Kin Don't

We have a rule of thumb when investing in small-caps: if a stock is going to implode, it will usually do so within the first 2 years after listing. Suit maker Kin Don provides an excellent example of this. Enjoy this horror story of questionable announcements, timely directors' dealings and several demonstrations of how to exploit Hong Kong's weak regulatory framework.

Kin Don't
1st September 2000

There's a rule of thumb we use when investing in small-caps: if a stock is going to implode, it will usually do so within the first 2 years after listing. So invest in a fresh IPO at your peril - nothing in the rules will protect you from disaster.

With this little maxim in mind, here is the story of Kin Don Holdings Limited (Kin Don), maker and distributor of men's suits, leatherware, leather goods and accessories in the PRC. This stunning IPO was brought to you by sponsor BNP Prime Peregrine and listed on 9-Sep-98, almost 2 years ago.

On paper, the track record looked good - turnover and profits had been growing steadily in the track record period (3 years to 30-Nov-98 and 4 months to 31-Mar-98) and the company forecast a net profit of not less than $110m for the year ending 30-Nov-99. In the event, that was the first and only profit Kin Don has recorded as a public company, coming in at $111.48m, up 19.7% on the previous year. Auditors Ernst & Young gave a clean audit report.

However, look back at the prospectus and we see that the company paid out dividends of $208.15m during the track record period, representing 83% of net profits. They then raised only $76m of net proceeds in the IPO - in other words, the company did not appear to need public money for expansion when it could have retained profits instead. On top of that, two pre-existing shareholders sold 30% of the shares on offer in the IPO, raising $37.5m gross.

After flotation, Kin Don was 56.1% owned by Keen Intelligence Corporation (KIC) which was 92% owned by Kin Don's Chairman Mr Au Tung Chi (Mr Au) and 8% by his youngest brother Mr Ou Tong De.

IPO flop

The IPO was not what you'd call popular. Only 60 public applications were received. Anyone who wanted $5m or less of stock (known as Pool A) got all that they wanted, since it was only 90% subscribed. In Pool B, the other 5 applications ensured that the public offer was over-subscribed by 30%. They would have failed to make the required minimum 100 shareholders, but fortunately 360 employees (mostly PRC production and warehouse staff) applied for a total of 986,000 shares - just 8% of the amount available for the employee tranche.

The corporate finance specialist

On 6-May-99, KIC gifted 19m shares, or 3.8% of Kin Don, to corporate finance specialist Kenneth Kon Hiu-king, an Executive Director of Kin Don. Mr Kon had joined the group in Jan-98 ahead of the Sep-98 float, and was responsible for the corporate planning, development and the finances of the group. At the time of the flotation, he was also an Executive Director of HK-listed Dan Form Holdings Company Ltd (0271).

Also on 6-May-99, KIC sold 11m shares in an off-market transaction at $1.00 each to an unknown party. Market volume that day was only 3.30m shares, and the stock closed at $1.12.

Directors resign

Four brothers of the Chairman (all surnamed Ou) were also on the board at the time of the IPO. Mr Au's elder brother, Mr Ou Tong Shu, was responsible for "the day to day financial and operational management of the Group's production in the PRC", and joined in 1993. A younger brother, Ou Tong Hui, was responsible for "production planning and day to day management of the Group's production facilities in the PRC" and joined in 1990.

Both of these jobs were pretty important, you might think. The directors' report dated 23-Apr-99 stated that (in the usual way) both men would retire by rotation at the Annual General Meeting and, being eligible, would offer themselves for re-election. Such a re-election would be a foregone conclusion since Mr Au was the controlling shareholder.

However, a month later, at the AGM on 26-May-99, the two brothers did not offer themselves for re-election. Obviously they had changed their minds. They owned a total of 100% of the shares of a company called Luminous Corporation (Luminous), which owned 49.5m shares of Kin Don, or 9.9% of the issued shares. As soon as the brothers left the board, their shareholdings as directors were no longer discloseable, and as they held less than 10%, the holding was not discloseable as a "substantial shareholding" either.

This normally sleepy stock then came to life, with volume jumping on 22-Jun-99 to 7.57m shares and the price rising 16.0% to $1.52. The next day, it rose to $1.65 on volume of 39.63m shares, or 7.9% of the company.

In the announcement, the directors said they were not aware of any reason for the recent increases in the price and trading volume, and:

You should note that your "associates" as defined in the Listing Rules does not include your brothers and sisters. Trading resumed on Friday 25-Jun-99 with very heavy volume of 183.71m shares (equivalent to 36.7% of the company) and the stock crashed 45.7% to close at $0.88. Once again, the SEHK required an announcement, which was dated 26-Jun-99. This time, the directors maintained that the previous announcement was still accurate, and then gave a lecture on the merits of the stock:

That would all be encouraging stuff, but note that this announcement was made over 3 weeks after the half-year end of Kin Don, 31-May-99. You will later see why this is significant.

On 29-Jun-99 the South China Morning Post reported that "rumours last week suggested Kin Don was about to place 60 million shares at $1.38 per share, but the placing turned out to be a private placing of existing shares".

We do not know whether these shares included any of the 49.5m shares held by the Ou brothers' company, Luminous, since as ex-directors their shareholdings were no longer discloseable.

Note to regulators: The solution to this problem is to amend the Securities (Disclosure of Interests) Ordinance (which are currently being redrafted into the combined SFC Bill) so that the obligation of disclosure persists for a reasonable period of time (say 1 year) after ceasing to be a director, unless that person dies in the meantime. This would prevent people "board hopping" to avoid disclosure of imminent stock transactions. The 1-year period would be the same as that applied under the connected transaction rules.

Interim results

On 18-Aug-99 Mr Wei Cheng Wen (Mr Wei) was appointed as an Executive Director of Kin Don.

On 30-Aug-99, just 1 day short of the 3-month deadline, the interim results of Kin Don were released. Oh dear. Turnover for the 6 months to 31-May-99 was down 25%, and the company had plunged into a net loss of $42.809m compared with a profit of $52.662m in the same period in the previous year.

This was after provisions for accounts receivable of $15m and provisions for inventories of $43m.

It makes you wonder just why the directors were so bullish in reminding investors of the previous year's results in that announcement on 25-Jun-99, over 3 weeks after the period ended.

On 1-Sep-99 Ou Tong Guo and Mr Kon (the corporate finance specialist who had been gifted 19m shares less than 4 months earlier) resigned, while a Mr Poon Chi Fai (Mr Poon) was appointed as an independent non-executive director. All we know about him is that he is a Justice of the Peace.

Things were not looking up in Mr Au's private investments either. On 16-May-99 the SCMP reported that a flat believed to be owned by Mr Au was up for sale. Not just any flat, but a 3,902 sq ft penthouse duplex in the harbour-front Convention Plaza luxury apartment block. Mr Au was believed to have bought the flat for $77m in May-97, near the top of the market. A case of harbour hubris, perhaps.

In the event, the flat was not sold and it later emerged that it was owned by a company called Kin Don (China) Ltd, which is owned 55% by Mr Au, 30% by Ou Tong Guo and 15% by Ou Tong Shu.

KIC pledges its stock

On 12-Oct-99, KIC pledged its remaining 250.5m shares (then 50.1% of Kin Don) to a company called Magical Eyes Ltd (Magical Eyes), in which a company called Polytec Holdings International Ltd was also interested (more about that later). This information was in a statutory disclosure printed by the Stock Exchange on 20-Oct-99.

Months later, it emerged that the loan was in the amount of $35m, or about $0.14 per share, that it was due after six months on 12-Apr-00, and that the interest rate was a whopping 24% p.a. - not a sign of a strong credit. A second legal charge was also granted on the Convention Plaza apartment (presumably behind a first mortgage from a bank).

Two Placings

In between the pledge by KIC and its disclosure, Kin Don Holdings agreed on 14-Oct-99 to place 65m new shares at $0.20 each through Koffman Securities to "more than six independent investors". No mention of the pledge by KIC was made in that announcement.

On 3-Nov-99, Philip Lam Kwing Sun (Mr Lam) was appointed as an Executive Director of Kin Don.

You might be wondering who Mr Wei, Mr Poon and Mr Lam are. Unfortunately, the Listing Rules do not require any biographical information to be disclosed on directors upon their appointment, only if they are still on board in the next annual report. In fact, issuers are not even required to publish an announcement - a simple "press release or such other method as the issuer thinks fit" will do. In practice, most publish a simple notice of appointment. So new directors might as well be from Mars, for all you know about them. This is a loophole because it allows directors (particularly so-called "independent" ones) to hop in and out of the boardroom between annual reports and avoid any disclosure except of their name.

We liken this to quantum fluctuations in a vacuum, where under Heisenberg's uncertainty principle, short-lived particles can jump in and out of existence without violating the conservation of energy. Quantum directors are similarly transient. But we digress...

Perhaps at this stage, having seen the shares lose over two thirds of their IPO price, the board of Kin Don felt things couldn't get much worse. Seeking motivation, they awarded 4 directors options over 44m shares at an exercise price of $0.255 and exercisable from 4-Nov-99 to 18-Aug-08.

Next, on 5-Nov-99, another placing was announced (by now the KIC pledge had been disclosed), again through Koffman Securities, this time for 35m new shares at the same price of $0.20, taking the total of the two placings to 100m shares, or 20% of the previous issued share capital. That reached the limit on new issues under the standard general mandate granted to the board at the AGM. The stated purpose of both issues, raising a total of $19.24m net, was to repay borrowings and for general working capital.

Even with the share capital enlarged by the placings, the option grant was equivalent to a hefty 7.7% of the issued shares (the maximum allowed is 10%). Of the 44m options, 14m went to each of Mr Au and his brother Ou Tong De, while 8m went to each of Mr Lam and Mr Wei.

Li Yang Joint Venture

On 20-Dec-99 Kin Don announced a joint venture with Li Yang Advertising Public Relations (HK) Limited (LYAPR). Kin Don and LYAPR had established a JV on 28-Jul-99 called Li Yang Broadcasting & Advertising (HK) Ltd (JV1). This in turn would enter into a 50:50 joint venture with Beijing Li Yang Advertising Co Ltd (BLYA) to establish a second-level mainland JV called Bright International Advertisement Co Ltd (JV2).

Both LYAPR and BLYA were controlled by Mr Li Yang, a "well known television programme host and dubber in the PRC". BLYA was appointed as the exclusive advertising agent and advertisement issuer of a television channel in the PRC for an initial term of 3 years from Sep-99 with first refusal for a further term of 5 years. For a nominal fee of $1, these rights would be transferred to JV2. The unnamed TV channel is broadcast through the network of Beijing Cable Television "with an estimated viewers of more than 20 million covering Beijing, Hebei and Tianjin".

This was a somewhat lopsided funding arrangement. Kin Don was to contribute a total of $50m cash for 48% of JV1 and give it a $30m interest-free loan, while LYAPR would contribute "production equipment and machineries valued at HK$18m as appraised by an independent valuer on 3-Jul-98" in return for 52% of JV1. So Kin Don would have a 24% interest in JV2.

LYBA would contribute RMB25m (HK$23.5m) in cash to the registered capital of JV2, while BLYA would contribute the same amount "by way of injection of tangible and intangible assets". It was not clear what JV1 would do with the rest of the $80m.

Silver Galaxy

Kin Don's $80m total contribution to JV1 was due in instalments - $40m by 30-Dec-99 and $40m (including the $30m loan) by 31-Jan-00.

Given Kin Don's recent losses, you might wonder where all that money would come from. On the same day, a Cayman Islands company called Silver Galaxy Investment Ltd (SG) agreed to advance on 30-Dec-99 an unsecured loan to Kin Don of HK$42m at an interest rate of 5% over HIBOR, repayable on 31-Mar-00. Silver Galaxy also had the right to elect, prior to drawdown, for repayment of part or all of the loan in the form of new shares at the one-month prior average market price, subject to a cap of $0.72 per share. Alternatively, Silver Galaxy could choose convertible bonds.

In the event, on 30-Dec-99 SG elected for half of the loan to be repayable in shares at $0.3645 per share, and the other $21m in cash. At that time, it was disclosed that "substantially all the profits of [SG] is indirectly owned by a Japanese company which is principally engaged in securities business". SG "indicated that it may dispose of the [new] shares after their issue".

Out of Options

On 30-Dec-99 (the day the first instalment on JV2 was due) Mr Au exercised part of his options, putting $3m into the company, and the remaining $0.57m for the rest of his options went in 3 weeks later on 19-Jan-00.

Third Placing

On 14-Jan-00 Kin Don agreed to place 150m new shares at $0.28 per share, a discount of 19% to the market price. This represented 24.1% of the existing issued shares. The placing agents were Hantec Securities Co. Ltd (Hantec) for 80m shares, and Ever-Long Securities Co. Ltd (Ever-Long) for 70m shares. A placing fee of 2.5% was paid.

What later emerged is that Hantec is wholly-owned by Mr Johnny Or Wai Sheun (Mr Or) who is Chairman of Polytec Group, and that Magical Eyes (the lender to KIC) is indirectly (presumably vial Polytec) wholly-owned by his family trust. In other words, the lender to KIC, which had a security interest in the controlling shareholding, was also the placing agent to Kin Don.

Polytec is a private group principally engaged in textile and garment manufacturing, property development and investment in Hong Kong and Macau. Mr Or is also a director of Campanhia de Electricidade de Macau, the Macau electricity monopoly.

Ever-Long is wholly owned by HK-listed Styland Holdings Ltd, headed by Kenneth Cheung Chi Shing. Mr Cheung was recently in the news on 11-Aug-00 when former fund manager Kevin Lee Kwok-wing was jailed for 6 years after being convicted of (amongst other things) accepting $4m in bribes from Mr Cheung in Mar-93 in return for arranging for Rockerfeller & Co (Far East) Ltd (of which Mr Lee was Managing Director) to purchase shares in Styland. No charges have been laid against Mr Cheung.

Issue of Convertible Debentures

On 22-Jan-00 Kin Don announced an issue of US$5m (HK$39m) of unsecured convertible debentures due 31-Dec-03. The stated purpose of the issue was to refinance the Silver Galaxy loan and to partly fund the $40m outstanding obligations to JV1.

The subscriber was a Cayman Islands company called Stone Church LLC. No information was given on its "independent third party" owners. The loan was unsecured. Completion of the subscription took place on 29-Feb-00.

The interest rate was 3%, while the formula for calculating the conversion price was horrendously complicated. The conversion price may be 130% of the average closing price over the 20 days prior to completion (that works out to $0.504725), but it also depends on the market price at the time of exercise.

If the average of the 5 worst days' share prices in the 20 days prior to a conversion taking place is less than $0.504725, then the conversion price is reduced to 88% of that average or $0.1892 (the Stipulated Price), whichever is higher. All this is after some simplification by Webb-site.com!

Crucially, in the event that the shares fall to the Stipulated Price or less for 10 days in a row, the debenture holder can require redemption of the bond at 115% of face value plus accrued interest.

Another bridging loan

On 2-Feb-00, Kin Don announced that the second $40m due to JV2 by 31-Jan-00 had been deferred. The $10m for equity was deferred just by 1 day, while the $30m shareholders loan was deferred until 2-Mar-00. Apparently cashflow was getting tight, partly because the circular seeking shareholders' approvals for the third placing and the convertible debenture issue had still not gone out, so the issue money was not available.

To fund the $10m, Kin Don borrowed another $10m from SG, repayable a month later at an interest rate of HIBOR+5%. The agreement provided that if the loan was not repaid, then SG would have the right to convert the debt into part of the stake in JV1 at cost.

Kin Don then owned 48% of JV1, but had not yet advanced the $30m shareholder's loan. A supplemental agreement provided that if the money was not paid by 2-Mar-00 then the JV1 partner could take back 18% of JV1 (based on an $80m valuation for 48% of JV1, implying a $333m valuation on JV2).

The brothers cash out

Ou Tong De exercised his share options on 11-Feb-00 and the other two directors exercised their options the next day, over 2 months since Kin Don's year end of 30-Nov-99. So much for long-term incentives. By now, the stock price had recovered on the back of the "treasure hunt" for shell situations that accompanied dot-com fever in the market.

Mr Wei sold 2m of his 8m option shares in the market between 15-Feb-00 and 17-Feb-00 at prices between $0.45-$0.43, then Mr Au purchased the balance of 6m shares on 17-Feb-00 at $0.425.

Ou Tong De sold his 14m option shares in the market between 17-Feb-00 and 29-Feb-00 at prices between $0.435 and $0.295.

Mr Lam sold 2.66m option shares in the market between 21-Feb-00 and 24-Feb-00 between $0.428 and $0.375, then Mr Au purchased the balance of 5.34m on 2-Mar-00 at $0.29.

We have previously explained in our loopholes section how the Listing Rules incentivise companies to delay their results so that directors can deal, since the cut-off is one month prior to the results. The solution is to prohibit dealings from one month after the period end, to incentivise early release of the results.

As you can see, at this stage Mr Au was still putting money into the shares, not taking it out as his fellow directors had done. Remember that his main holding, through KIC, was pledged to Mr Or's company as security for a loan. It was probably important to maintain the value of the collateral for the loan, and also if the price fell too far, then Kin Don's convertible debenture would become repayable too.

Man over-board

The two original independent non-executive directors (INEDs) of Kin Don, Ms Margaret Man and Mr Fan Jia Yan, both resigned on 1-Mar-00. One of the vacancies was filled by solicitor Robert Ip Chun Chung, who is also an INED of Ecopro Hi-Tech Holdings Ltd, a NED of Sen Hong Resources Holdings Ltd, as well as being an Executive Director of Wing Lee International Holdings Ltd.

On 14-Mar-00 Mr Au was granted 3.75m share options exercisable until 18-Aug-08 at $0.235 per share. He exercised them on on 23-Mar-00.

Results overdue

While the other directors were cashing in their share options, the 30-Nov-99 financial year-end had passed, and the 5-month deadline for reporting the results was approaching. On 28-Apr-00, the last possible day, Kin Don announced (Word format) that it could not produce audited results as:

Pity that they didn't have significant turnover in the accounts themselves. In the unaudited results released instead, turnover dropped 25% to $300.2m and earnings crashed to a net loss of $155.6m. The provisions incurred in the first half of the year for accounts receivable had increased by $10m.

The board set itself the target of announcing the final results and dispatching the annual report by 31-May-00.

Sure enough, on 31-May-00 came another delay (Word format), this time to 30-Jun-00. 6 months after the year-end, the directors wrote:

By 30-Jun-00, the problem was getting more specific. The announcement (Word format) said:

"Going concern consideration" is accountant-speak for deciding whether it is fair to assume that the business is still viable based on its financial position - that is, whether it is still a "going concern". Once again, the results were delayed to 15-Aug-00.

The return of Mr Or

Remember the lender who had made a $35m loan to KIC, the controlling shareholder, secured on its 250.5m shares in Kin Don? Well now, $30m of the debt was overdue, and Mr Or was back with a full-blown rescue proposal to take control.

On 29-Jun-00 his BVI company, Marble King International Ltd (Marble King) conditionally agreed to subscribe 1,200m shares at $0.05 each, injecting $60m for 56% of the enlarged company.

Marble King also agreed to subscribe 3,400m convertible preference shares at $0.05 each, but only 10% of the principal would be paid on completion, or $17m. The company cannot call up the remaining 90% - it is entirely optional on the part of the holder. In the meantime, the paid-up amount bears interest at 5% and all shares are redeemable.

This effectively means that Marble King would subscribe 340m redeemable convertible preference shares and get 3,060m share options thrown in.

Note to regulators: The technique neatly sidesteps the Listing Rule that limits outstanding share options (excluding executive options) to 20% of the issued capital. The same system was used recently by tobacco tycoon Charles Ho Tsu- kwok when he took over Perfect Treasure Holdings and renamed it Global China Technology Group.

This financing technique also ensures that there will still be over 25% of the ordinary shares in public hands, while the convertible preference shares are an option on future new shares if the company expands. The original (pre-rescue) shareholders would be diluted down from 100% to 17% of the company.

So initially, Mr Or was to inject $77m gross into Kin Don. The deal was conditional upon Marble King being reasonably satisfied that the net tangible assets of Kin Don at 31-May-00 were not less than $20m. The company disclosed that at 31-Mar-00, it had outstanding debts of $157m, so gearing was up to 785%.

On 18-Jul-00, the deal was scrapped because the condition was not fulfilled. So we know that net assets at 31-May-00 were less than $20m, or $0.021 per share.

On 24-Jul-00, Robert Ip Chun Chung resigned as an INED, having lasted just under 5 months. He was replaced on the same day by Mr Liu Kwong Sang, a Certified Public Accountant.

End Game

Things went from bad to worse. On 15-Aug-00, the Nov-99 results were again delayed to 30-Sep-00. Hey - why not just wait and publish two years in one go?

At the same time, Kin Don announced that Stone Church LLC, the holder of outstanding convertible debentures of US$3.75m, had written on 8-Aug-00 and demanded its money back, because the stock price had fallen below the Stipulated Price ($0.1892) for 10 consecutive days. Incidentally, it seems that US$1.25m of the debenture had already been converted. Kin Don said that it did not have the resources to redeem the outstanding bonds.

Note to regulators: HK Listing Rules do not require punctual disclosure of conversions and option or warrant exercises, so it is impossible to know how many shares are in issue without trotting down to the registrar and asking them. This makes life more fun for people running stock indexes since they don't always know from day to day what the correct market capitalisation weightings are.

By this stage, Mr Or was evidently losing patience, and Magical Eyes began to liquidate KIC's holdings of 250.5m shares in the market, starting on 7-Aug-00 to 9-Aug-00 with 5,172,000 shares.

Magical Eyes sold the remaining 245.328m shares "in the market" on 17-Aug-00. The price was $0.095 per share, or $23.3m in total. You'll never guess who bought them. OK, maybe you have guessed - it was Marble King, Mr Or's other company, as announced on 22-Aug-00. Mr Or is now the proud owner of 26% of Kin Don.

What next? It depends to some extent on exactly how bad things are in Kin Don, how the losses were incurred, and what kind of shape Polytec is in (very little is known about this private group). We can expect some kind of restructuring proposal in which, if suitable for listing, Polytec could be injected into Kin Don.

For long-term shareholders (if there are any) this provides little solace. The shares closed yesterday at $0.097, down 90.3% from the IPO price. The only dividend ever paid was 3.4 cents for the year to 30-Nov-98, and the company has net assets of less than $0.027 per share. The shares are now trading on "hope" value alone.

As we remarked at the outset, cases like this provide a strong reason to avoid small-cap IPOs until the companies are tried and tested in the market.

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Kin Don't 1st September 2000