Second Opinion

Time for a second visit to the Webb-site.com surgery for Town Health, which we critcised last year. Now, with the shares down another 78%, they have made a placing with persons who the SFC is not satisfied are independent of the controlling shareholder, while the SEHK has approved the issue. This highlights the ongoing conflict between the SEHK, one of the World's only for-profit regulators, and the SFC, a conflict which is holding up the reform of the market.

Second Opinion
20th June 2001

It's time for a second look at local medical chain Town Health International Holdings Ltd (Town Health, 8138) which entered our surgery back in November 2000, when we recommended some pretty stiff medicine.

Four weeks after its IPO, the company announced a plan to spend almost half its IPO proceeds on an acquisition of a health products distributor from a related party.

We criticised the Company for failing to disclose in its prospectus the identity of one of the company's Initial Management Shareholders, Johnny Lau Wing Hung (Mr Lau), who is the Chairman of Suwa International Holdings Ltd (Suwa). We pointed out that Town Health's Vice Chairman, Derek Sum Kwong Yip (Mr Sum), is also an Executive Director of Suwa.

Mr Lau and Mr Sum owned 85% and 15% respectively of Jacobson Medical Corporation (Jacobson), which at the IPO held 34.9m shares of Town Health, or 8.72% of the company. We also noted that the original announcement of the deal stated that Jacobson Medical (Hong Kong) Ltd (Jacobson HK), in which Mr Sum had a 10% interest and was Managing Director, was one of the top 5 suppliers to Town Health, which contradicted a prospectus statement that none of the directors had any interest in the top 5 suppliers.

Town Health's response

The day after our article, Town Health put out a "clarification". In a hilarious twist of logic, they said that

Gee, the lawyers must have worked long and hard on that one. The company also stated that (contrary to the first announcement) Jacobson HK is not one of the five largest suppliers of the group. Without actually naming the supplier they were referring to, they said that Mr Lau owns 51% of it and the other 49% is owned by an "independent third party", although Mr Sum is a director of the supplier. They did not mention whether that ownership was the same at the time of the IPO.

Anyway, the Stock Exchange muttered its usual stuff about "reserves the right to take action against the Company, the Directors and any relevant parties for possible breach of the GEM Listing Rules" - and nothing more was said.

You'll be pleased to hear that 18 days later, Town Health announced that the deal was scrapped.

Next Deal

On 9-Feb-01 Town Health announced the purchase of a 46.43% stake in Luxembourg Medicine Co Ltd (Luxembourg) from a BVI company owned by "an individual" who is an "independent third party". In a later circular, the individual was named as "Ms. W.M. Fung". The vendor retained 45.02% while the remaining 8.55% was owned by 6 other "independent third parties".

Luxembourg's principal business is the manufacture and sale of cough syrup under the brand name "Madam Pearl's". According to an import alert by the US FDA, the product contains Codeine, an ingredient specially regulated because of its abuse potential. The product is a registered pharmaceutical in Hong Kong.

The price on the deal was HK$39m in cash, just more than Town Health's net IPO proceeds of $38m, although the company insists that the deal was funded from "internal resources other than the proceeds of [the IPO]". This avoids any implication that there has been a change of intended use of the IPO proceeds.

Luxembourg had audited net assets at 31-Dec-99 of only HK$0.42m, which had risen to $8.01m (unaudited) at 30-Nov-00 (presumably based on 11 months' earnings), meaning that Town Health's share was $3.72m.

The turnover and earnings of Luxembourg had been falling, with net profits down from $21.3m in 1998 to $13.6m in 1999 and an unaudited $8.6m in the 11 months to 30-Nov-00. Despite this slump, Town Health described the business as "promising" and said the consideration was reportedly agreed "having regard to the future growth prospects".

Another deal

On 28-Mar-01 Town Health announced the purchase of a 24% stake in century-old Wai Yuen Tong Medicine Co Ltd (WYTM) from HK-listed Wang On Group Ltd (Wang On).

There's an interesting history to this deal. On 22-Dec-00 Wang On announced that it had agreed to buy a 99.79% stake in WYTM from a BVI company called Bio-Project Ltd (BPL), whose owner was not identified.

WYTM is principally engaged in the business of manufacturing, processing and retailing Chinese medicine which includes products sold under its own brand name "Wai Yuen Tong". Net assets at 31-Dec-99 were HK$35.9m and net earnings were $9.6m in 1998 and $10.3m in 1999.

In fact, Wang On had paid the entire $127m purchase price, or 41.8% of its own net assets, as a "loan" in instalments on 3-Nov-00 and 29-Nov-00, but shareholders did not hear about it until 22-Dec-00 and had not yet approved the deal. They eventually did so on 27-Feb-01. Wang On had breached the Listing Rules by failing to disclose the loan. As usual the Stock Exchange "reserved its right to take further action against the Company and/or its director" and nothing more was said.

Now back to Town Health. In its own announcement, it disclosed the owner of BPL was "Mr Chan Ken". As a result of the deal, Town Health owns 24% of WYTM purchased from Wang On, which retains 75.79%, while 3 individuals own the remaining 0.21%. The purchase price is $30.06m in cash, of which $25.06m came from "internal resources" and the other $5m from the IPO proceeds. Town Health this claimed this was in line with the prospectus plan to utilise $5m to "partially fund the establishment and/or acquisition of not less than three traditional Chinese medicine consultation centers". We think it is a bit of a stretch to relate that to an investment in a medicine maker and retailer.

Earnings of WYTM were $9.45m in 1998 and $9.14m in 1999, rising to $11.56m (unaudited) in the 11 months to 30-Nov-00.

Jacobson Unloads

Now remember Jacobson, the shareholder which held 8.32% of Town Health after the IPO? They were subject to the 6-month lock-up on their holding under the GEM rules (as waived from the original rule of 2 years). The day that lock up expired, Jacobson began to unload its shares, selling 2.644m shares on 18-20 Apr-01 as the price dropped from $1.20 to $0.64, then 2.83m shares on 23-Apr-01, and 1m shares on 24-25-Apr-01. As Jacobson's stake is below the antiquated 10% disclosure threshold, we only know this because the company was forced to announce possible reasons for the market volatility.

Placing

When we issued our wealth warning on this stock on 19-Nov-00, the price was $2.25. Having outlayed $69m of cash on the two acquisitions, of which $64m was from "internal resources", those resouces must have been getting low.

On 3-May-01 Town Health decided it was time to raise more cash from the market, having seen the price slide 78% from our warning to $0.50. They announced a placing of 50m existing shares from the controlling shareholder at $0.45, matched by a subscription of 50m new shares at the same price (less expenses).

The placing by Great China Brokerage Ltd went to a total of 20 placees. A total of 24.5m of these placing shares (49% of the issue) went to employees or directors of the placing agent and their spouses, and unusually, a partial breakdown of the placing list was disclosed in the announcement.

Next, it was announced on 8-May-01 that Jacobson had sold another 13.09m shares, or 3.27% of Town Health.

SFC says No

Now as a result of the placing of 50m existing shares, Origin Ltd, the controlling shareholder of Town Health, saw its stake drop from 49.12% to 36.62%, just above the 35% that it had undertaken to maintain for 12 months after the IPO. It was intended to increase this back to 43.66% by the subscription of the same number of new shares. However, as that is more than a 5% increase, it requires the consent of the SFC under the Takeover Code. This consent is normally given, subject to:

In other words, to qualify for the waiver, the placing has to at least appear to be with independent placees. Now on 16-May-01 Town Health announced that the SFC was not yet satisfied, and it was extending the deadline for the subscription by 3 weeks, to 7-Jun-01, with the consent of the Stock Exchange, which normally requires these deals to be done within 14 days after the placing. A second extension of 2 more weeks was announced on 7-Jun-01.

Finally, on 14-Jun-01, the SFC told the controlling shareholder that it was not satisfied that the placees of the Placing are independent of the controlling shareholder.

To us, this statement carries the implication that the SFC believes there may be some connection or understanding between one or more placees and the controlling shareholder and it has not been satisfied to the contrary. The SFC is prohibited from commenting on the case.

Accordingly, on 15-Jun-01 Town Health announced that it would scale back the subscription to 34m shares so that Origin's stake only increased by 4.96% to 41.58%, within the 5% limit of the annual "creeper" allowance under the Takeover Code. That means that a bid waiver is no longer required and they don't need to care about what the SFC thinks.

Stock Exchange says Yes

Despite the SFC's ruling, the Stock Exchange has not said that the placing and subscription in any way amounts to a connected transaction. Instead, they have treated it as a normal issue under the general mandate, and the GEM Listing Committee granted approval of the subscription which was completed on 18-Jun-01.

Split Regulation

So let's see: the SFC smells a problem, and says that it is not satisfied that the placees are independent, but the Stock Exchange in effect says that it is satisfied, by granting approval of the listing of the new shares without treating the deal as a connected transaction. The SFC only rarely goes so far as to block a placing, and is likely to have acted with good reason.

This highlights the ongoing rift between the two bodies. Webb-site.com pointed out the problem in an article back in Jul-99 during the merger process which gave rise to Hong Kong Exchanges & Clearing Ltd, the parent of the SEHK.

The Stock Exchange is now one of the World's only for-profit regulators, and should not be in control of the listing process. There is a direct conflict of interest between the short-term maximisation of profits (achievable by minimising regulatory expenditure and relaxing rules to increase listings) and the long-term quality of market regulation. In London, this conflict of interest was recognised and the Listing Authority was transferred from the London Stock Exchange to the Financial Services Authority when the exchange was turned into a for-profit company. Hong Kong has yet to learn that lesson and move the Listing Division to the SFC as we advocate.

Almost a year ago, on 30-Jun-00 the SEHK and SFC closed a consultation period on whether the GEM Listing Rule Waivers should remain in place. Since then, no news has been announced on the results of this consultation, despite several statements by officials that it was coming soon. All you have to go on is the responses of readers of Webb-site.com.

Sources indicate that there is continuing dispute between the powerful GEM Listing Committee of the SEHK, which wants the waivers to stay, and the SFC, which wants a stricter approach. The SFC has the power to approve or reject changes to the Listing Rules under Section 35 of the Stock Exchanges Unification Ordinance, but cannot force changes, which must be proposed by the SEHK under Section 34 of that Ordinance. The SFC can, however, revoke its consent to the existing blanket waivers of the listing rules by the SEHK, which have the same effect as amending them. We believe it should do so until agreement is reached. This has gone on long enough.

It seems clear that so long as we have two different regulators supervising listed companies, one of them for-profit, then market regulation will be inefficient, inconsistent, fractious and slow to reform.

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Second Opinion 20th June 2001