Listing Rules Review Part 1: Stop Displacement

The SEHK has published a long-awaited consultation paper on amendments to the corporate governance aspects of its Listing Rules. It's 175 pages long, so we'll being covering this in a series of articles before making our concluding submission. We start with the general placing mandate for non-pre-emptive issues, where the Exchange proposes cosmetic changes which fail to bring Hong Kong up to international best practice.

Listing Rules Review
Part 1: Stop Displacement
23rd January 2002

If you own an apartment in Hong Kong, then you also own a proportionate fraction of the underlying government land lease, the fraction typically being the ratio of your floor area to the total floor area of the apartment block. Shares in companies are similar - you own a percentage of the company and all its underlying assets, being the ratio of your shares to the total number of shares in issue.

How would you feel then, if the building's owners committee decided to sell newly-created fractions of that land lease, say 20% at a time, diluting your ownership rights? And what if one owner holds the majority of the votes in the committee, and keeps on issuing new fractions of the land to his "best friends", who he claims are independent and not acting as his nominees? Pretty unfair, isn't it? You start off owning say 1.00% of the land, after the first issue, you only have 1/1.2=0.83%, and after 4 such issues you only have 0.48%. Your property rights have been diluted in half.

In terms of listed companies, this is what is known as a "non-pre-emptive issue" or "no first refusal". It means that existing shareholders are not given the right to maintain their voting stake by subscribing for their share of a new issue, nor do they have the opportunity to sell their rights in the market.

The General Mandate

The "general mandate" rule in Hong Kong allows an issuer to obtain approval from shareholders (including the controlling shareholder) to make non-pre-emptive issues of shares for cash, up to a number equal to 20% of the existing issued shares. So for example, a company with 100m shares in issue can issue 20m more.

The approval needed to issue these shares is an ordinary resolution, requiring a 50% majority of those who vote. In Hong Kong, there is no requirement that each voting share be counted, only a show of hands (in which the public, via depository HKSCC, are represented by only one hand), and the SEHK does not propose to change that, but we will cover voting procedures in our next article in this series.

As a consequence of low voting turn-out, the show of hands, and often an outright controlling stake, it is easy for a controlling shareholder, who normally also runs the board, to propose and approve themselves a new general mandate. There is no limit on the frequency with which companies can seek a fresh mandate from shareholders. Indeed, there is not even a requirement in the Listing Rules that they make an announcement that they are doing so. Some simply send out a one-page notice of special general meeting, which most beneficial owners would never see, since their broker or custodian holds the stock.

Case study 1 - it's raining placings

We've written about bad governance arising from the general mandate on many previous occasions. Take for example, Singapore Hong Kong Properties Investment Ltd which, incidentally, doesn't own any Singapore properties. When we wrote that story in Jul-99, the company had made 7 placings in less than 6 months, getting through 4 general mandates and one specific approval in the process. It had increased it share capital by 193%, and diluted net asset value by 45%. After we wrote that story, the company went on to do many more placings, and the price has fallen 98% from $0.047 to $0.001 (the minimum SEHK offer price, hence no bid). Now they are proposing to rename the company "Baolong Aerospace (Hong Kong) Ltd" in conjunction with an acquisition which, incidentally, has nothing much to do with Aerospace - it makes motor coaches. Go figure.

Case study 2 - the Dilution Solution

In another case, just one general mandate placing was enough to cause problems. A cash shell called Pacific Challenge Holdings Ltd (PCH) had a 26.12% substantial shareholder, Kistefos, who had used its votes to block a proposal by the 30.00% controlling shareholder (E1 Media Technology Ltd, controlled by Dr Lily Chiang) to sell to PCH a tiny dot-com in return for almost all the cash in the listed company. Kistefos was able to block this thanks to the connected transaction listing rules which required independent shareholders' approval, and the fact that they demanded a poll.

Shortly afterwards, the controlling shareholder (through its board control) decided to do a placing of new shares for cash, even though PCH had no need for it, sitting on a cash pile. They used almost all the 20% general mandate (19.93% to be exact), issuing 23.8m new shares to each of two individuals, who met the technical definition of "independent", although one of them was a life-long employee of another listed company founded by Dr Chiang's dad. You get the picture.

This non-pre-emptive placing diluted Kistefos down to 21.78%, and shortly afterwards, backed by reputedly the richest man in Norway, Kistefos went off to court in Bermuda (where PCH is domiciled) and is still seeking legal redress there. Its an extremely rare case of legal action which is unaffordable to most investors. Meanwhile, Dr Chiang and E1 Media were busy buying up shares which just happened to be available in the market, increasing their stake by 23.552m shares (coincidentally, just a shade less than the amount placed with each of the 2 placees) from 25.31% to 33.53% between 5-Oct-00 and 15-Jan-01.

International Best Practice

As we first explained as long ago as 17-May-99 in our article The Placing Game, in the UK, from which HK's market derives most of its regulatory framework, the standard is firstly that the law contains statutory rights of pre-emption, and secondly these should only be waived in respect of issues for cash which are:

These Pre-emption Guidelines were actually set by institutional investors in 1987 through the Pre-emption Group, which includes issuers. The investors are able to do so due to the near-absence of controlling shareholders, and as a consequence it is extremely rare for any listed company to breach these guidelines. That's the key difference to Hong Kong - in the UK, investors can make policy rather than suffer it.

The SEHK's Position

On page 36 of the new Consultation Paper, the SEHK notes the UK position, but then goes on to claim that Hong Kong is somehow different - an argument which simply doesn't wash. The SEHK writes, in relation to pre-emption:

What garbage. That's the old "our market is different" excuse trotted out again. Do we want to reach international best practice or not? In nearly every market, the majority of issuers by number are "relatively small" compared with the blue-chips - that's the nature of market distribution, and the UK also has hundreds of small listed companies, including its own second board (AIM). It is also true in all markets that many listed companies "rely on external funds" for their growth - or else why would they list in the first place?

Despite all this, UK investors have still determined that they prefer, as owners of their companies, to protect their property by going through rights issues to raise cash rather than non-pre-emptive issues.

It is certainly true that a placing takes less time than a rights issue, but the extra time and documentation is a minor cost in return for the preservation of investors' fundamental rights to protect their property and choose whether to take up their rights or allow their stake to be diluted, in which case they may be able to sell their rights to someone who wants the new shares.

On pricing, the SEHK offers similar platitudes. Instead of the UK best practice of a maximum 5% discount to market price, it proposes a limit of 20%, unless there are "exceptional circumstances". Whilst this might seem like an improvement from the current absence of any limit at all, in practice, the vast majority of HK placings would already fit within that discount. So no big deal.

One small improvement is offered by the SEHK, namely that controlling shareholders who sell stock in a placing and simultaneously subscribe new shares (what is known as a "placing and top-up") should no longer be allowed to maintain their voting stake by subscribing more shares than they placed out. We of course support the removal of this "pre-emption for us but not for you" rule. However we note that it is very easy for the controller, through the placing, to warehouse stock with supposedly "independent" parties and then transfer it back later, recovering their voting rights. That is at the root of most of the abuses of the general mandate, because it will nearly always be impossible for regulators to detect when such back-door placings are going on.

Quarterly reporting

So there you have Part 1 of our review of the Consultation Paper. Not a great start, and it doesn't get much better.

The paper does contain good news in the form of a proposal for quarterly reporting, for which we can thank China's regulator, the CSRC, who have required it in mainland stock markets starting this first quarter of 2002. Peer pressure is a wonderful thing, and Hong Kong's embarrassment at being overtaken has pushed the lackadaisical SEHK into action - but even now, we hear some companies complaining that quarterly reporting would be too much work, or that too much disclosure might cause short-termism and volatility.

There you go again, that old "Hong Kong is different" excuse. Investors can't cope with all that information. Good point, let's abolish all reporting, then companies can save time and money, and we can all trade on pure speculation - unless of course, you are a controlling shareholder, in which case you already run the company and have all the facts at your fingertips.

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