CONT CONNECTED & DISCLOSEABLE TRANS & NOTE OF EGM

3.2       Terms of the New CNACG Framework Agreement

 

The key terms of the New CNACG Framework Agreement are as follows: Services:                Finance  lease  and  operating  lease services:

CNACG Group will provide finance lease  and  operating lease services in respect of, among other things, aircraft, engines, simulators, equipment and vehicles to the Group; the Group will provide finance lease and operating lease services in respect  of, among other  things,  equipment and vehicles  to CNACG    Group.

 

CNACG  Ground Services

 

Transactions conducted between any member of  the  Group  on the one hand and any member of CNACG Group on the other hand include but not limited to : ground support services, aircraft maintenance services, aircraft repair services, property  investment and management services, ticket and tourism services, logistics services, administrative management services, cleaning and washing services, resident security services, lounge supplies procurement services  and  aircraft  material  procurement services.

 

Pricing  terms:                         Finance  lease  and  operating  lease services:

 

The final transaction price will be determined on arm's length negotiations between both parties after taking certain factors into account and with reference to the prices for the same type of lease services offered by independent third parties. Such certain factors considered above include purchasing price of the leasing subject, interest rate and arrangement fees (if any) (for finance lease), rental fee (for operating lease), the lease terms, the feature of the leasing subject and the comparable market rental prices. The final transaction price should not be higher than the transaction prices offered by the at least two independent third parties on the same conditions.

 

CNACG  Ground Services

 

The pricing policies for ground support services and other services provided to or by the Group are set forth below:

 

(i)         Follow the government pricing or guide price (if  any), including but not limited to the guidance from the Civil Aviation Administration of the PRC (CAAC) and the International Air Transport Association on the  prices of ground support services and other terms, and the requirements on the pricing of navigation information stipulated by CAAC and Air Traffic Management Bureau (ATMB);

 

(ii)        If no government pricing or guide price is available, the final transaction price will be determined on arm's length negotiations between the parties, with firstly making reference to the market prices offered by at least two independent third parties for the same type  of  service, and after taking certain factors into account such as service standard, service scope,  business  volume  and  specific  need of parties. If any service need of  the  service  recipient changes, appropriate adjustment will be made to the transaction price after  negotiation  between  both  parties based on the extent of variation in relevant costs,  service quality or other factors; and

 

(iii)       If neither the above cases is applicable, the price will be determined on a basis of cost plus  reasonable  profit. The costs are mainly based on the costs and expenses of the service provider, including costs of human resources, facility, equipment and materials. Reasonable profit margin

will be determined mainly  making  reference  to,  among others, the historical average prices on similar products or services (where possible) published in relevant industry, and/ or the profit margin of the comparable products and services disclosed by other listed companies. The profit margin of CNACG Group shall not exceed 10%. The final transaction prices shall be determined on terms that to the Group are no less favourable to  those  provided  by  independent  third parties to the Group or those provided by CNACG Group to independent third parties (with regards to the receiving of services by the Group), or no more favourable to CNACG Group than those provided by the Group to the independent third parties (with regards to the rendering of services by the Group).

 

Term  and  termination:   The  initial  term  of  the  New  CNACG  Framework  Agreement   is three years commencing from 1 January 2020 and ending on 31 December 2022, which is automatically renewable for successive terms of three years after the expiry of its initial term subject to the fulfilment of requirements under Hong Kong Listing Rules/ Shanghai Listing Rules and  obtaining  the  required  approval. Before expiry of the New CNACG  Framework  Agreement,  the Board will re-assess the terms and conditions of the New CNACG Framework Agreement, and the Company will re-comply with the relevant rules governing connected transactions  under  the  Hong Kong Listing Rules. During the term of the New  CNACG Framework Agreement,  the  agreement  can  be  terminated  on  any 31 December by either party thereto by serving the other party a written notice of termination of not less than three months.

 

Finance  lease  and  operating leases

 

To assess the fairness and reasonableness of the terms of the finance lease and operating lease transactions under the CNACG Transactions, we have obtained and reviewed the New CNACG Framework Agreement. Based on our discussion  with  the  Management,  we understand that before entering into any lease agreements, the Group will obtain and review at least two lease proposals from independent third parties through requests for proposals or other public procurement processes, and evaluate whether the comprehensive costs (including principle or rental fee and arrangement fees, if any) provided by the CNACG Group are fair and reasonable and no less favourable to the Group than those offered  by  independent third parties.

 

Based on our understanding from the Management, interest rates used for finance leases for, among others, aircrafts, is usually with reference to official lending rate promulgated by the People's Bank of China ("PBOC"). We have also understood from the Management that as at the Latest Practicable Date, the period of finance leases for aircrafts would  not be less than 5 years. We note the PBOC official lending rate for period greater than 5 years is 4.9% as of the Latest Practicable Date. We further understand from the Management that the length of the implementation agreements for each finance lease as  well  as  operating  lease  item  would be with reference to useful life of the relevant aviation asset which is usually over 10 years for aircraft  and  3-20  years  for  aviation equipment.

 

We understand from the Management that the Group has entered into similar leasing arrangements with CNACG Group and/or independent third parties from time to time in the past. In this regard, we have requested the Company to provide us with, among other things, samples of proposals/quotations submitted by CNACG Group and independent third parties respectively in 2018 as regards aircraft finance lease ("Sample Aircraft Finance Leases") for the same type of the leasing subject. Also, we understand the Company has previously entered into aviation equipment operating lease with CNACG Group. We have separately requested for and were provided with two previous operating leases relating to aviation equipment entered into with an independent third party  and  CNACG  Group  respectively  ("Sample Other Leases") as an example to illustrate the common  terms  of  an  aviation  equipment under operating lease.

 

From the Sample Aircraft Finance Leases provided, we noted that the interest rates used for Sample Aircraft Finance Leases were determined with reference to official lending rate promulgated by the PBOC and the terms for such Sample Aircraft  Finance  Leases  ranged between 10-12 years in duration. We also noted from the Sample Aircraft Finance Leases and from our discussion with the Management that the Company would consider, among  others factors, whether the total cost of borrowing (i.e. the rate offered) by the lender is considered favourable among the quotes received and whether the amount of financing available to be provided by the lender is sufficient to satisfy the Company's requirements, before entering into any formal lease agreements. Based on the supporting documents relevant to the approval of the Sample Aircraft Finance Leases, we noted that the Sample Aircraft Finance Leases were jointly reviewed and approved by at least three different departments of the Company.

 

On the Sample Other Leases provided, we have discussed  with  the  Management and noted that the duration of the agreements are of a term of 5 years or above. Based  on the discussion with the Management, we understand that the  total  rental  for  the  period  is determined with reference to the cost of  the  aviation  equipment.  Separately,  we  understand from the Management that in comparing different quotes for the same equipment, the Company would also calculate the embedded interest offered. The reference rate used is also the PBOC official rate. In addition to the above, and similar to that  of  aircraft  finance  leases,  we understand the Company selects the lender based on,  among  others,  whether  the  required amount of financing for the subject aviation equipment is available as well as the rental per period payable. Again, prior to entering into of any operating leases for aviation equipment, we understand that the agreements are jointly reviewed and approved by at least three different departments  of  the Company.

 

Based on the above, we consider the terms of the finance lease  and  operating  lease services under the CNACG Transactions are generally in line with the market. Furthermore, we would  consider  the  New  CNACG  Framework  Agreement  as  regards  the  finance  lease  and operating lease as simply a mean to provide the Company with an additional  flexibility  in selecting financing provider but not an obligation  for  the  Company  to  enter  into agreements with CNACG, which is in the interest of the Company.

 

CNACG  Ground Services

 

The pricing  policies for  CNACG Ground Services  are set  forth    below:

 

(i)         Follow the government pricing or guide price if it is available, including but not limited to the guidance from the Civil Aviation Administration  of  the  PRC (CAAC) and the International Air Transport Association on the prices of ground support services and other terms, and the  requirements  on  the  pricing  of navigation information stipulated by CAAC and Air Traffic Management Bureau (ATMB);

 

(ii)        If no government pricing or guide  price  is  available,  the  final  transaction price will be determined on arm's length negotiations between the parties, with firstly making reference to the market prices offered by at least two independent third parties on the market for the same type of service and after taking  certain  factors into account such as service standard, service scope, business volume and specific need of parties. If any service need of the service recipient changes, appropriate adjustment will be made to the transaction price after negotiation between both parties based on the extent of variation in relevant  costs, service quality or other factors; and

 

(iii)       If neither the above cases is applicable, the price will be determined on the basis of cost plus reasonable profit. The costs are mainly based on  the  costs  and expenses of the service provider, including costs of human resources and costs of facility, equipment and materials. Reasonable profit margin will be determined mainly making reference to the historical average prices on similar products or services (where possible) published in relevant industry, and/or the profit margin of the comparable products and services disclosed by other listed companies. The profit margin of CNACG Group shall not exceed  10%.  The  final  transaction prices shall be determined on terms that to the Group are no less favourable to those provided by independent third parties to the Group or those provided by CNACG Group to independent third parties (with regards to the receiving  of services by the Group), or no more favourable to CNACG Group than  those provided by the Group to the independent third parties (with regards to  the rendering of services by the Group).

 

Similar to that of  ACC Ground Services  in  relation to  services provided by ACC  Group to the Group, we understand that prior  to  entering  into  any  agreements  with  the  CNACG Group for the CNACG Ground Services sought, the Group would first of all make references to the Guidance and also consider cost of  similar  services  provided  by  independent  third parties. If and when required, we understand from the Management that the Group would also require the CNACG Group to provide supporting document to substantiate that the quote and/ or profit margin provided to the Group is no different to quotes provided to independent third parties.

 

We further understand that the  Group's  relevant  department  would  be  responsible for the verifications of such comparisons made and to confirm that  the  margins  quoted  by  the Group for similar services provided to its customers and therefore the  margins  quoted  by CNACG Group would be considered as reasonable. Similar to our independent work done for the ACC Ground Services, to determine the fairness and reasonable of the use of "cost plus no more than 10% profit margin" element of the pricing policy, we have, on a best-effort basis, through public domain, noted that an industry player that has been listed on the Exchange for more than 10 years and is engaged in a similar line business and with similar geographical coverage, namely China Southern (Stock Code:1055)  has,  in  its  respective  announcements dated 16 December 2016 and 27 December 2018 disclosed that its pricing policy for ground services provided by its connected person is also on a cost plus a profit margin of 10% basis. In this respect, we would consider the use of cost  plus  no  more  than  10%  profit  margin concept is not uncommon in the market. We have also reviewed the existing CNACG ground services agreement (the "Existing CNACG Ground Services  Agreement")  and  compared it with one sample ground services transaction entered into with independent  third  parties  in relation to services similar to that of the CNACG Ground Services transactions and noted that the terms offered are similar. We further noted that according to the internal policy procedures as described in the section headed "4. Internal  control  procedures"  below,  the  Existing CNACG Ground Services Agreement were jointly reviewed and approved by at least three different  departments  of  the  Company  including  the  asset  management department.

 

In light of the aforementioned, we consider the pricing basis  for  CNACG  Ground Services  to  be  fair  and reasonable.

 

3.3       Historical amounts and historical caps and the proposed annual caps

 

The table below sets out (i) the annual caps of the Group for the three years ended/ending 31 December 2017, 2018 and 2019; and (ii) the actual aggregate amounts paid by the Group for each of the two years ended 31 December 2017 and 2018 and from January to August 2019, and  the estimated aggregate amounts payable for the year ending 31 December 2019.

 

	Historical  Amounts				Historical Caps
	for the year ended 31 December		Actual amount for the period from January to August 2019	Estimated annual amount for 2019	for the year ended/ ending 31 December
Transactions	2017	2018			2017	2018Note 1	2019
Transaction amount for aircraft finance lease service (US$ Million)	N/A	957	550	1,490	N/A	1,046.59	1,492.03
Finance lease for engines and simulators, operating lease for back-up aircraft engines, and back-up ground support equipment, ground support services and other services (RMB Million)	378	416	351	503	2,450	2,450	2,450

 

Notes:

 

1.          In terms of maximum transaction amount for aircraft finance lease service, it covers the period from 1 June 2018 to 31 December 2018.

 

2.          For the three years ended/ending 31 December 2017, 2018 and 2019, both the  estimated  aggregate amounts payable to, and the actual amounts paid to the Group by the CNACG Group are below the de minimis threshold as stipulated under Rule 14A.76(1)(a) of the Hong Kong Listing Rules.

 

3.          For the three years ended/ending 31 December 2017, 2018 and 2019, utilisation rate of the annual caps for finance lease of engines and simulators, operating lease of back-up aircraft engines and back-up ground support equipment, ground support services and other services was low. The main reason leads to such low utilisation rate is that the operating lease projects relating to engine, simulator and ground support equipment of the subsidiary under CNACG that engages in leasing services were still at start-up stage, thus number of projects under progress is limited.

 

We have discussed the basis for its estimated  transaction  amount  for  2019  with  the Management and understand that it has considered,  among  others,  the  actual  value  of  the  finance lease services entered with CNACG Group and expected finance leases to be entered with CNACG Group in 2019. Having considered the aforementioned,  we  consider  the  bases  used  to  estimate the total transaction value for 2019 to be fair and reasonable.

 

The table below sets out the proposed annual caps for the total amount payable to CNACG Group by the Group for each of the three years ending 31 December 2020, 2021 and 2022, respectively:

 

	Proposed  Annual Caps for  the  year  ending  31 December
Transactions	2020	2021	2022
	(in  millions  of RMB)
Total value of right-of-use assets in relation to finance lease and operating lease entered into by the Group   as lessee	14,500	16,000	16,500
Ground support services and other services	600	690	807

 

Finance  lease  and  operating lease

 

As disclosed in the letter from the Board of the Circular, the annual caps relating to the finance lease and operating lease to be entered into between the Group and the CNACG Group are:

 

•           For the finance lease for aircraft were determined with reference to: (i) the aircraft introduction plan for each of the three years (based on the Company's  2019  Interim Report, the Group expects to introduce 55, 93, and 42 aircrafts to its fleet for years 2019 to 2021 respectively, and the average compound annual growth rate of the Group's fleet capacity for years 2019 to 2021 is 8.85%. It is also assumed that the growth rate of fleet expansion of the Group in 2022 will not exceed such rate), and the aggregate principal amount of the aircraft finance lease with CNACG Group is estimated based on the assumption that half of the aggregate consideration amounts of the aircraft scheduled to be introduced during the period from 2020 and 2022 according to confirmed orders will be introduced by way of finance lease with CNACG Group; (ii) the average lease term of aircraft being 10 to 12 years; (iii) the benchmark lending rate for RMB loans above 5 years promulgated PBOC of 4.9%; and (iv) an arrangement fee of 0.5%  based  on prevailing market conditions. When estimating financing lease in connection with assets such as engines in the following three years which, according to the Company, accounts for a minimal portion of the  respective  annual  caps,  the  Company  had  considered related financial leasing needs and adopted rate of interest fee  and  arrangement  fee of same aircraft financing lease for estimation; and

 

•           For operating leases involving engines, simulators and equipment (together "Aviation Equipment") for each of 2020, 2021, 2022 are estimated with reference to: (i)  the historical transaction amounts; (ii) the operation  condition  of  the  Aviation  Equipment and the Group's commercial demand for operating lease in the following three years;

(iii) the operating lease price and terms of the same or similar assets in the domestic market; and (iv) a reasonable cushion to cater for the Group's operating need from time to time.

 

We have discussed and understand from the Management that approximately 95% of the total annual cap for finance lease and operating lease to be entered into by the Group as lessee is attributable to the anticipated total value of right-of-use assets relating to finance lease of aircraft ("Aircraft Finance Leases PV"). Based on the disclosures made in the letter from the Board of the Circular, the planned Aircraft Finance Leases PV is RMB13.8 billion, RMB15.1 billion and RMB15.9 billion  for  2020,  2021  and  2022 respectively.

 

We further noted from the Management that the maximum aggregate principal amount of the aircraft finance lease with CNACG Group for any particular year shall not exceed half of the aggregate consideration amounts for the total aircraft projected to be added by using finance leases during the said year. As such, the computation process the Company has adopted only accounted for half of the total expected purchase price of the total aircrafts scheduled to be introduced using finance lease as the relevant principal amount. We note that the Company's peers, China Southern and China Eastern in their respective continuing connected transaction circulars dated 26 October 2017 and 30 September 2019, adopts a similar computation process of accounting for only half of the total expected purchase price of total aircrafts scheduled to be introduced as the relevant principal amount.

 

As advised by the Management, pursuant to IFRS 16, the finance lease entered into by the Company as the lessee will be recognised as right-of-use assets and discounted using the Company's incremental borrowing rate, and the result of such calculation is used to determine the total annual cap for the finance lease and operating leases for the specific year. Accordingly, the amounts of the Aircraft Finance Leases PV for each of the years 2020, 2021 and 2022, being the total value of right- of-use assets relating to the aircraft finance leases expected to be entered into between the Company and CNACG Group during 2020, 2021, and 2022 respectively, constitute the annual cap  for  the respective years. We have noted that China Eastern has adopted a similar approach to determining its annual caps for aircraft finance leases in its circular dated 30 September 2019. We have reviewed the computation of the respective values for the right-of-use assets relating to the planned aircraft finance leases and noted that it is calculated by discounting the estimated total financing amount required for 50% of the total new aircrafts (including interest and arrangement fees) to be  introduced  for  the particular year by a discount rate of 4.9% (for leases with terms over 5 years) which is equivalent to the Company's prescribed internal incremental borrowing rates for loans/leases over five years. We have reviewed the Group's 2019 Interim Report and noted that the interest rate for the Group's interest-bearing bank and other loans repayable ranged from 1.95%  to  5.02%  (median  interest rate being 3.49%) and range of interest rates for corporate bonds repayable  is  from  2.84%  to  5.30% (median interest rate being 4.07%) as at 30 June 2019. Given the range and the median of interest rates applicable to the Group's interest-bearing bank loans and other borrowings, and the fact that the use of the internal rate, being 4.9%, is towards the higher end of the aforementioned quoted ranges, we would consider the Company's use of discount rate of 4.9% to be prudent.

 

In addition to the above, we have also carried out the following independent work and considered  the  following factors:

 

(1)        we understand from the Management that the finance lease  contracts  for  aircraft  is usually between 10 years and 12 years in duration. As mentioned under the paragraph headed "3.2 Terms of the New CNACG  Framework  Agreement"  above,  we  have obtained and reviewed 6 Sample Aircraft Finance Leases submitted by independent third parties and noted that the duration for the leases were all between 10 and 12 years. In this respect, we would consider the expected lease period of between 10 years and 12 years  to be normal  business  practice  for the aviation  industry  in   China;

 

(2)        we understand from the Management that the interest rate for the finance leases are normally set with reference to the PBOC rate for the corresponding length of the lease. In light of the fact that the aircraft finance leases are usually between 10 and 12 years in length, we have reviewed the PBOC website and have confirmed that, as at the Latest Practicable Date, the corresponding reference interest rate  for  loans  for  period  longer than 5 years in the PRC is 4.9%. Based on the Sample Aircraft Finance Leases, we also noted that the leases entered into between the Group and independent third parties were all with reference to the PBOC official rate. We are therefore of the view  that  it  is common reference interest rate for  aircraft  finance  leases  to  be  determined with reference to the PBOC official rate;

 

(3)        based on the Sample Aircraft Finance Leases obtained we understand the one-off arrangement fees quoted by independent third-party lessors were based on a percentage ranging from nil to 0.5%. As such we are of the view it is not uncommon for arrangement fees to be included in aircraft finance lease agreements and it is reasonable for the Company to include the arrangement fee of 0.5% in its computation process for Aircraft Finance Leases PV; and

 

(4)        we have reviewed the projected number of aircraft to be added to the Group's aircraft fleet. We have reviewed the Company's 2016 Annual Report, 2017 Annual Report and 2018 Annual Report and noted that the Group introduced 54, 56 and 50 aircrafts respectively for 2016, 2017 and 2018. Of the number of new aircrafts introduced, 9, 23, 34 were acquired under finance leases for 2016, 2017 and 2018 respectively. Based on the Company's 2019 Interim Report, the Group expects to introduce 55, 93,  and  42 aircrafts to its fleet for years 2019 to 2021 respectively and with  reference  to  the published number of aircraft operated by the Group as disclosed in the Company's 2018 Annual Report and our discussion with the Management, the Group's total aircraft fleet for 2019 to 2021 would be estimated to reach approximately 709, 799, and 840 aircrafts respectively, representing an average compound annual growth rate of approximately 8.85%. We understand from the Management that the growth rate of aircrafts acquired under finance leases are expected to continue into 2022. Based on such projection and our review, we consider this assumption to also be prudent.

 

We also understand that the Management has also included a buffer in its estimated amounts for Aircraft Finance Leases PV to account for possible fluctuations in  foreign  exchange  rate  and possible changes in business needs. Based on our understanding,  as  the  leases  are normally denominated in the USD, we consider the  buffer  which  provides  flexibility  for  accommodating, among others, any possible fluctuations in foreign exchange rate, to be prudent.

In this respect, and considering the above, we are of the view that such estimates for calculating the Aircraft Finance Leases PV for 2020, 2021  and  2022,  which  accounts  for approximately 95% of the respective total  annual  cap  for  the  finance  lease  and  operating  lease, is fair  and reasonable.

 

We have discussed and understand  from  the  Management  that  anticipated  financing required for Aviation Equipment using operating leases for 2020 to 2022 were mainly estimated by reference to the expected purchase schedules of engines and related aviation equipment  and  their  respective market prices. We understand the market prices referred to is based on the Company's  previous purchases of similar engines and aviation equipment  and  with  independent  third  parties,  and  the length of similar operating leases entered into by the Group.

 

In assessing the fairness and reasonableness of the above, we have obtained and reviewed the Company's expected acquisition of Aviation Equipment by way of operating lease arrangements with the CNACG Group for the three years ending 31 December 2022 and the historical operating lease record involving Aviation Equipment between 2017-2019. Based on our review, we note the Group expects to finance, on average, with acquisition of 16 engines and other related aviation equipment on an annual basis between 2020 and 2022 and we note such an anticipated plan represents only approximately 19.5% of the average total acquisition  of  Aviation  Equipment  by  way  of  operating lease between 2017 and 2019. As such, we would consider the bases used for the aforesaid purchase plan for the three years ended 2022 to be prudent and in addition,  we  consider  the  possibility  of entering into of Aviation Equipment operating leases under the New CNACG Framework Agreement between the Company and CNACG Group simply represents an additional financing option for the Group to acquiring Aviation Equipment. From the information provided, the finance lease and operating lease period for engines ranges between 5 to 12 years and for other aviation equipment, the average  lease  period  is  around  6 years.

 

Similar to that of Aircraft Finance Leases PV, we were advised  by  the  Management  that pursuant to IFRS 16, Aviation Equipment will be recognised as right-of-use assets and such right-of- use asset value (the "Aviation Equipment Leases PV"), being the estimated total rental fee for the Aviation Equipment to be purchased from CNACG Group after discounted by the Company's internal incremental borrowing rate, is used to determine the total annual cap for  the  operating  leases  of Aviation Equipment to be entered with CNACG Group.  We  noted  that  China  Eastern  has  also adopted a similar approach to determining its annual cap for operating leases in its circular dated 30 September 2019. As advised by the Management, the prescribed internal incremental borrowing rate referred to for leases with a term longer than five years is 4.9%, and 4.75% for leases with a term of 5 years or below. Similar to the aforementioned with Aircraft Finance Lease PV, we have reviewed the Group's 2019 Interim Report and noted that the interest rate for the Group's interest-bearing bank and other loans repayable ranged from 1.95% to 5.02% (median interest rate being 3.49%) and range of interest rates for corporate bonds repayable is from 2.84% to 5.30% (median interest rate being 4.07%). Given the range and the median of interest rates applicable to the Group's interest-bearing bank loans and other borrowings, and the fact that the use of the internal rate, being 4.9% for leases with a term of more than five years and 4.75% for leases with  a  term  of  five  years  or  below, is towards the higher end of  the aforementioned  quoted  ranges, we  would consider  the  Company's  use of internal rate of 4.9% and 4.75% to be prudent.

 

Based on the discussion above, we consider the estimation for the Aviation Equipment Leases PV for years 2020, 2021 and 2022, which accounts for  approximately  5%  of  the  respective  total annual cap for the finance lease and operating lease, is fair and reasonable as far as the Company and Independent  Shareholders  are  concerned.

 

CNACG  Ground Services

 

As disclosed in the letter from the Board of the Circular,  the  annual  caps  relating  to  the CNACG Ground Services for the three years ending 31 December 2022 are: (i) increase in the need for relevant services by an expected annual rate of 9% throughout 2020 and 2022; (ii) increase in unit price for relevant services provided by CNACG Group by an  annual  rate  of  approximately  7% between 2020 and 2022; and (iii) a reasonable cushion to cater for the Group's operating need from time  to time.

 

The 2020 annual cap of RMB600 million for CNACG Ground Services payable by the Group to CNACG Group was mainly estimated by reference to historical increases in ground support and other  services  provided  by  CNACG Group.

 

In assessing the fairness and reasonableness of the annual caps, we have  carried  out  the following  independent  work  and  considered  the  following factors:

 

(1)        Based on our discussion with the Management, we understand the demand for ground support and other services is directly linked with the size of the Group's aircraft fleet. With reference to the 2018 Annual Report and our  discussion  with  the  Management, given the published number of total aircraft operated by the Group as for year ended 2018, the total aircraft fleet to be operated by the Group, based  on  its  estimations disclosed in the 2019 Interim Report would be approximately 709, 799, and 840 respectively for 2019 to 2021, representing an average compound annual growth rate of approximately 8.85%. Based on our understanding  from  the  Management,  this growth rate is expected to continue into 2022; and

 

(2)        We have discussed and understood from the Management the key factors for increase in unit price for ground support and other services would be the growth in the cost of providing such a service. With reference to the statistics  published  by  the  National Bureau of Statistics of China, the indices of gross domestic product increased by approximately 6.6% between 2017 and 2018 and by approximately 6.8% between 2016 and 2017. As such, an increase in unit price of 7% is considered to be in line.

 

In light of the above, we would be of the view with the Company that the estimation of the respective annual caps for CNACG Ground Services is fair and reasonable.

 

4.         Internal control procedures

 

As disclosed in the letter from the Board of the Circular, the Company has adopted a set of effective internal control measures to supervise the continuing connected transactions of the Group:

 

•           Before entering into individual ACC Transactions and CNACG Transactions, the finance department, the legal department, the asset management department (which has a dedicated sub-division responsible for management of connected transactions) and if applicable, certain other relevant departments of the Company review the proposed terms for the individual ACC Transactions and CNACG Transactions and discuss with the relevant business department of the Group to ensure that such transactions are conducted on normal commercial terms and in compliance with the pricing policy of the Group before these relevant departments approve the finalised transaction agreements according to their authority within the Group;

 

•           The asset management department of the Company is responsible for overseeing the connected transactions of the Company. The asset management department will  monitor  and  collect detailed information on the ACC Transactions and CNACG Transactions on a regular basis, including but not limited to the implementation of pricing policies, payment arrangements and actual transaction amount of each finance lease transaction, operating lease  transaction  and ground support services and other services to ensure that the transactions are conducted in accordance with the New ACC Framework Agreement and New  CNACG  Framework Agreement. In addition, the asset management department will be responsible for monitoring and reviewing the balance amount of the annual cap for the ACC Transactions and CNACG Transactions on a monthly basis and if the annual cap for the ACC Transactions and/or the CNACG Transactions is expected to be exceeded for a particular year, it will report to the management and take appropriate measures in accordance with the  relevant  requirements  in Hong Kong Listing Rules and/or Shanghai Listing Rules;

 

•           The Company's internal audit department is responsible for performing the annual assessment on the internal control procedures of the Group, including but not limited to the relevant information on the management of the continuing connected  transactions.  In  addition,  the internal audit department is responsible for compiling the annual internal  control assessment report and submitting the report to the Board for examination and approval;

 

•           The senior management of the Company is responsible for supervising and monitoring the adoption of internal control procedures by the above-mentioned business departments, so as to ensure the implementation pricing policies is  in  compliance  with  relevant  framework agreement and actual transaction amounts are controlled within annual caps. The senior management of the Company also reviews the implementation of pricing policies and the monitoring of annual caps annually; and

 

•           The independent auditor of the Company and the independent non-executive Directors will conduct an annual review on the continuing connected transactions of the Group.

 

We consider the requirement to obtain of at least two independent quotes (where  applicable)  is reasonable for the Company to assess the then prevailing market terms of finance and operating leases and/ or ground services and/or other relevant services offered by independent third parties. As such, we are of the view with the Directors that the internal control  procedures and  policies  relating to  the  ACC  Transactions and CNACG Transactions have demonstrated the Group's practices of getting access to market information and having regular assessment on the terms of the ACC Transactions and CNACG Transactions so as to make sure that its  terms will  be no  less favourable  (so  far as  the Group  is  concerned) than  those prevailing in  the  market  for  similar transactions.

 

5.         Hong Kong Listing Rules Requirements

 

Pursuant to Rule 14A.55 of the Hong Kong Listing Rules, the independent non-executive Directors will confirm in the annual report of the Company that the Group's continuing connected transactions have been entered into (1) in the ordinary and usual course of business of the Company; (2) on normal commercial terms or on terms no less favourable to the Group than terms available from independent third parties; (3) in accordance with the relevant agreement; and (4) on terms that are fair and reasonable and in the interests of the Shareholders as a whole.

 

The auditors of the Company will also perform a review of the Group's continuing connected transactions and will confirm in the annual report of the Company that such continuing connected transactions were conducted in the manner stated in Rule 14A.56 of the Hong Kong Listing Rules.

 

For each financial year of the Company during the terms of the New ACC Framework Agreement and New CNACG Framework Agreement, the subject implementation transactions under  the  New  ACC Framework Agreement and the New CNACG Framework Agreement will be subject to review by the independent non-executive Directors and the Company's auditors as required by the provisions of the Rules 14A.55 and 14A.56 of the Hong Kong Listing Rules respectively. The independent non-executive Directors must confirm in the annual report of the Company for the years  2020-2022  such  transactions  have been entered  into:

 

(1)       in the ordinary and usual course of business of the Company;

 

(2)       either on normal commercial terms or, if there are  not  sufficient  comparable  transactions to judge whether they are on normal commercial terms, on terms no less  favourable  to  the Company than terms available to or from (as appropriate) independent third parties; and

 

(3)       in accordance with the relevant agreements governing them on  terms  that  are  fair  and reasonable and in the interests of the Company and the Shareholders.

 

Furthermore, the Hong Kong Listing Rules require that the Company's auditors must provide a letter to the Board (with a copy provided to the Hong Kong Stock Exchange at least ten business days prior to the bulk printing of the annual report of the Company), confirming that the Transactions:

 

(1)       have received the approval of the Board;

 

(2)       are in accordance with the pricing policies of the Company if the transactions involve provision of goods or services by the Company have been entered into in accordance with the relevant agreement governing the transactions; and

 

(3)       have not exceeded the cap disclosed in its previous announcement.

 

Given the above, we believe there will be sufficient procedures and arrangements in place to ensure that the Transactions will be conducted on terms that  are  fair  and  reasonable  and  on  normal commercial terms  as  far  as  the  Independent  Shareholders  are concerned.

 

OPINION  AND  RECOMMENDATION

 

Having considered the principal factors and reasons set out above, we are of the view that that the terms of the New ACC Framework Agreement and the New CNACG Framework Agreement (including the respective annual caps) are on normal commercial terms and in the ordinary and usual course of business of the Group and are fair and reasonable so far as the Company and the Independent Shareholders are concerned. We also consider that the entering into of New  ACC  Framework  Agreement  and  the  New CNACG Framework Agreement is in the interests of the Company and the Shareholders as a whole. Accordingly, we advise the Independent Shareholders, and the Independent Board Committee to recommend the Independent Shareholders, to vote in favour of the ordinary resolutions to be proposed at the EGM to approve the New ACC Framework Agreement and the New  CNACG  Framework  Agreement,  and  the adoption  of  the  respective  annual caps.

 

Ms. Lyan Tam is a licensed person registered with the Securities and Futures Commission and as a responsible officer of Somerley to carry out Type  6  (advising  on  corporate  finance)  regulated  activities under the SFO and has over 17 years of experience in corporate finance industry.

 

1.         RESPONSIBILITY STATEMENT

 

This circular, for which the Directors collectively and individually accept full responsibility, includes particulars given in compliance with the Hong  Kong  Listing  Rules  for  the  purpose  of  giving information with regard to the Group. The Directors, having made all reasonable enquiries, confirm that to the best of their knowledge and belief the information contained in this circular is accurate and complete in all material respects and not misleading or deceptive, and there are no other matters the omission of which would make any  statement  herein  or  this  circular misleading.

 

2.         DISCLOSURE OF INTERESTS OF DIRECTORS AND SUPERVISORS

 

As at the Latest Practicable Date, none of the Directors, Supervisors  or  chief  executive  of  the Company had interests or short positions in the shares, underlying shares and/or debentures (as the case may be) of the Company or its associated corporations (within the meaning of Part XV of the SFO) which were notifiable to the Company and the Hong Kong Stock Exchange pursuant to the SFO, or were recorded in the register maintained by the Company pursuant to section 352 of the SFO, or which were notifiable to the Company and the Hong Kong Stock Exchange pursuant to the Model Code for Securities Transactions by Directors  of  Listed Companies.

 

As at the Latest Practicable Date, none of the Directors or Supervisors  has  any  direct  or  indirect interest in any assets which have been, since 31 December 2018 (the  date  to  which  the  latest published audited financial statements of the Group were made up), acquired or  disposed  of  by  or  leased  to  any member of the Group or are proposed to be acquired or disposed of by or leased to any member of the Group.

 

None of the Directors or Supervisors of the Company is materially interested in any contract or arrangement subsisting at the Latest Practicable Date and which is significant in relation to the business of the Group.

 

Mr. John Robert Slosar is a non-executive Director of the Company and is concurrently the chairman and an executive director of Cathay Pacific. Cathay Pacific is a substantial  shareholder  of  the Company, holding 2,633,725,455 H shares in the Company as at  the  Latest  Practicable  Date,  and  it  wholly  owns Cathay Dragon. Mr. Cai Jianjiang, who is the chairman and a non-executive Director of the Company, and Mr. Song Zhiyong, who is an executive Director of the Company, are concurrently non-executive directors of Cathay Pacific. Cathay Pacific and Cathay Dragon compete or are likely to compete either  directly or indirectly with the Company in some aspects of the business of the Company as they operate airline services to certain destinations, which are also served by the Company.

 

Save as mentioned above, as at the Latest Practicable Date, none of the Directors or Supervisors and their respective close associates (as defined in the Hong Kong Listing Rules) has any competing interests which would be required to be disclosed under Rule 8.10 of the Hong Kong Listing Rules as if each of them was  a  controlling  shareholder  of  the Company.

 

3.         SERVICE CONTRACTS

 

As at the Latest Practicable Date, none of the Directors or Supervisors has any existing or proposed service contract with any member of the Group which is not expiring or terminable by the Group within one year  without  payment  of  compensation  (other  than  statutory compensation).

 

4.         DIRECTORS' AND SUPERVISORS' EMPLOYMENT WITH SUBSTANTIAL SHAREHOLDERS

 

The followings are the particulars of Directors' and Supervisors' employment with substantial Shareholders  as  at  the  Latest  Practicable Date:

 

Directors

 

Mr. Cai Jianjiang, a non-executive Director and the chairman of the Board of the Company, served as the chairman of the board of directors and a member and secretary of the communist party group of CNAHC. He  is also  a  non-executive  director and  deputy chairman of the  board of  directors of  Cathay Pacific.

 

Mr. Song Zhiyong, the executive Director, the vice chairman of the Board and the president of the Company, served as director, the general manager, and a member and the deputy secretary of the communist party group of CNAHC. He is also a non-executive director of Cathay Pacific.

 

Mr. Cao Jianxiong, a non-executive Director of the Company, served  as  a  director  and  a member and the deputy secretary of the communist party group of CNAHC.

 

Mr. Xue Yasong, the employee representative Director of the Company, served as the employee representative director and the President of the Labour Union of CNAHC.

 

Mr. John Robert Slosar, a non-executive Director of the Company, served as  an  executive director and the chairman of the board of directors of Cathay Pacific.

 

Supervisors

 

Mr. He Chaofan, the supervisor of the Company, serves as the president of CNACG.

 

5.         NO MATERIAL ADVERSE CHANGE

 

The Directors confirm that as at the Latest Practicable  Date,  there  has  been  no  material  adverse change in the Group's financial or trading position since 31 December 2018, being the date to which the latest  published  audited  financial  statements of  the  Group  have  been  made up.

 

6.         EXPERT

 

The following is the qualifications of the expert who has given its opinions or advices, which are contained  in  this circular:

 

Name	Qualification
Somerley  Capital  Limited	a corporation licensed to carry out Type 1 (dealing in securities) and Type 6 (advising on corporate finance) regulated  activities  under  the SFO

 

a.         As at the Latest Practicable Date, Somerley did not have any direct or indirect interest in any assets which have been acquired or disposed of by or leased to any member of the Group, or are proposed to be acquired or disposed of by or leased to any member of the Group since 31 December 2018 (the date to which the latest  published  audited  financial  statements  of  the Group were made up);

 

b.         As at the Latest Practicable Date, Somerley was not beneficially interested in the share capital of any member of the Group and had no right, whether legally enforceable or not, to subscribe for or to nominate persons to subscribe for securities in any member of the Group; and

 

c.         Somerley has given and has not withdrawn its written consent to the issue of this circular with inclusion of its opinion and the reference to its name included herein in the form and context in which it appears.

 

7.         MISCELLANEOUS

 

a.         The joint company secretaries of the Company are Mr. Zhou Feng and Ms. Tam Shuit Mui. Ms. Tam is an associate member of the Hong Kong Institute of Certified Public Accountants (HKICPA).

 

b.         The registered address of the Company is at Blue Sky Mansion, 28 Tianzhu Road, Airport Industrial Zone, Shunyi District, Beijing, the PRC. The head office of the Company is at No. 30, Tianzhu Road, Airport Industrial Zone, Shunyi District, Beijing, the PRC.

 

c.         The H share registrar and transfer office of  the  Company  is  Computershare  Hong  Kong Investor Services Limited, Shops 1712-1716, 17th Floor, Hopewell Centre, 183 Queen's Road East, Wanchai, Hong Kong.

 

8.         DOCUMENTS AVAILABLE FOR INSPECTION

 

Copies of the following documents are available for inspection at the principal place of business of the Company in Hong Kong at 5th Floor, CNAC House, 12  Tung  Fai  Road,  Hong  Kong  International Airport, Hong Kong during normal business hours on any business day from the date of this circular until 18 November  2019:

 

a.         New ACC Framework Agreement;

 

b.         New CNACG Framework Agreement;

 

c.         the letter from the Independent Board Committee to the Independent Shareholders, the text of which is set out on pages 26 to 27 of this circular;

 

d.         the letter from Somerley to the Independent Board Committee and  the  Independent Shareholders, the text of which is set out on pages 28 to 64 of this circular;

 

e.         the consent letter issued by the expert referred to in this circular; and

 

f.          this circular.