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Alibaba's spotlight on HK regulation
18th September 2013

We've resisted writing until now about the hypothetical listing plans of Alibaba Group Holding Ltd (Alibaba), which has yet to publish any concrete proposals and has largely been conducting its campaign for special treatment by means of off-the-record briefings, leaked e-mails and lobbying, but it is worth looking at the broader context.

Alibaba reportedly initially asked for an A/B or two-tier share structure, in which management would hold first-class shares with more votes per dollar of equity than second-class shareholders. They were reportedly told, either by the Stock Exchange or Securities and Futures Commission (SFC) or both, that this was unacceptable. Next, they suggested that management would have some kind of rights baked into Memorandum and Articles of association (M&A) which would give a self-selecting group of past and present management known as the "partners" the right to nominate a majority of the directors, in effect giving them a veto on any change of control.

The history of A/B Shares in HK

This is not the first time that the issue of dual-class shares has come up in HK. On 27-Mar-1987, Jardine Matheson Holdings Ltd proposed a bonus issue of 4 "B" shares for every existing ordinary share (which would be redesignated as "A" shares). This was followed 4 days later by proposals from Cheung Kong (Holdings) Ltd (0001) and Hutchison Whampoa Ltd (0013), both controlled by Li Ka-shing, each proposing a bonus issue of one "B" share for every two ordinary shares.

What such an issue would do is of course allow existing controlling shareholders to dilute their economic interest without diluting their control, or to increase their voting control without investing more money, by selling their low-voting shares and buying the high-voting shares instead. For example, if 5 B-shares are economically equivalent to 1 A-share, then after a bonus issue of B-shares, you can sell an A-share with 1 vote and buy 5 B-shares with 5 votes.

Uproar ensued. If nothing was done, then with 3 of the biggest companies underway, many other hongs would likely follow suit. At that time, securities laws were regulated by the Government's Office of Commissioner for Securities (the subsequent market crash and 1-week closure in October that year eventually led to the formation of the SFC in 1989). On 7-Apr-1987, there was a joint statement from the Securities Commissioner, Ray Astin, and then Chairman of the Stock Exchange, Ronald Li Fook Shiu (later jailed for corruption), rejecting the Jardine proposal and banning any further issues of B-shares. That policy has survived 26 years until now.

There were, at the time of the ban, 5 existing companies which had already issued B-Shares, including 3 controlled by Wheelock & Co Ltd (0020). Only one remains, namely Swire Pacific Ltd (which by coincidence has the stock codes 19/87, reminding us of the year this policy was set). Lane Crawford International Ltd was privatised on 30-Jul-1999 after your editor forced a bump in the offer in one of his earlier pieces of activism. Wheelock Properties Ltd and its subsidiary Realty Development Corp Ltd both unified their A/B shares on 31-Jul-2000 and have since been privatised. Grand Hotel Holdings Ltd was privatised by Hang Lung Properties Ltd (0101) on 26-Feb-2003.

So Swire Pacific has been on its own for the last 10 years. As of 30-Jun-2013 the British family firm John Swire & Sons Ltd owns 30.78% of the low-voting A-shares and 68.49% of the higher-voting B-shares, giving it 45.80% of the equity and 59.74% of the voting rights. Economically, every 5 B-shares is equivalent to 1 A-share, but each share has 1 vote. The share of equity has been steadily increasing (5 years ago it was 36.50%), and we would expect that they will get to 50% of the equity in the next few years and then they would feel safe enough to unify the share classes while still having majority voting control. It's the right thing to do, and would put an end to A/B structures in HK.

Pyramid structures

There is another way to disconnect voting control from economic interests, and that is to build a pyramid of partly-owned subsidiaries, so that the person at the top controls the ones at the bottom with only a small economic interest. Put simply, a 3-layer pyramid with 50% at each level gives you 12.5% of the equity of the bottom companies, but outright control. Typically this is done by spinning off minority interests in subsidiaries as new listings. Later, they can be privatised again at a discount. There are plenty of examples of this structure in HK, and some groups play the market like an accordion, expanding and contracting according to the flavour of the year, whether it is an infrastructure spin-off, a REIT or a dotcom play.

But at least each company in the pyramid has to obey Listing Rules on connected transactions (with some well-exploited loopholes), have its own board, and report financial results separately. If it issues fresh equity, then it dilutes its parent unless the parent invests to maintain its stake. There is also a Takeover Code which deters minority squeeze-outs - anyone, or any group of shareholders, with 10% of the public shares can prevent compulsory purchase of their shares. Still, given a choice, most investors would rather be alongside the controller at the top of the pyramid than down at the bottom.

No, you can't pick and choose your own rules

We recognise that some markets allow dual-share structures. In the US, recent examples include Facebook and Google - the latter moving to a triple-share structure with a distribution of non-voting "C-shares" after the founders decided that even with B-shares (which have 10x the votes of the publicly-traded A-shares) they were likely to lose control.

The US also has 50 different jurisdictions with corporate laws that compete to offer management-friendly constitutions (as well as competing tax laws). That has helped facilitate anti-shareholder measures such as poison pills, golden parachutes (automatic payouts to management on a change of control), and a general difficulty in getting candidates onto the board. There is also no Takeover Code in the US, so companies get to write their own - recently we were treated to the spectacle of Dell Inc's independent directors changing the voting rules so that abstentions did not count in the privatisation by Michael Dell and his private equity partner. A simple majority of votes cast was all that it took.

As economic interests and voting interests diverge, the "agency problems" (or in layperson's terms, management playing with other people's money) tend to drag down shareholder value. Click here for a paper that looks at dual-class US companies. In the US, this is to some extent offset by a litigation and class action environment that can deter, but not eliminate, bad behaviour. Just ask shareholders of Hollinger International, the US company once controlled by now-convicted felon Conrad Black through a 2-tier voting structure. You can read the report by the Special Committee of Hollinger International here.

Hong Kong has no class action system, and consequently no real litigation deterrent from investors, who individually cannot justify the cost of action. There are also practical limitations from the fact that most companies that are listed in this offshore haven have no real presence here, and cross-border enforcement of judgments, as well as regulatory reach of the SFC and Police, is notoriously difficult. There is no extradition treaty between Hong Kong and the PRC (or Taiwan, or Macau). As a consequence, the emphasis in HK is very much on prevention rather than cure of abuse.

Companies can choose between these competing systems, as well as other market characteristics, such as the collective body of internet analysts which is undoubtedly greater in the US than HK. But what companies cannot do is pick and choose the weakest aspects of each market and cobble them together in their own constitution with special exemption from the Listing Rules. Alibaba should not get exemptions in HK any more than it could hope to get exemption from the US litigation system if it lists there.

Every management team thinks they are special, but none of them deserve special protection against a change of control. There is an element of China-think in the so-called "partnership" proposal; China is a nation with a Constitution which bakes in leadership by the Communist Party which picks its own successors. If the HK regulators make an exception for one new listing, then many future applicants will want the same thing, and many existing listed companies will complain that they should be allowed to do it too. It would be like 1987 all over again, when a potential avalanche of B-shares was only stopped by the regulator.

The discount on management lock-in

Setting aside the Conrad Blacks of this world, there is still the issue that a management lock-in prevents corrective changes being made by outside owners. This is a particular risk where a company is run by founders who have an emotional and sentimental attachment to their life's work, and can be too close to realise when outside help or a change of management is needed. While some of today's internet leaders are given almost god-like status by the media, the halo may fade and their skills and knowledge may become stale. How will their shareholders then feel as they watch the management destroy their equity? Would Steve Ballmer still be carrying on as CEO of Microsoft if he had 51% of the voting rights but only 5% of the equity? News of his pending retirement sent the stock shooting up.

If you doubt that structures which separate votes from ownership, or entrench management, create a discount, then just conduct the following thought experiment. Imagine there are two companies preparing for listing (X and Y), identical in every way, with management owning 20% of the equity, but:

  • In Company X, the incumbent management and their chosen successors have a veto over future changes in control, either through super-voting shares or through constitutional rights. They also have the ability to issue fresh equity while maintaining that control.
  • In Company Y, there are no such privileges, and all the outside shareholders, with 80% of the votes between them, can change the management if and when they deem it necessary to do so. Any issue of fresh equity dilutes all shareholders and all voting rights equally.

Which company would you rather own in the IPO? How much of a discount would you expect if there was no prospect of ever being able to change the management without their consent?

HKEx's conflict of interest

The reported efforts of Hong Kong Exchanges and Clearing Ltd (HKEx, 0388) to find a convoluted way around its own Listing Rules, for the sake of a massive piece of business from a potential client, provide a useful reminder of the conflict of interests between profit and regulation. This is why it should not be having these conversations in the first place, because it should not be the "front-end" regulator of listed companies. Hong Kong last held this debate 10 years ago, a year after the Exchange shot itself in the foot over the Penny Stocks Incident. The Government appointed an Expert Group, led by the former Chairman of the Australian regulator, to review the regulatory structure, and the Expert Group issued a report on 21-Mar-2003 recommending moving the Listing function to a new Listing Authority within the SFC, scrapping the "dual filing" system and giving the Listing Rules statutory backing.

The Financial Secretary at the time, Antony Leung Kam Chung, accepted the recommendations and committed to take them forward. What followed was a rearguard campaign led by then HKEx Chairman Charles Lee Yeh Kwong, a lawyer close to the local tycoons, to stop the reform in its tracks. Three weeks later, on 10-Apr-2003, the Financial Secretary did a U-turn and announced a public consultation on the report, which itself had been produced after widespread consultation.

The second consultation, dubbed "Proposals to Enhance the Regulation of Listing" or PERL, was concluded on 26-Mar-2004, and the watered-down proposal was that HKEx would remain as the front-line regulator, but Listing Rules on 3 areas would move under the SFC. In the end, after another 9 years of arguing, diluting and foot-dragging, only 1 of those rules made it into statute, the requirement to disclose price-sensitive Inside Information, which came into effect on 1-Jan-2013, and even then, non-compliance is a civil but not criminal offence, unlike insider dealing, which became a criminal offence in 2003.

Recommendations

This ongoing conflict of interests for HKEx is not in the interests of HK or investors at large. A decade after the Government first accepted and then rejected the Expert Group's recommendations, it should now take the opportunity of the Alibaba episode to put the issue of Listed company regulation back on the agenda. The Stock Exchange's Listing Division should be merged into the SFC's Corporate Finance Division to create a new "Listings and Takeovers Authority" with statutory backing for both the Listing Rules and the Takeover Code, and an advisory body should be put in place to advise the SFC on changes to both, in effect merging the Listing Committee and the Takeover Panel to form a holistic approach. This "Listings and Takeovers Panel" should not be tasked with vetting IPO prospectuses on Thursday afternoons - that should be the job of full time regulators, aided by comments submitted from the market on publicly-filed draft prospectuses.

HKEx's own board structure

The greatest irony of all in Alibaba's proposal is that HKEx itself has a constitution which cements control of the company, not by management, but by the Government. Under the M&A and the Securities and Futures Ordinance, the CEO of HKEx is automatically ("ex officio") a director, not subject to shareholder elections, and 6 other directors are appointed by the Financial Secretary. The Chairman has to be approved by the Chief Executive of HK. Only 6 out of the 13 directors can be elected by shareholders, even though the Government only owns about 6% of the company. The CEO of HKEx is also an ex officio member of the Listing Committee which makes the Listing Rules and approves main-board IPO prospectuses.

And why was this Government control deemed necessary? Purportedly it was because HKEx is also a regulator of listed companies, and so these "public interest" directors were needed to stop the company putting short-term profits ahead of the public interest. So if the Listing function were moved to the SFC, then this would remove the main excuse for this structure, particularly if the statutory monopoly on running a stock market is abolished. Everything else could be dealt with by prudential regulation rather than Government involvement in management.

There is only one other HK-listed company with special rights in its M&A - and again, it is HK Government-controlled. It is train operator and property developer MTR Corporation Ltd (0066), where the Chief Executive of HK can appoint up to 3 directors. In practice though, since the Government has a majority shareholding, it elects all the directors, including the so-called independent directors. And guess what - the former CEO of the MTRC, Chow Chung Kong, is now Chairman of HKEx so he has moved between the only 2 HK-Government-controlled listed companies. Needless to say, he is also an Executive Councillor (an outside member of HK's cabinet), as all 3 Chairmen of HKEx have been.

Note: Webb-site founder David Webb is a former elected INED of HKEx (2003-2008) and is a Deputy Chairman of the Takeover Panel since 2013 and a member of it since 2001.

Webb-site.com, 2013


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