a prominent notice next to all boxes for application forms summarising the change and how it might affect applications.
• (ii) Disclosure of actual changes made by newspaper announcements no later than the day before the subscription is due to close - Any change in the price range, size or timing of an issue should be announced in newspapers as soon as practicable after a change is to be effected and in any event, no later than the day before the offer is due to close. The announcement should:
  • specify the revised terms of an offer;
  • explain what impact, if any, the revised terms would have on the applications made or to be made by investors;
  • remind investors who have submitted applications of their right to withdraw applications and the timing during which to do so, and if they so wish, to submit new applications; and
  • provide up-to-date information on the issuer including, as a minimum, impact on any forecast profit or forecast earnings per share of the issuer, and statements as to sufficiency of working capital, use of proceeds and net asset values of the issuer.
• (iii) Providing investors with a right to withdraw - Investors who have submitted application for shares prior to announcement of any change in the terms of an offer should be allowed to withdraw the original application, and if they so wish, to make a revised application having regard to the changes. It is anticipated that underwriters would choose to allow investors to withdraw by cancelling their cheques submitted with their original applications. The SFC and the SEHK note that at present, investors who have applied for shares prior to an announcement of a reduction of the price below the original price range are only entitled to receive refund of the requisite application moneys plus costs. It is recommended that the right to withdraw should be extended to such investors.

63 . Should the flexibility discussed in this section VI be allowed, the safeguards referred to above would provide investors under the subscription tranche with an opportunity to withdraw from their original applications when new terms to an issue are introduced, and the necessary information to enable them to decide whether or not they should participate in an issue under revised terms. Whilst the SFC and the SEHK wish to further consider the issues involved in introducing more flexibility in the subscription tranche, we wish to invite comments from the public on the subject generally.

VII. Eligibility to apply for shares in the Subscription Tranche and the Placing Tranche

64. The Kwong On Bank incident in June 1996 highlighted the difference of treatment between retail investors who apply for shares under the subscription tranche and retail investors who are able to apply for shares under the placing tranche.

65. Since the Kwong On Bank case, the SFC has required the placing tranche to be restricted to institutional and professional investors. Underwriters are asked, to the maximum practical extent, to exclude individual investors (whether they apply through banks or institutions), from the placing tranche. However, it is accepted that some individual investors behave as institutional investors both in terms of the size of their investment and their investment patterns. Therefore, to date, the SFC has accepted that professional investors may include individual investors resident in Hong Kong who meet the following criteria:

• (i) they are existing customers of underwriters investing through corporations, partnerships, family trusts, etc ;
• (ii) they are active investors who generally invest in secondary markets in large size; and
• (iii) they are investors who have previously purchased shares in more than three initial public offerings through the underwriters,

provided that allocations to these customers of the shares under an offer are consistent with their normal investing pattern or profile. Underwriters have found these restrictions to be onerous and difficult to administer.

66. The difficulties raised in the preceding paragraph serve to illustrate the wider difficulty of operating any scheme of allocation which assumes that it is possible to make clear distinctions between various types of investors. Whilst terminology such as "retail", "professional" and "institutional" investors, are in popular use, there is no clear definition for each term. There is probably a rough, commonly accepted "profile" which serves to illustrate each class of investors, but there is insufficient precision in the illustration to make each class mutually exclusive from the other. Thus, any scheme of allocation which is based on such vague distinctions is bound to be difficult and onerous to operate. They also raise issues of equity between classes which are difficult to resolve since a "professional" investor could sometimes be a "retail" investor and vice versa.

67. In order to address the issues raised above, the SFC and the SEHK have identified two possible approaches for discussion and comment. A third alternative is to maintain the existing system. Each of these alternatives is discussed in detail in paragraphs 68 to 77 below.

(a) Option 1 - The current approach

68. Under the existing system, all investors (whether Hong Kong or overseas institutional, professional or retail investors) are able to apply for shares under the subscription tranche subject:

• (i) to the Listing Rules requirements that no multiple applications could be made; and
• (ii) to the interim measures with respect to the Allocation of Shares in Initial Public Offerings issued by the SEHK and the SFC in May 1997 (the " 1997 Joint Announcement")(Appendix 6 ).

69. Under the 1997 Joint Announcement, the SFC and the SEHK require the total number of securities available for public subscription (taking account of any clawback feature) to be divided equally into two pools: pool A and pool B. The shares in pool A should be allocated on an equitable basis to applicants who have applied for shares in the value of HK$5 million or less (i.e. mainly retail investors). The shares in pool B should be allocated on an equitable basis to applicants who have applied for securities in the value of more than HK$5 million, and up to the total value of shares in pool B (i.e. non-retail investors). Applications in pool B will likely receive different allocation ratios than applications in pool A. Where one of the pools is under-subscribed, any surplus shares should be transferred to satisfy applications in the other pool, and be allocated to investors who applied for shares under that pool. As a consequence of these procedures, investors are indirectly restricted from applying for more than 50% of the shares available in the public subscription tranche. These interim measures were introduced partly to reduce the pressure which IPOs have imposed on the Hong Kong banking system, and partly to increase the chances of small retail investors being allocated more shares under the subscription tranche.

70. Under the existing system, Hong Kong and overseas institutional and professional investors are able to express interest for shares under the placing tranche. There are currently no rules which prohibit individual retail investors from applying for shares under that tranche. However, as mentioned in paragraph 65 above, underwriters would, in practice, exclude these retail investors from the placing tranche. Only individual investors who meet the criteria summarised in that paragraph would be given access to the placing tranche.

71. It is believed that the existing system has not given investors a reasonably equal opportunity to apply for shares in IPOs: under the subscription tranche, large applications from non-retail investors have the effect of reducing the chances of share-allocation to smaller retail investors; and there are currently no rules which prevent retail investors from applying for shares under the placing tranche as an alternative or additional route to applying for shares under the subscription tranche, so that certain individual retail investors may be able to obtain different or "preferential" treatment under the book-building system than other retail investors.

(b) Option 2

72. As an alternative to the current system, the following approach may be taken:

• (i) As in the subscription tranche where no restrictions on access have been placed on any particular type of investors, similarly no restrictions on access to any particular type of investors should apply to the placing tranche. Therefore, retail or individual investors who meet the criteria laid down by underwriters for investors under the placing tranche should be given the chance to apply for shares so long as they are not treated differently or "preferentially" than other investors who apply for shares under that tranche. Underwriters should not be required to exclude individual retail investors from the placing tranche as they are currently required to do.
• (ii) Offers by way of subscription have historically been open to all investors. The subscription tranche in the combined offering mechanism has also operated along the same lines in the past four years. There is no particular reason to change this practice. However, the high level of applications made by non-retail Hong Kong investors (which resulted in high over-subscription rates) have caused adverse impact on the monetary system, and have reduced the opportunity of local retail investors in obtaining more shares under the subscription tranche. These issues should be addressed. Therefore, whilst non-retail investors should be allowed to continue to participate in the subscription tranche, the shares which they could apply for should be limited or scaled down. This would have the benefit of providing greater opportunity for retail investors to obtain more shares under the subscription tranche. The interim measures set out in the 1997 Joint Announcement (which prevent investors from applying for more than 50% of the shares available under the subscription tranche) could be adopted as long term measures.
• (iii) In order to ensure that this Option 2 would not operate to encourage investors to apply for shares under both tranches, rules against "double-dipping" or applying for shares under more than one tranche should be introduced. So far as the subscription tranche is concerned, there are, at present, rules against multiple applications. Such rules should have the effect of preventing investors from applying under both pool A and pool B of the subscription tranche at the same time. Additional requirements, however, would have to be introduced to ensure that an investor (whether he is a retail, a professional or an institutional investor) would not be able to acquire shares under the subscription tranche and the placing tranche for the same issue simultaneously. This could be done, for example, by requiring investors under the subscription tranche to undertake and confirm in the application form that he has not indicated and would not indicate interest for shares under the placing tranche; and by requiring investors under the placing tranche to provide an undertaking or confirmation to the underwriters before shares are being allocated to them that they have not applied, and would not apply, for shares under the subscription tranche of the same issue.

73. In summary, Option 2 has the following characteristics:

• (i) All investors would be eligible to apply for shares under both the placing and the subscription tranche. In this respect, Option 2 is less restrictive than Option 1 which operates to exclude the majority of individual retail investors from participating in the placing tranche in practice.
• (ii) Different criteria would be applicable to each tranche to maintain "fairness of treatment" to investors under the same tranche. It recognises that treatment to investors between tranches is inherently different.
• (iii) Option 2 is, however, restrictive in two principal respects. First, as in the case of Option 1, it seeks to restrict the shares in respect of which "non-retail" investors are allowed to apply for under the subscription tranche by adopting the interim measures introduced in the 1997 Joint Announcement as long term measures. Secondly, if and to the extent that an investor (whether retail, institutional or professional) has chosen to apply for shares under either the placing or the subscription tranche, Option 2 seeks to prevent him from applying for shares under the other tranche of the same issue. Accordingly, it is up to the investor to decide which tranche he wishes to participate in, but once he has applied for or indicated interest for shares under either tranche, he would be excluded from participating in the other tranche of the same issue. This latter requirement is currently not applicable to Option 1.

(c) Option 3

74. A third alternative would be (i) to define "retail" investors or those investors who may participate in the subscription tranche, and allow such investors only to participate in the subscription tranche; and (ii) to allow or require all other investors (i.e. "non-retail" investors) to participate in the placing tranche. If this approach is adopted, certain objective criteria have to be established to distinguish a "retail" investor from a "non-retail" investor. This distinction could be made by reference to a specified value of shares that an investor may apply for in an issue, i.e. participation in the subscription tranche could be limited to applicants who apply for a certain value of shares that does not exceed a specified dollar figure. By limiting the value of shares to be applied for in each application, the aggregate value of applications would be reduced, thereby reducing the amount of funds that would be tied up during IPOs.

75. A "capped" dollar figure could be set at HK$5 million. Past statistics shows that setting a limit at this level would not adversely affect retail investors: Out of seven listings in 1996/1997, except in two cases where 9.2% and 8.2% of investors applied for shares worth more than $5 million, less than 3% of investors in these listings submitted applications worth more than $5 million. The likely impact of a HK$5 million limit are :

• (i) small investors would receive a larger percentage of their application than the percentage they currently receive;
• (ii) the total funds required in the subscription would be decreased thus reducing pressures on the monetary system; and
• (iii) there may be an increase in under-subscription for unpopular issues.

76. Under this Option 3, investors intending to apply for more than HK$5 million worth of shares would have to apply for shares through the placing tranche. Whether such investors could receive an allocation of shares would depend on whether they meet the allocation criteria laid down for that tranche, how they are perceived vis-a-vis other investors who have indicated interest for shares under the same tranche, and ultimately how underwriters exercise their discretion. Underwriters would also be required to ensure that no shares under the placing tranche would be allocated to "retail" investors, i.e. investors who apply for shares at or below the HK$5 million limit. In summary, Option 3 has the following characteristics:

• (i) "Retail" investors would be defined to mean investors who apply for or indicate interest for shares in the value of HK$5 million or below. They would only be eligible to apply for shares under the subscription tranche. Any investor who wishes to apply for shares exceeding the value of HK$5 million would be regarded as "non-retail" investors. They would only be eligible to participate in the placing tranche.
• (ii) The HK$5 million criterion of distinguishing "retail" investors from "non-retail" investors disregards whether the investor concerned is an individual or an institution. If Option 3 is adopted, the interim measures set out in the 1997 Joint Announcement and the criteria set out in paragraph 65 above (in allowing certain individual retail investors to participate in the placing tranche) would not be applicable. However, the present rules against multiple applications in the subscription tranche would continue to apply.
• (iii) One of the suggestions put forward as a variation of Option 3 is for the shares of the placing tranche to be divided so that part of the shares available would be designated for placing to international non-retail investors to be conducted by an international syndicate of underwriters, and the remaining part of the shares would be designated for placing to Hong Kong non-retail investors to be conducted by a local syndicate of underwriters so that a Hong Kong book-building tranche within the placing tranche is to be set up.

77. The public is invited to express views on the general issues highlighted in paragraph 66 above and the three approaches (including the suggested variation of Option 3) described above. The SFC and the SEHK welcome suggestions on any other alternative approaches which could address the issues highlighted in this section VII.

VIII. Announcement of indications of interest in the Placing Tranche

78. Certain sectors of the market have suggested that transparency of the placing tranche should be improved by requiring underwriters and issuers to disclose more information on the level of indications of interest expressed by investors during the book-building process.

79. With respect to offers for subscription, Rule 12.08 of the Listing Rules presently require the results of an offer, the basis of allotment of the securities, and where appropriate, the basis of any acceptance of excess applications, to be published no later than the morning of the business day next after the allotment letters or other relevant documents of title are posted (i.e. before trading of the relevant shares commences). In making such announcements, issuers also disclose the total number of valid applications received and the extent to which an offer or the subscription tranche is subscribed in numerical terms.

80. There is currently no requirement under the Listing Rules for the disclosure of the results of the placing or the book-building. As a matter of practice and for market transparency purposes, however, the SFC and the SEHK have required issuers to include in the announcement of results of the subscription tranche, information regarding the level of demand for shares under the placing tranche. Such information, however, is only limited to a qualitative description of the extent of demand, no numerical description is given.

81. The question is whether the gross numerical figure of indications of interest expressed by investors under the placing tranche as recorded in the books of underwriters should be disclosed to the public prior to the commencement of trading of the relevant securities in Hong Kong and at the same time as the results of the public subscription are announced.

(a) Reasons in favour of disclosure

82. The principal reason in favour of such disclosure is that transparency with respect to demand for shares under the placing tranche would be improved. In so far as the public is given information on the level of valid applications for shares under the subscription tranche, similar information on the level of gross demand for shares under the placing tranche should also be provided, so that the overall reception of an issue will be more transparent to the market. The gross numerical figure of demand under the book would give investors additional information on how much demand for shares has not been satisfied at the allocation stage, which may impact on the secondary market trading of the securities. It may also reflect difference in the degree of reception for the shares between Hong Kong investors under the public subscription tranche and international investors under the placing tranche.

83. Furthermore, the numerical level of demand for shares indicated by investors during the book-building process, if not publicly disclosed, may constitute unpublished price-sensitive information or "relevant information" under the Securities (Insider Dealing) Ordinance. If underwriters make short coverings or engage in other dealings of shares in the secondary market in possession of such unpublished information, these activities would probably constitute insider dealing under that Ordinance. Accordingly, it would be preferable for underwriters to announce the numerical level of demand for shares under the placing tranche before they commence any short covering activities or any other dealings on the relevant securities in Hong Kong. In addition, because of the potential price-sensitive nature of information regarding the book, underwriters and the syndicate should ensure that such information is kept strictly confidential at all times and strict "Chinese wall" arrangements are maintained between an underwriter's corporate finance division and the other divisions of the same firm.

(b) Reasons against disclosure

84. Underwriters are against the idea of providing more transparency on the level of demand for shares under the book and give the following reasons:

• (i) It is asserted that the gross number of indications of interest expressed by investors during book-building is not meaningful information, and in many instances, may be misleading information - This is because firstly, unlike application forms submitted by applicants under the public subscription tranche, indications of interest by investors during book-building are not binding in nature, whether on the issuer's part or on the investors' part. Secondly, many investors tend to inflate their demand for shares so that their indications of interest do not reflect the actual amount of shares they wish to acquire ultimately. Thirdly, underwriters argue that the gross number of indications takes no account of the "quality" of the demand, the allocation of which is subject to their discretion based on, for example, whether the investors are likely to be long-term or shorter-term holders of the shares. Therefore, underwriters believe that disclosure of indications of interest would not actually provide the desired transparency but may be misleading to the market.
• (ii) It is asserted that disclosure of the gross number of indications of interest would promote speculative behaviour and create volatility in the secondary market - Underwriters argue that this is particularly the case where the gross number of indications of interest is high : the high gross number tends to suggest that the issue is "hot", so disclosure of such information would likely influence more investors to speculate on the securities in the secondary market, creating volatility.
• (iii) It is asserted that requiring this disclosure of interest would be contrary to current international practice - Underwriters point out that if the requirement of disclosing the gross number of indications of interest under the book is imposed in Hong Kong, it would be contrary to the current practice of book-built placings. This may impair the workings of simultaneous global offerings involving Hong Kong and other major markets. No other international markets require such information to be disclosed.
• (iv) It is asserted that requiring this disclosure of interest would be inconsistent with the concerns of overseas regulators - U.S. underwriters have claimed that the U.S. Securities and Exchange Commission (the " SEC ") had cautioned broker-dealers not to disseminate information on indications of interest on book-building to the public. U.S. underwriters claim, therefore, to be concerned that publication of the level of interest would, if it came to the attention of the SEC, result in questions or objections on the part of the SEC. However, no specific U.S. rule prohibiting such disclosure has been brought to our attention. Furthermore, based on SFC's discussions with relevant SEC staff, the SFC has been given to understand that there is no such rule.

85. The SFC and the SEHK are not convinced by the above assertions. It is probably true that in a popular issue, indications of interest are likely to be inflated so that they do not represent the real demand. This is also the case in the level of applications for shares under the subscription tranche. However, in an unpopular or poorly received issue, indications of interest are more likely to be a realistic assessment of demand. Hence, disclosure of the gross numerical demand for shares under the placing tranche would serve as useful information to an investor. If underwriters are concerned that the numerical description of the level of demand may be misleading in a particular case, a commentary on the quality of demand could be made in the announcement.

86. The public is invited to comment on whether transparency of the placing tranche should be improved by requiring underwriters and issuers to disclose more information on the level of demand for shares expressed by investors during the book-building period, and specifically, the question highlighted in paragraph 81 above.

CONSULTATION

The SFC and the SEHK invite the public to provide comments on this Consultation Paper by 8 August 1997. Comments should be sent to:

The Securities and Futures Commission

12 Floor, Edinburgh Tower,

The Landmark, 15 Queen's Road Central

Hong Kong.

For the attention of the Secretary to the Commission.

Interested persons may also provide comments by E-mail to cf@sfc.hk.

This Paper is available at the offices of the SEHK (36th Floor, Jardine House, 1 Connaught Place, Central, Hong Kong) and the SFC (see above) as well as on the SFC Internet Home Page at http://www.sfc.hk, and on the SEHK Website at http://www.sehk.com.hk.

Securities and Futures Commission The Stock Exchange of Hong Kong Limited

25 June 1997

APPENDICES

APPENDIX 1

THE STOCK EXCHANGE OF HONG KONG LIMITED SECURITIES AND FUTURES COMMISSION

Joint Policy Statement on Offering Mechanisms

The Stock Exchange of Hong Kong Limited (the "Exchange") and the Securities and Futures Commission ("SFC") have recognized that global equity offerings, which involve the tapping of funds from both the domestic and international markets, have become more common for large scale new issues in Hong Kong. Accordingly, a joint Working Party was set up by the two authorities earlier this year to study the subject of offering mechanisms. Set forth below is a synopsis of the views and conclusions of the Working Party which have been endorsed by the Exchange and the SFC.

The Working Party was established to review whether the Hong Kong fixed price public offer method disadvantages Hong Kong in the context of participating in multi-jurisdictional equity offerings and whether Hong Kong should adopt alternative forms of offering mechanisms. In pursuing this goal, both the Exchange and the SFC had in mind to introduce greater flexibility for the public distribution of securities in equity offerings while ensuring that the interests of local investors are not disadvantaged by this approach.

In the case of a simultaneous dual listing in Hong Kong and another overseas market where the placing or book-building system is used and where the commencement of trading is to occur on the same day, issuers have encountered difficulties in reconciling the timing for the commencement of trading of the Hong Kong fixed price subscription tranche and the U.S. placing tranche.

The Working Party consulted a number of merchant banks who have participated in recent global equity offerings and in particular, studied the U.S. system of book-building, stabilization and distribution system as a whole. The Exchange is of the view that there are feasible solutions, although still subject to refinement, for reconciling the offering timetables of an offer for subscription and a book-built placing which do not require amendments to the existing Listing Rules. For example, if trading in Hong Kong can commence within 5 days after a range price public offer is closed, then, coupled with a price fixing on a weekend in the U.S., it would appear that the timing problem can be resolved.

The task of finding an optimal schedule which reconciles the needs of international investors with those of local subscribers is ultimately a commercial one and there is little need for regulatory intervention. For the purposes of enhancing market transparency and minimizing grey market activities however, it would be preferable in the case of dual listings for trading in Hong Kong to commence as soon as possible after allocation and at least simultaneously with or before the commencement of trading on overseas exchanges.

In order to achieve simultaneous dual listings, the Hong Kong initial public offering timetable has to be shortened to accommodate the practice of dealing immediately after allocation under the U.S. book-building system, or at the very least, to minimize the period of time between allocation and commencement of trading. The Exchange and the SFC have identified a number of feasible options to achieve this. It is up to an issuer and its underwriter to decide whether to adopt one of these acceptable ways or to come up with some other methods. One way to achieve this is to publish in some form the identities of the successful applicants in newspapers so that they become aware of their respective allotments and would be able to trade immediately provided arrangements are made to meet settlement obligations. Another option is to require all applicants to subscribe shares through brokers by using yellow application forms only. Since the allotted shares are deposited directly into CCASS, successful allottees can commence trading once allocation is complete and can withdraw the physical scrips at a later date if they so desire. A third option is to allow only successful yellow form applicants to trade on the day immediately after price fixing with the white form applicants (i.e. those who want their shares to be registered under their own names) to commence trading upon receipt of the scrips. None of these suggested options require amendments to the Listing Rules.

In a global offering involving a simultaneous Hong Kong subscription and an international placing, it is up to the issuer and the underwriter to determine the size of the Hong Kong subscription tranche and the international placing tranche(s). The Exchange does not intend at this time to stipulate a minimum dollar value or percentage of a new issue that must be allocated for public subscription in Hong Kong. This is a matter for the issuer and its underwriter to decide. However, the Exchange expects underwriters and issuers to have due regard to the interests of local retail investors in any new listing in developing offering mechanisms that are suitable for their issues at the time.

Inter-tranche flow of allocations between the local and the international tranche should be permitted so that securities may be allocated to markets where real demand lies. The objective is to facilitate optimal equilibrium between the primary market supply and demand and to minimize market imbalance. In the case where the inter-tranche flow may be effected, whether through a claw-back formula or otherwise determined by the issuer and the underwriter, such disclosure should be clearly made in the offering documents.

The Exchange and the SFC recognize the need to accept alternative offering mechanisms. Underwriters and issuers who wish to offer shares through other methods in addition to the traditional public subscription are encouraged to seek early consultation with the Exchange.

Where shares of the Hong Kong public offer tranche are sold by way of an offering method other than the traditional subscription method, issuers are expected to ensure that the alternative method does not disadvantage retail participation and that the allocation of shares is made independent of the applicant's identity, the time of application and any business relationship between the applicant and the issuer or any of its advisers, but should only be a function of the number of shares applied for and, if any, bid price(s).

As part of the study, the SFC has examined the need for rules permitting stabilization during the initial public offering period in Hong Kong in the context of the Securities Ordinance and Hong Kong's participation in global offerings. The SFC's position is that where underwriters have over-allotted in an offering (with or without the benefit of an over-allotment option), genuine purchases in the secondary market effected solely for the purpose of covering such over-allotment (short covering) would not of themselves infringe the relevant provisions of the Securities Ordinance which prohibit market manipulation in the form of pegging or stabilizing the price of securities. This means that an underwriter of a global offering, who is short shares in a new issue due solely to over-allotment, can cover its short position in the Hong Kong secondary market, even though the distribution might not be completed in other markets, so long as the underwriter's trading does not constitute manipulation as contemplated in the Securities Ordinance.

If the underwriters wish to reserve the right to over-allot it is important that this fact be disclosed in the prospectus, together with details of any over-allotment option granted by the company to the underwriters. The prospectus should also include a statement that the underwriters may cover the over-allotment either by purchasing the shares in the secondary market or by exercising the over-allotment option or a combination of both.

From discussions between the SFC and underwriters of global offerings, it appears that the ability for underwriters to short cover in Hong Kong obviates any need to bring in rules permitting stabilization during the initial public offering period.

For and on behalf of For and on behalf of

The Stock Exchange of Hong Kong Limited Securities and Futures Commission

Herbert Hui Laura M. Cha

Executive Director Member of the Commission

and Head of Listing and Executive Director

4th November. 1994

APPENDIX 2

List of Global Equity Offerings (1993 - May 1997)

APPENDIX 3

APPENDIX 4

Book-building : General Information

A. Benefits of Book-building -v- Public Subscription

1. Underwriters generally argue that the principal reasons for adopting book-building are that :

(a) book-building matches price with demand more accurately;

(b) the offering can be sized according to demand;

(c) there is no underwriting risk;

(d) it creates competition between investors;

(e) it allows access to overseas demand; and

(f) it provides increased investor transparency to issuers and allows issuers to select an initial shareholder profile for themselves.

2. Book-building matches price with demand more accurately

The principle behind book-building is that investors are given the opportunity to indicate their demand for shares before the price is fixed and prior to finalisation of the prospectus. Underwriters would "build a book" by obtaining non-binding expressions of interest from potential investors in which they indicated the likely number of shares and the price at which they are prepared to accept. At the end of the marketing or "book-building" period, the overall size of the offer and the price at which shares would be sold were determined, having regard to the demand indicated during the book-building process, allocations to investors are made and underwriters enter into binding commitments to underwrite the sale of shares allocated to investors.

In this structure, underwriting does not occur until the final few hours of the book-building period just prior to the announcement of trading and immediately after the size and the issue price of the offer have been finalised. As the price is fixed on the basis of investor demand and as the duration between the time when the price is fixed and when trading commences is short, theoretically, the likelihood of the issue price being fixed at a great disparity to the actual trading price would be minimised - hence, better price discovery and price matches demand more accurately.

Underwriters represent that in contrast, in a traditional Hong Kong offer for subscription structure, an issue is underwritten typically for an offer period of about 7 days usually at substantial discount to the share price in order to allow for or reflect market risks during the offer period. According to underwriters, this discount would be more substantial in global equity issues where the size of offers is comparatively bigger and where underwriters are faced with different market risks and conditions in multi-jurisdictions.

3. The offering can be sized according to demand

Because the price and size of an offer are fixed at the end of the book-building period based on indications of demand, if demand increases, the price could be increased to adjust supply and demand; alternatively, the size of the offer could be increased. On the contrary, if the offer is not as well-received as expected, the size of the offer or the price could be reduced, again, to adjust supply and demand and to prevent the share price from collapsing immediately on commencement of trading.

In contrast, in a front-end underwriting as in the case of the traditional Hong Kong offer for subscription, the price and size of an offer are fixed at the outset with little or no flexibility to adjust the offering parameters according to demand.

4. There is no underwriting risk in Book-building

Another disadvantage with the inability to adjust the offer size in a traditional front-end underwriting is that if the market does not have sufficient demand for the shares being offered, underwriters would be required to take up the shares themselves, a risk which they would rather not take, particularly in volatile market conditions. Theoretically, performance by the underwriter of the underwriting obligation by taking up substantial shares creates an overhang of shares which can adversely affect the issuer's share price performance for some time afterwards. In a typical book-building, underwriters would not normally enter into the underwriting agreement until the book is filled so that underwriters rarely end up having to acquire the shares being offered from the issuer in such a mechanism.

5. Book-building creates competition between investors

Underwriters believe that an important feature of the book-building structure was the ability to create price tension between investors with investors competing against each other in a single offer. This structure would result in better price discovery for the benefit of the issuer.

6. Book-building allows full access to overseas demand

The book-building system is commonly used and well-understood in the U.S., the U.K. and a number of other overseas jurisdictions. Underwriters believe that the use of this system would allow issuers much more flexibility in accessing funds in these overseas markets.

7. Book-building provides increased investor transparency to issuers and allows issuers to select an initial shareholder profile

Underwriters represent that as the "book" is built by potential investors indicating demand for shares, the lead manager of an issue would become fully aware of the identity and through experience, the investment history or objectives of each investor or group of investors should the expression of interest come from a broker. Book-building therefore provides transparency to the issuer with respect to the investor base. In addition, since indications of interest by investors are not binding in nature, there is no obligation on the part of the underwriters or the issuer to accept or satisfy demands for shares. The lead manager could, as a general matter, accept an indication of interest over another without having to justify its reasons, or scale down bids proportionately. This gives the lead manager a considerable advantage in that it could use its discretion to favour investors, e.g. investors whom it perceives to be long-term holders, or investors who have past or potential business relationship with the lead manager. It also means that if the lead manager could identify dealers or investors who would sell or sell short shortly after trading commences, it could use its discretion not to allocate shares or reduce the number of shares to be allocated to them. The process presumes experience on the part of the underwriting syndicate and consultation with the issuer to define, and then obtain, the desired initial shareholder profile for the issuer.

In contrast, discretion in allocating shares to investors under the public subscription method does not exist. No subjective assessment of the quality of demand by the underwriters or lead manager is allowed. Allocation of shares in public subscriptions is made on the basis of the number of shares applied for on a strict pro-rata basis and independent of the identity, time of application and any relationship which may exist between the applicant and the issuer or the underwriters.

B. Principal Features of U.S. style book-building

8. The book-building process is most commonly used in the U.S. where the Securities Act of 1933 and the rules made under it are sufficiently flexible to accommodate the tender offer structure and the fact that no offer price will have to be set at the time of the registration statement being declared effective. The principal features of the U.S. style book-building are summarised below.

9. An initial public offering of shares in the U.S. is fundamentally different from a fixed-price offer for sale or subscription in Hong Kong in that there is no direct offering of shares to the public at large and the concept of a subscription period does not exist. The public can express interest for IPO shares through brokers. Thus, the book is usually made up of brokers, dealers and institutional investors such as pension and mutual funds.

10. The Securities & Exchange Commission ("SEC") normally takes 4 to 6 weeks to review the registration document (including the prospectus) of a new issuer. During this period solicitation of sales are permitted and managers may circulate the preliminary prospectus, otherwise known as the "red-herring" document, to potential institutional investors and retail brokers.

11. The marketing effort, which takes the form of road shows, involves presentations to different categories of investors. Members of the syndicate are actively involved in marketing the issue as opposed to simply being underwriters or buyers of last resort. Usually, 60% of the fees received by underwriters for participating in an offer is in the form of sales commission, 20% is received as manager for managing the issue, and the remaining 20% is received as underwriting commission.

12. The marketing phase is a period of active price negotiation based on, but not restricted to, an indicative price range. This price discovery process in building the "book" is similar to plotting the demand curve for an issue. As mentioned in section A above, the lead manager (also known as the bookrunner in a book-building process) would approach investors and seek an indication of their demand at various price levels. The final price is set by the bookrunner based on information gathered during the marketing phase regarding demand at various price levels, and is usually set at a level such that there will be further demand for the shares after trading commences.

13. In a successful offering, the underwriter distributes all shares in a matter of hours on the basis of oral confirmation. The lead manager tightly controls the distribution process, and monitors demand from various underwriters and institutions before allocating the shares. A particular underwriter's allocation of shares depends on its perceived ability to sell shares and may vary significantly from its underwriting commitment. Allocation is at the sole discretion of the lead manager (or bookrunner). In other words, in the book-building process underwriters enjoy absolute discretion in allotting shares. In contrast, in a fixed-price public offer in Hong Kong, the sponsor's decisions in allocating shares take no account of the identity of investors.

14. In order to have the scope to support a new listing, underwriters would over-allocate the shares being offered to create a short position. Initially, the short position is covered by a combination of (i) stock-borrowing from certain existing shareholders of the issuer and from large institutions with whom shares have been placed, and (ii) agreement with investors to whom shares are promised to be placed but not delivered, by making a cash payment to compensate for late delivery. The short position is then covered by purchases in the secondary market or, if the market price of the shares rises above the issue price, by exercising the over-allotment option (also referred to as the "Greenshoe option") provided by the issuer. Under U.S. rules, the shares which can be issued under a Greenshoe option is restricted to 15% of the total number of shares on offer and this is now the norm. When an issue is very popular, underwriters will normally only over-allocate shares up to the size of the Greenshoe (i.e. 15% of the issue size). However, if the issue does not attract much support, underwriters may well over-allocate shares beyond the number of shares that may be issued under the Greenshoe option. This would give underwriters the ability to cover short positions by purchasing a larger number of shares in the secondary market. However, in doing this, underwriters would risk incurring losses if the shares trade above the issue price.

15. Another significant difference between a U.S. style book-building and a fixed price public offer in Hong Kong is in the timing and extent of its underwriting obligation. In a fixed-price public offer, the shares are priced and underwritten prior to the subscription period. In case of under-subscription, the underwriters are required to purchase at the issue price shares which have not been taken up by the public. Under a U.S. style book-building, the underwriting obligation of the syndicate is subject to the issue price being agreed between the issuer and the lead manager after the book-building exercise has concluded, but prior to the commencement of trading.

APPENDIX 5

The Combined Offering Mechanism

This Appendix summarises the principal characteristics of the combined offering mechanism. It should, however, be noted that variations to the typical structure do exist.

1. The "hybrid" approach

The total size of an issue is usually divided into two tranches: the Hong Kong subscription tranche and the international placing tranche. Between 1994 to 1995, the percentages of shares allocated to the tranches differ materially (see Appendix 2 ). Since the beginning of 1996, the initial allocation of shares between the subscription tranche and the placing tranche (i.e. disregarding any shares which may be issued as a result of the exercise of the over-allotment option (see paragraph 6 below) and the effect of any clawback (see paragraph 9 below)) is, in most cases, between 10-15% and 85-90% respectively (also see Appendix 2 ).

2. The Hong Kong subscription tranche

The Hong Kong subscription tranche is open to members of the public as well as to institutional and professional investors. One of the purposes of retaining a public subscription tranche in global equity offerings to be listed on the SEHK is to allow retail investors in Hong Kong to participate in these offerings. Therefore, Hong Kong individual retail investors are expected to apply for shares through the public subscription tranche. Individual retail investors (including individual investors applying through banks and other institutions) seeking shares in the international placing tranche are unlikely to be allotted any shares. Overseas investors (whether retail, institutional or professional) can also apply for shares under the subscription tranche.

Applicants for shares under the subscription tranche are required to pay, on application, the maximum price of the indicative price range set out in Hong Kong prospectuses (see paragraph 8 below). If the issue price, as finally determined (also see paragraph 8), is lower than the upper end of the price range, appropriate refunds of application moneys without interest will be made to successful applicants.

3. The international placing tranche

Under the international placing tranche, shares are usually selectively marketed to international (including Hong Kong) institutional and professional investors who have sizeable demands. Professional investors generally include brokers, dealers, companies (including fund managers) whose ordinary business involves dealing in shares and other securities, and corporate entities which regularly invest in shares and other securities. As a matter of practice, no allocation of shares would be given to individuals.

4. Allocation of shares under the Hong Kong subscription tranche

Allocation of shares under the subscription tranche is based solely on the level of valid applications received under that tranche. The basis of allocation may vary, depending on the number of shares validly applied for by applicants, but subject to that, allocation is made strictly on a pro-rata basis. Where appropriate (e.g. where shares under the subscription tranche are over-subscribed), the allocation of shares could consist of balloting, which would mean that some applicants may receive a higher allocation than others who have applied for the same number of shares. Applicants who are not successful in the ballot may not receive any new shares.

5. Allocation of shares under the international placing tranche

Allocation of shares under the placing tranche is usually based on a number of factors including the level and timing of demand, total size of an investor's invested assets or equity assets in the relevant sector, whether or not it is expected that the investor is likely to buy further, and/or hold or sell the shares after they are listed on the SEHK or any other overseas exchange, and the investors' past or potential business relationship with the lead underwriter. Allocation is normally intended to result in the distribution of the shares to, and the establishment of, a solid institutional and professional shareholder base for the issuer.

6. The over-allotment option and over-allocation of shares

The issuer usually grants an over-allotment option to the lead manager appointed to manage the issue. Under the option, the lead manager usually has the right, exercisable for 30 days from the prospectus date, to require the issuer to allot and issue up to 15% of the issue size at the issue price to cover over-allocations of shares. The number of shares which may be over-allocated does not usually exceed the number of shares in respect of which the over-allotment option has been granted.

7. Underwriting aspects

Shares under the public subscription tranche are only underwritten provided that certain conditions are satisfied, including the new issue price being agreed, and the signing of the pricing agreement and the placing agreement by underwriters. Upon execution of these agreements and the satisfaction of certain standard conditions, the international placing tranche will be fully underwritten by the placing underwriters.

Since the Hong Kong underwriting agreement is subject to satisfaction of the above conditions, issue of shares under the public subscription tranche will not proceed unless all conditions are met. If these conditions have not been fulfilled or waived on or before trading commences on the SEHK, all application moneys received under the public subscription tranche will be returned to applicants without interest.

8. Pricing

The international placing underwriters will solicit from prospective professional and institutional investors indications of interest in acquiring shares under the international placing tranche by way of book-building. Prospective professional and institutional investors will be required to specify the number of shares they would be prepared to acquire either at different prices or at a particular price. This process of "book-building" usually continues up to, and ceases on, the price determination date.

The final issue price is usually fixed by agreement between (i) the lead manager on behalf of the underwriters, and (ii) the issuer, on the price determination date, when market demand for the shares has been determined through the book-building process.

The price determination date usually falls on or around the latest date fixed for the lodging of applications under the subscription tranche. The intention is for the price to be fixed sufficiently early to ensure that adequate time is allowed for the basis of allocation of shares under the subscription tranche to be announced, and for refunds of application moneys to be made before trading commences.

Hong Kong prospectuses usually quote an indicative price range under which the issue price will be fixed, subject to adjustment. The upper end of the price range is usually fixed and prospectuses usually provide that the final issue price will in no circumstances be more than a certain amount. The lower end of the price range, however, may be adjusted downwards upon the circumstances described below.

If, based on the level of interest expressed by investors during the book-building process, the lead manager (on behalf of the underwriters and with the consent of the issuer) considers it appropriate, the indicative price range may be reduced below that stated in the prospectus at any time prior to the latest date fixed for lodging applications under the public subscription tranche. If the price range is reduced, the issuer will, as soon as practicable following the decision to make such reduction, and in any event no later than the morning of the day which is the latest day for lodging applications, cause to be published in newspapers widely circulated in Hong Kong notice of the reduction of the price range stating the new price range below which the final issue price cannot be fixed.

At present, applicants who handed in applications under the subscription tranche would not normally be allowed withdraw their applications, even if the indicative price range is reduced.

9. "Clawback" or Inter-tranche flows of allocations

Allocation of shares between the public subscription tranche and the international placing tranche is subject to adjustment depending on the rate of subscription under both tranches.

If the number of new shares validly applied for under the subscription tranche is over-subscribed by a specified rate, then shares originally allocated for the placing tranche would be re-allocated or "clawed-back" to satisfy applications under the subscription tranche. Usually, the higher the over-subscription rate under the subscription tranche, the more shares would be "clawed-back" from the placing tranche up to the limit of a maximum number of shares.

If the subscription tranche is not fully subscribed, re-allocation or "clawback" of shares from that tranche to the placing tranche for the purpose of meeting demands under the placing tranche could take place. In such circumstances, the lead manager is usually given absolute discretion to re-allocate to the placing tranche all or any un-subscribed shares originally allocated to the subscription tranche as it deems appropriate.

10. Stabilisation

In global equity offerings involving the combined offering mechanism, it is common for underwriters to effect transactions which stabilise or maintain the market price of the newly issued shares at levels other than those which might otherwise prevail. Such transactions may be effected in all jurisdictions where it is permissible to do so and in compliance with the applicable laws and regulatory requirements.

Stabilisation is a practice used by underwriters in some markets to facilitate the distribution of securities. To effect stabilisation, the underwriters may bid for, or purchase, the newly issued securities in the secondary market during a specified period of time to retard, and if possible, prevent a decline in the initial public offer price of the securities.

However, stabilisation is a practice not commonly associated with the distribution of securities in Hong Kong. There are provisions in the Securities Ordinance prohibiting market manipulation in the form of pegging or stabilising the price of securities. In Hong Kong, stabilisation activities on the SEHK are restricted to cases where underwriters purchase shares in the secondary market genuinely and solely for the purpose of covering over-allocations in the relevant offer. This position was clearly set out in the 1994 Joint Policy Statement.

APPENDIX 6

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