Taiwan: Taiwan’s changing face

Author: | Published: 1 Oct 2010
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Several recent developments in Taiwan have the potential to significantly affect and in some cases alter traditional private equity and venture capital activities in Taiwan.
These recent developments may be summarised as follows: (1) limitations over the issuance of privately issued public equities (Pipes) at a significant discount to market price to non-strategic investors; (2) the development of a strong regional market for listing medium sized foreign companies via the Taiwan Stock Exchange (TWSE) and the Taiwan Gretai Securities Market (OTC) and; (3) the implementation of the Economic Cooperation Framework Agreement (ECFA) between Taiwan and China.

While it is too early to tell whether the combined effects of these developments would substantially increase or decrease the level of investments overall, our preliminary assessment is that the combined effect of these developments could lead to more growth capital activities by venture capital funds and middle market private equity funds.

Limitations on Pricing of Pipes

Historically, private equity funds and hedge funds have not been active in making investments directly in Pipe offerings, largely on account of the three-year lock-up during which the Pipes would not be freely transferable. However, the availability of the ability of Pipes to be priced at a deep discount to market has sometimes served as a catalyst for investments, especially in the situation where the funds are purchasing a block of Pipes from existing shareholders rather than in the primary offering (due to the fact that in most cases the applicable holding period does not re-start if Pipes are transferred to qualified institutional buyers).

Recently, the Financial Supervisory Commission of the Ministry of Economic Affairs, ROC (FSC) has further tightened regulations restricting the placement of Pipes in Taiwan. The FSC has taken the view that Pipes permitted under Articles 43-6 to 43-8 of the ROC Securities and Exchange Act have been abused to the detriment of shareholder rights. Following the amendments, Pipes other than securities issued to non-related parties by public companies operating at a loss remain subject to the rules prior to the amendments. All other Pipes must abide by further restrictions.

One of the major amendments altered the calculation of the average market price from which the maximum discount of 20% may be taken as the price for the Pipes. Where the average market price was previously either the price for the securities of the common stock at closing during the prior business day or the average of the price at closing for the prior three business days or five business days, the average market price now requires a comparison between the price determined using the pre-amendment method and the average price at closing over the prior 30 business days. The higher price is to be used when determining the maximum discount.

A second major amendment altered the rules for Pipes issued by companies operating at a profit. As the FSC believes that companies operating at a profit should generally make public offerings as its method for raising more funds, it has adopted amendments to curb usage of Pipes. Public companies operating at a profit are prohibited from issuing Pipes unless the public company only has one shareholder, or unless the investor is a strategic investor, or the public company is in financial difficulties and its plan to raise money through Pipes is approved by the competent authority. A strategic investor is defined to mean an investor that will increase the profitability of the issuer because of its experience, technologies, know-how, product brand or distribution channels, etc., which will allow for horizontal, vertical or collaborative efficiencies that will be beneficial to the issuing company. Public companies operating at a profit are also prohibited from issuing Pipes to related parties.

We expect most private equity funds and hedge funds will not be considered to be strategic investors, absent special circumstances.

A third major amendment also altered the rules for Pipes issued by companies operating at a loss, if such securities are issued to related parties. The issuance of such securities must be discussed and approved by the board of directors with specificity, and full disclosure must be made to shareholders.

Failure to comply with these new Pipes rules may result in authorities disapproving any future application to register the securities for sale to the public (this step is required after the expiration of the relevant lock up period in order to allow public trading of such securities).

While the purchases of Pipes under the new rules would directly affect some forms of private equity investments in Taiwan, we also note that other forms of private equity investments in Taiwan to date are not affected and we may also see a rise in other forms of transactions which are potential substitutes for Pipes, such as SPOs and ECBs (however, SPOs and ECBs do not have the pricing advantages vis a vis Pipes).

Legal issues for foreign companies IPOs

In early 2008, the TWSE began to encourage foreign companies to conduct their initial public offerings (IPOs) in Taiwan. For private equity and especially venture capital funds with investments in the Great China region, exits via Taiwan's capital markets are fast growing in popularity. This is on account of several competitive advantages that are attractive to rapidly growing companies, particularly in the technology sectors: relatively high P/E ratios, excellent liquidity even for medium and small sized companies, a cluster effect among technology companies resulting in high interest, familiarity among investors and analysts, and significantly lower IPO costs. As of September 13 2010, there is one foreign company (Integrated Memory Logic Limited) listed on the TWSE and one foreign company (Array Inc.) listed on the Taiwan OTC.

To date, up to 59 candidates are in the TWSE pipeline; five applied for primary listing in 2010 and the TWSE listing committee has already approved three companies to be listed in the near future.

We highlight some issues of relevance to the directors of foreign issuers below.

Thresholds

Not all types of foreign company will be able to list via the TWSE or the Taiwan OTC. For example, foreign companies whose revenues derive mostly from Taiwanese sources will be encouraged to reorganise as a domestic listing, rather than a foreign listing, and those foreign companies whose shareholdings exceed a maximum amount of PRC ownership will also be precluded (see further below on this issue). Finally, there are basic financial, profitability and paid in capital requirements for listing via the TWSE and the Taiwan OTC, which must be met by a foreign company.

Conversely, assuming that the foreign company qualifies for listing on the TWSE or the Taiwan OTC, there are some peculiarities about the Taiwan listing process which require some consideration. Unlike the rule-based listing process in most other jurisdictions, the Taiwan listing process is a merit-based review and therefore the foreign company must be prepared for a review process that could be more detailed from a business perspective than in other jurisdictions. The listing process can easily exceed six months and usually exceeds a year.

Accordingly, any of the issues below, if not dealt with in a manner satisfactory to the TWSE staff, will result in significant delays.

Conversion offshore holding structure

TWSE regulations require that a foreign issuer amend its organising documents to include a number of provisions based on the TWSE's Guideline For Shareholders' Protection that reflect Taiwan's domestic corporate law. Some of these provisions may be incompatible or inconsistent with the corporate laws of the foreign company's state of incorporation. In consideration of the foregoing, although the TWSE does not require the company to be incorporated in any particular jurisdiction, most foreign companies choose to restructure under a company organized in an offshore jurisdiction which offers a balance between international recognition and flexibility in its internal corporate governance laws and regulations. To date, by far the most popular jurisdiction has been the Cayman Islands.

Thus, in drafting the listing company's memorandum and articles of incorporation, Taiwan counsel and Cayman Islands counsel must work together to ensure that all provisions required by the TWSE are included and that none of such provisions conflict with Cayman Islands law.

Informal caps

It's very common for foreign companies to use incentive stock options and other equity awards to motivate their employees. Foreign companies should therefore be aware that listing on the TWSE may restrict their incentive plans in several key ways.

Most Taiwan listed companies operate under a de facto cap on shares underlying incentive stock options for employees, equal to 15% of the companies' overall issued and outstanding shares. In consideration of this, the TWSE would likely question foreign issuers with options authorized under an incentive plan in excess of 15%.

If the foreign company intends to issue stock options that would exceed the 15% cap, the company should take steps to ensure that the amount of stock options is below the cap prior to listing. In addition to the foregoing, the TWSE may also question issuances of a significant amount of options in the period leading up to an IPO.

Preferred stock and shareholders agreements

Startup companies typically undergo one or more rounds of preferred stock financings during their development. The company's organising documents will provide for certain preferential rights to preferred stockholders, such as priority over common stockholders for liquidation and dividends. In addition, the preferred stock investors may have agreements among themselves and with the company that provide for a number of additional rights, such as voting agreements, information rights and restrictions on transfer of the company's common or preferred stock.

Foreign companies planning on listing on TWSE should ensure that all preferred stock will be converted to common stock at the time the company submits its application for listing, and that any agreements among shareholders should be terminated as well. Taiwan domestic law generally favours equality and free trading among shareholders, and the existence of preferred stock and shareholders agreements will raise significant questions from Taiwan's investors and regulators.

Restrictions regarding mainland China

A foreign company with investments or operations in the PRC may list on TWSE as long as the listing company is a holding company rather than the PRC entity itself. However, Taiwan laws governing Taiwan-PRC cross-strait relations have other restrictions on investment by PRC citizens in a TWSE-listed company. In particular, a foreign company cannot list on TWSE if 30% or more of its shares are held by PRC shareholders, or if a PRC shareholder has significant management influence over the company. Foreign companies with significant PRC shareholders or influence, or companies that do not know the nationality of their shareholders or management, should consider this issue ahead when planning for a TWSE listing.

Further observations

Foreign companies considering a TWSE listing should note that they might be required to adopt some Taiwanese corporate practices. These practices may differ enormously from corporate practice in other jurisdictions, and may have different impacts on the interests of investors, directors, management or employees.

Generally speaking, the more flexibility and simplicity a foreign company can accept in its capital structure and compensation plans, the more it will be able to adapt to TWSE compliance requirements. Many potential issues can be addressed or avoided by good communication with TWSE officers. Foreign companies considering or preparing a TWSE listing should work closely with their Taiwan underwriter and counsel to determine how to handle these issues efficiently.

Economic cooperation framework agreement

On June 29 2010, representatives of Taiwan and China signed the Economic Cooperation Framework Agreement (ECFA), a preferential trade agreement aiming to reduce tariffs and commercial barriers between the two sides. The agreement will become effective after both sides have completed relevant procedures and notified the other party of the same. Taiwan's Executive Yuan approved the ECFA on July 2 2010 and its parliament approved the deal on August 17. The signing of the ECFA creates heated debates in Taiwan as to the effects on local Taiwan businesses, as well as on how the government has presented it to the public.

We provide, below, a summary or brief introduction to the ECFA and focus on the Early Harvest Program with respect to financial service sectors under the ECFA.

Sector Commitments by Taiwan Commitments by China
Banking A Chinese bank having a representative office in Taiwan for more than one year may apply for approval to set up a branch. -A Taiwan bank having a representative office in China for more than one year may apply for approval to set up a branch or subsidiary.

-A Taiwan bank having a branch or subsidiary in China for more than two years that has been profitable for the previous year may apply for approval to offer Rmb services.

-A Taiwan bank having a branch or subsidiary in China for more than one year and is profitable may first apply for approval to offer Rmb services to Taiwan businesses operating in China.
Insurance None A Taiwan insurance company may apply for approval to conduct business in China if the requirement of “5, 3, 2” (assets of an insurance company be at least $5 billion, incorporated for more than 30 years and with a representative office in China for more than 2 years) is met, through either integration or strategic consolidation.
Securities/Futures None -Simply the procedures for obtaining licenses by Taiwan securities agents in China.

-Provide convenience to qualified Taiwan financial institutions in applying for China QDII qualification.

Summary of ECFA

The aim of ECFA, as stipulated in the agreement itself, is to strengthen trade and investment cooperation between Taiwan and China, gradually reducing or eliminating the barriers in existence. The agreement is divided into two main categories of trade: goods and services. Based on the Early Harvest Program list for trade in goods, China will apply zero tariff for 539 types of goods imported to China from Taiwan over a period of three years,; whereas Taiwan will also apply zero tariffs with respect to 267 goods imported to Taiwan. In respect of trade in services, based on the Early Harvest Program, China opens up 11 items to Taiwan, on the other hand, Taiwan opens up nine items to China.

The signing of the ECFA further lifts restrictions regulating financial service sectors across the Taiwan Strait, in furtherance of the ROC's Regulations Governing Approvals of Banks to Engage in Financial Activities Between the Taiwan Area and the Mainland Area (as amended the Regulations). In terms of financial service sectors under the Early Harvest Program, Taiwan only offers one commitment with respect to the banking sector. That is, a Chinese bank which is permitted to set up a representative office in Taiwan for more than one year may apply for approval to set up a branch. Nevertheless, the above commitment only represents a slight relaxation of what is already permitted under the Regulations. Under the Regulations, the requirement is two years. In contrast to the sole commitment given by Taiwan, China offers a wider range of relaxations, in all banking, securities and insurance areas. For instance, under the banking area, the waiting period for entry to the Chinese market and the offering of Rmb services by Taiwan banks are shorter. For the key provisions of commitments see the box.

The commitments offered by China under the Early Harvest Program seem to be more preferential than those offered to Hong Kong under Mainland China and Hong Kong Closer Economic Partnership Arrangement (Cepa). For example, with the re-defined "5,3,2" for insurance companies, the number of Taiwanese insurance companies qualified to conduct businesses in China are increased from the current six to ten.

ECFA is seen as the most significant agreement signed between Taiwan and China in terms of financial cooperation. However, Taiwan's financial sectors are complaining that the "opening is too small": that Taiwan's securities firms may only invest up to 33.3% in China's securities firms, Taiwan's banks may only invest in China's banks either directly or through an offshore subsidiary but not both, and China's banks can only choose to either set up branches in Taiwan or invest in Taiwan's banks and aggregate investment in an individual Taiwanese bank by a Chinese bank cannot exceed 5%. Specifically, under the Early Harvest Program, Taiwan only opens up one item for bank in respect of financial service sectors. Many see this as a concession given by the Chinese government for political reasons. More negotiations between the two sides to lift more restrictions are yet to be done.. For instance Cepa was signed on June 29 2003, where seven supplements were thereafter signed between October 27 2004 and May 27 2010. However, financial arrangements were not brought up at negotiation table until Supplement III. The two sides will resume the second round of negotiations by the end of 2010. As restrictions on investments across the Taiwan Strait are gradually lifted, foreign investors in Taiwan will be offered an alternative option of existing investments with Chinese partners. However, we caution that the implementation of ECFA and related regulations will likely be a gradual process.

ECFA effect on PE and VC funds

For private equity and venture capital funds, the further development of ECFA and the gradual opening of Cross Straits trade have some immediate benefits. For example, as intellectual property protection is stronger in Taiwan vis-à-vis China, Taiwan becomes a suitable base for high tech companies who have intellectual property protection concerns. In addition, as Chinese companies can now establish a permanent presence in Taiwan, synergies may be realised via merger and acquisitions and joint ventures across the Taiwan Strait. Indeed, LCS had recently acted on the first major acquisition of a substantial portion of assets by a Taiwan list company by a Chinese listed company. Private equity and venture capital funds that own stakes in potential buyout targets in both Taiwan and China may be interested in exploring such opportunities. Finally, as mentioned above, many technology companies based in China under an offshore holding structure are beginning to look to Taiwan's capital markets for IPO; the further cooperation between Taiwanese and Chinese financial institutions will undoubtedly contribute to this growing trend as well and further strengthen this exit option for many private equity and venture capital funds investing in the Great China region.

About the author

Victor Chang has extensive multi-jurisdiction transactional experience in mergers and acquisitions (M&A), private equity fund formations and cross border transactions of all types, frequently involving parties from the US, Europe, Canada, Australia, Taiwan and China.  Chang has been recognised as a leading attorney in the areas of private equity and venture capital by Asia Law.  Prior to joining LCS in 2003, Chang was deputy general counsel of Trader Classified Media, N.V., a leading classified media company traded on the Paris Bourse and also practiced for seven years in Boston, Massachusetts.

Contact information

Victor Chang
LCS & Partners

Email:victorchang@lcs.com.tw
Tel: 8862-2729-8000 ext. 7722


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