HKCB Sale

By popular demand, we comment on the sale by HKCB Bank Holdings of Hongkong Chinese Bank to CITIC Ka Wah Bank, and the accompanying increase in the holding of Lippo China Resources in HKCBH, which many investors were surprised did not trigger a general offer. We also take a look at the chequered past of the two banks, which were surely made for each other, and what we know about an ICAC investigation involving a former Alternate CEO of CKW.

What did you expect?
4th November 2001

For months now, The Hongkong Chinese Bank, Limited (the Bank) has been up for sale. It is wholly-owned by The HKCB Bank Holding Co Ltd (HKCBH) which is listed on the SEHK.

The references to discussions with the eventual purchaser, CITIC Ka Wah Bank Ltd (CKW) go back at least as far as 17-Apr-01 when HKCBH described media reports as "not accurate" (note, that does not mean they were baseless) and that there was nothing yet to disclose. From a low of $2.025 on 5-Apr-01, the shares climbed to $3.85 on 20-Apr-01

The first confirmation of serious discussions came on 12-Sep-01 when HKCBH stated:

From this point on, the market should have been on notice that the likely shape of the deal was that HKCBH would sell the Bank, but not that HKCBH itself would be sold. Hence the deal was not likely to trigger an offer for HKCBH.

When the deal was finally announced on Friday, that's exactly what happened, with the Bank (and a portfolio of mortgage loans held by a fellow subsidiary) being sold to CKW by HKCBH for HK$4,200m (US$538m), of which 80% will be cash and 20% in Certificates of Deposit. The deal represents about 1.42 times the Bank's adjusted book value at 31-Mar-01.

This leaves HKCBH with a huge pile of cash as well as a relatively small financial services business. It will pay "not less than $1 per share" as a special cash dividend after the sale. At $1 per share, that works out at $1,352m.

Shareholder approval

The immediate parent of HKCBH is a company called Lippo CRE (Financial Services) Ltd (LCRE), a private Cayman Islands company which owns 58.78% of HKCBH. Hence it was able to give written approval of the sale, and no shareholders' meeting of HKCBH is needed.

How we got here

To understand the rest of this deal, you need first to understand the current ownership structure.

Wind the clock back to the colonial era, and you will find a deal on 18-Jun-97, in which HK-listed China Resources Enterprise, Ltd (CRE) acquired 50% of the Bank from its parent, China Resources (Holdings) Co Ltd, which is ultimately owned by the PRC Government, for $2bn, of which $1,270m was in cash and the balance in new shares at $25.80 per CRE share. Ah yes, those were the days of red-chip mania - the shares closed the previous day at $27.70 and on Friday (2-Nov-01) they closed at $7.85, down 72% in a little over 4 years.

On the same day as CRE bought half the Bank, it turned around and agreed to sell it to HKCBH in return for 444,444,444 new shares in HKCBH at $4.50 each, totalling the same price of $2bn. That's how HKCBH ended up with 100% of the Bank.

The other half of the Bank was already owned by HKCBH and prior to the restructuring, HK-listed Lippo Ltd (Lippo) held 349,983,996 shares (54.1%) of HKCBH. Simultaneously, Lippo transferred this interest to another listed subsidiary, which was renamed Lippo China Resources Ltd (LCR). Lippo is controlled by the Riady family of Indonesia, who have a listed group there of the same name.

LCR and CRE agreed to pool their total of 794,428,440 HKCBH shares (74.42%) into a joint venture, LCRE, which was 50% owned by each of them. As CRE put in more shares than Lippo, in order to balance the amounts, Lippo also paid CRE a cash amount in respect of half the difference, that is $212,536,000, or $4.50 per share.

The two shareholders of LCRE signed a shareholders agreement which gave LCR and CRE equal representation in the board room, but crucially, LCR had the right to appoint the chairman who would have a casting vote. That casting vote means that LCRE was and is a subsidiary of LCR. Since LCR is a subsidiary of Lippo, that meant there was no change in the control of HKCBH and the Bank, both of which remained subsidiaries of Lippo before and after the 1997 restructuring.

Incidentally, you may yet be hearing more about that deal, because according to press reports in Feb-01, a well-known local broker and 2 others had been accused of insider dealing in the shares of HKCBH and LCR in the run up to the deal, and the Insider Dealing Tribunal was due to hear the case. Believe it or not, the IDT still does not have a web site - so much for transparent dealing.

The restructuring was completed on 2-Sep-97, and on 18-Sep-97 HKCBH placed 150m new shares at $10.925 per share through W.I. Carr Indosuez, raising a net $1,591m, just before the HK market crashed.

The aborted deal

The destiny of HKCBH has been uncertain for literally years. At one time, it looked like going in the opposite direction. Back on 23-Jun-98, LCR said it was in "serious discussions with potential purchasers" of its entire 50% stake in LCRE, and the next day admitted that one of these potential purchasers was CRE. A conditional deal was announced on 2-Jul-98, in which CRE would buy the 50% stake from LCR at a price equivalent to $2.97 per HKCBH share (a 7% premium to market), triggering a general offer, since LCRE would become a subsidiary of CRE, giving it outright control of HKCBH.

That deal was conditional on, amongst other things, regulatory consents from the banking supervisors, the Hong Kong Monetary Authority and People's Bank of China, to be received by 30-Sep-98. The approvals were not forthcoming, and the deal lapsed. It has never been revealed exactly why this was the case, or how hard CRE tried to get approvals, given that the market was deteriorating in the meantime. We leave you to speculate on what Joseph Yam thought about the prospect of his HKMA regulating a red-chip bank.

Later, on 19-Mar-99, the Bank became the first in many years to declare a loss, with HKCBH reporting a loss of $646m and a massive increase in non-performing loans. That was quite an achievement in a cosy cartel market where a banking license was like an ATM card on the economy.

Unwinding the joint venture

Now jump forward to the present day. At the same time as selling off the Bank, the two partners have decided to unwind their joint venture, and LCR announced it will buy 50% of LCRE from CRE (which CRE announced it would sell), for $1,509,414,036, representing $3.80 for each of the 794,428,440 HKCBH shares (58.78%) held by LCRE, although of course the announcement doesn't actually spell out that price! CRE had previously announced on 30-May-01 that the sale of its interest in HKCBH was part of its plans, so it should come as no surprise.

CRE also sold LCR a direct holding of 78.890,000 shares (5.84%) of HKCBH at the same price per share, raising the total cost to LCR to $1,809m. The dividend that LCR would receive, based on $1 per HKCBH share, is only $873m, so the difference will have to come from their own balance sheet unless they increase the dividend payout from HKCBH. To break even, the dividend would have to be $2.07 per share, but don't hold your breath hoping for a higher dividend, because at 30-Jun-01, LCR had a cash pile of $824m as well as substantial short-term investment holdings, so it can easily afford this.

That purchase price of $3.80 per HKCBH share, negotiated at arms length, was well above the market price. When trading resumed after the announcements, the market price dived 31.5% from $3.175 to $2.175. Investors clearly were disappointed by the deal.

Webb-site.com was then inundated with media calls asking about the implications under the takeover code, and whether other HKCBH shareholders were getting a raw deal.

Opinion

The takeover code has always been about acquiring or consolidating control - in current terms, that means becoming interested in 30% or more of the voting rights, or increasing by more than 2% in any 12-month period, when your initial holding is between 30% and 50%. If you have held 50% or more for more than a year, then you can more or less buy whatever you like, so long as you abide by the free float requirement.

LCRE has held more than 50% of HKCBH since it was established, and has always been a subsidiary of LCR and Lippo, because of the casting vote in LCRE. The accounts of LCR and Lippo always recorded LCRE and the Bank as a subsidiary. Before the 1997 restructuring, the Bank was simply a more direct subsidiary of Lippo.

The simple fact is, although you may not like the long pyramid of control, HKCBH was already majority controlled by Lippo and will remain that way after the current deal. There are many such "pyramid" structures in Asia, where an ultimate controlling shareholder has a very small economic interest in assets at the base of the pyramid.

LCR's economic interest in HKCBH will increase from 29.39% to 64.62%, but its voting interest only changes from 58.78% to 64.62%. That means that minority shareholders of HKCBH have not seen any change in control. So no takeover offer is triggered.

The $4,200m proceeds of the sale of the Bank represent $3.108 per share of HKCBH, of which $2.486 is in cash. They could certainly afford to pay a bigger dividend than $1 per share. In general, we've never liked listed companies hanging on to more cash than they need for their current trading requirements. It is simply an inefficient allocation of capital. If there's no clear plan, then they should return it to shareholders and let them do the investing.

Why the discount?

The reason why the minority shares of so many HK-listed companies trade at such a steep discount to their underlying asset value, is the poor corporate governance framework of Hong Kong. Investors have no idea what a cash-rich company will do with the money, and so they discount the stock for the risk that the money may be frittered away. They cannot be sure, as a matter of right, that they will be treated fairly.

If a majority-owned company buys assets from related parties, then at least that will be subject to independent shareholders' approval, but if it buys assets from "independent third parties", then public shareholders will have no input. Too many companies never reveal the identity of beneficial owners behind "independent third party" companies, so again investors cannot be sure that there isn't a secret connected transaction in progress. If we had truly independent directors in Hong Kong's board rooms, elected only by minority shareholders, then it would increase the scrutiny of such transactions. Alas, that day has not yet come.

Another way for a major shareholder to extract cash is to dramatically increase salaries or bonuses to directors, which despite being transactions with a related party, are not subject to shareholders' approval.

We are not suggesting that HKCBH will do any of this, but the risk is always there, to a lesser or greater degree, with any HK-listed company. Only better governance rules and laws, and the ability to enforce them through a system such as HAMS, would reduce the discounts of controlled companies.

Peaches and Cream

And did they get a good price for the Bank? Well we're not talking about HSBC here. The Bank has been a poor performer and any price above book value must be looked at as some sort of victory. It's hard to avoid the thought that these two banks were made for each other - both have a chequered past riddled with "problem loans", having been hit hard by the financial crisis. Out of CKW's loan portfolio of about $20bn at 31-Dec-97, $6.9bn, or some 35%, "gradually became problematic" as the bank put it.

The former Honorary Chairman of CKW and Vice-Chairman of CITIC, Mr Jin Deqin, resigned from CKW on 12-Apr-98 "due to advance age" and was detained by mainland authorities 2 weeks later and subsequently convicted of embezzlement by a PRC court. Xinhua, the mainland mouthpiece, reported that he "used his official post to embezzle tens of millions of yuan in an abominable crime and grave plot". In Jun-00, at the age of 79, he was sentenced to life (or what's left of it) in jail. The full specifics of the case were never revealed, and there was never any suggestion of a connection between the alleged embezzlement and CKW.

At the end of 1997, CKW's management team "comprised entirely of mainland bankers" but it has since been through a string of management changes in an effort to import professional skills from the HK market.

Case in progress

In a curious development, a young former Director and Alternate Chief Executive of CKW, Zhang Mingqian (Mr Zhang), apparently committed suicide on 2-Sep-01 by jumping from his 29th-floor flat. A spokesperson for the ICAC confirmed to the SCMP that Mr Zhang had been arrested in May-01 in connection with a corruption and fraud investigation. The spokesperson refused to disclose whether the case involved CKW, but said the case had been referred to the ICAC by the HK Monetary Authority. On 4-Sep-01 the SCMP reported that two other people, including another of the bank's employees, had been arrested.

The timing of Mr Zhang's arrest closely coincides with his rotational retirement from the board of CKW at the AGM on 3-May-01, in which it was stated that "due to job re-arrangement, [he] was not re-elected" which contrasts with the statement in the directors' report dated 12-Feb-01 that he would stand for re-election (as most directors do every 3 years). In between those dates, something must have changed.

Two of the HK professionals previously brought in to the group were promoted to director the day after the AGM, and this was followed by a change of Chief Executive on 6-Jul-01 "due to internal job-rearrangement in CITIC". Ah, that old job re-arrangement thing again. At the same time, the two professionals became Alternate CEOs as well. This was followed 6 days later by the appointment of parent CITIC's Chief Accountant to the board of CKW, which should help the reporting lines to Beijing.

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What did you expect? 4th November 2001