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The Beijing Siphon
12th May 1999

On 13-Jul-98 Beijing Enterprises Holdings (BEH) announced that it was paying RMB1,500m (about HK$1,401m) to Beijing Municipal Water Company (BMWC), apparently   for a concession "to operate water purification business", for 20 years, at Phase 1 of the No. 9 Water Treatment Plant, which is owned by BMWC.

In fact, BEH won't be doing any operating, because it has contracted all these duties back to BMWC under a 20-year "operation and maintenance agreement", which takes the deal round in a circle. "I will agree to operate your water plant, if you will agree to operate it for me"

BEH goes into the annuity business

BEH has essentially entered into a financing transaction. In return for its RMB1,500m investment, BEH will get an annual income of RMB210m for 20 years, subject to the necessary tariffs being approved from time to time by (you guessed it) the Beijing Municipal Government. The tariff formula provides that If the volume of water treated increases, the tariff automatically decreases to provide the same net income. Tariff approvals are always subject to other pressures such as controlling consumer price inflation, so the government's approval in future cannot be taken for granted. If BMWC makes any profit (after distribution costs) by selling the water to end users, than this gets paid to BEH, but that would be an unexpected bonus.

The purchase of an annual income of RMB210m for 20 years is a simple annuity and any student of finance could calculate that the internal rate of return (IRR) on the annuity is 12.7% per annum. In fact, we are given a clue to this because in the "operation and maintenance agreement", any late payments are subject to penalty charges of 12.74% per annum.

BMWC is owned by the Beijing Public Utility Bureau, part of the Beijing Municipal Government. The Beijing government also owns 100% of Beijing Holdings Ltd (BHL), the controlling shareholder of Beijing Enterprises. That's BEH's whole raison d'etre - it is a "window" company of the Municipal Government, and as such is their listed vehicle in Hong Kong.

In its much-publicised flotation in May-1997 at the peak of red-chip mania, BEH raised HK$2.46 billion from the public, and by 31-Dec-97 had a net cash position of about HK$1.6 billion. That's nearly equal to the $1.4 billion spent on the water company annuity. As the government controls both companies, from their perspective, it's out of one pocket and into the other.

It's None of Your Business

Now you may, or may not, think that 12.7% is a fair return for a RMB-denominated tariff-linked 20-year annuity issued by a Chinese water company. We don't need to pass judgement on that here, although our red-chip IPO fans might have been expecting somewhat more dynamic return on their funds.

However, if you had a view on this, forget it, because the transaction was not treated as a "connected transaction" under Hong Kong Listing Rules, so minority shareholders did not get to approve it.

That's right, the Stock Exchange regards BMWC, controlled by the municipal government, as independent of BEH, which is controlled by the same government. We are not talking about a deal between provinces here, but a deal between arms of the same municipal government. The Author raised this issue with the Exchange last July. Whether or not as a consequence, we now have a new amendment to the Listing Rule 19A.21, announced on 26-Apr-99, which confirms "the Exchange will not normally consider a PRC Government Body as a connected person of a PRC issuer". While this doesn't specifically apply to BEH, which is incorporated in Hong Kong, the principle is no doubt the same. The definition of "PRC Government Body" includes virtually all forms of government from county to State level.

The Exchange explained to the Author that the PRC is different, that it would be impractical if every purchase of state-owned assets by a window company was subject to independent shareholders' approval , and that they therefor limit the scope of "connected persons" to the ultimate incorporated shareholder (in this case BHL), not its owners.

This line of reasoning defeats the whole purpose of connected transaction rules, which is to prevent abuse of minority shareholders' funds. Let's face it, H-shares and red chips have not exactly covered themselves in glory when it comes to shareholder returns. If a PRC government wishes to inject assets into its window company (and take cash out in return), it can now do so without minority shareholders' approval. Even if the assets are owned by the corporate shareholder of the listed window company, it would be easy to avoid the rules by first transferring the assets out to a separate arm of the government that was then not regarded as "connected" to the listed company. The rule also creates a two-tier playing field, since it doesn't apply to listed companies which are not government-controlled. Hong Kong tycoons still have to follow the rules and (except for small deals) ask their minority shareholders before dealing with the company. We doubt if this is quite what Deng Xiaoping had in mind with "one country, two systems".

You're not Connected, but you can have a Bid Waiver

Finally, the Stock Exchange position is inconsistent with the way the SFC regards PRC governmental shareholders for the purposes of the Takeover Code. In this case, the SFC is asked to give waivers from the requirement to make a general offer when a controlling shareholding is transferred from one government arm to another. For example, Panda Electronics Group Company, which controls H-Share Nanjing Panda Electronics, was recently transferred from the State Ministry of Information Industry to the Nanjing Municipal Government. Under the Listing Rules, both of these "PRC Government Bodies" would not be connected persons of the H-share company, but under the Takeover Code, a bid waiver was granted, presumably on the basis that common control existed, by tracing the line of command all the way up to the State Council and back down again. We agree with that approach, but it is clearly inconsistent with the Listing Rules.

How difficult can it be?

Minority shareholder protection in Hong Kong is bad enough with out deliberately weakening the rules to allow transactions like the Beijing Siphon without minority shareholders' approval. If a deal makes sense, they will not turn it down. The cost of printing a circular and renting a hotel meeting room is more than offset by the deterrent effect such a rule would have and the beneficial consequences to shareholder returns. Fewer bad deals means higher profits. The Exchange should reverse its ruling and clarify that any purchase by a listed company which is controlled by a PRC Government Body should be treated as a connected transaction if the counterparty is, or is controlled by, another PRC Government Body. If this inconveniences a few innocent deals then it is better than letting all deals go through unchecked.

The Shanghai Industrial case

We should be grateful that Hong Kong's South Pacific Hotel was controlled by the immediate corporate parent of red-chip Shanghai Industrial Holdings, so that the proposed injection of the hotel into the red chip was made subject to shareholders' approval in December last year. Readers may recall that this was one of the rare deals to be scrapped when minority shareholders threatened to vote it down as being too expensive. This was complicated by the Hong Kong Government's quandary over whether and how it would vote its newly-acquired stake if the meeting went ahead. The meeting was cancelled, but If the hotel company had been owned by, say, the Shanghai Tourism Bureau ("an independent third party not connected...."), things might have been different!

© Webb-site.com, 1999

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