Takeover Code Consultation
6 May 2001
|In this article:|
Schemes of Arrangement
Share Repurchase Offers
SUBMIT YOUR VIEW
On 10-Apr-01 the SFC announced the publication of a consultation paper on a review of the Codes on Takeovers and Mergers and the Code on Share Repurchases. Webb-site.com has long campaigned for several of the proposed changes and broadly welcomes the proposals, with a few exceptions. In this article, we take you through the details, explain what it means to the public investor, and we invite you to submit your own views to the SFC. Your vote can make a difference!
The most fundamental proposed change is to the "trigger", the shareholding level at which a person who acquires shares must make a general offer. The proposal is to reduce the trigger to 30% from 35%.
The purpose of the Trigger is to ensure that when someone buys enough shares so that they effectively control the board of a company then they must make a general offer to all other shareholders on the same terms. This is number two in the "ten commandments" formally known as the General Principles of the Takeover Code.
As we explained in our critical article HK's Takeunder Code (18-Dec-00) there are frequent cases in which someone pays a very high premium over the market price for a 34.9% stake in a company, then changes the board of directors, demonstrating that control has changed hands. We called this procedure a "takeunder" because it ducks under the trigger and avoids making a general offer.
We are delighted that the SFC has taken this point on board. Time will tell whether 30% is low enough. There are people who believe that 25% would be more appropriate, but we believe the 30% level should be tested for a year and then we will see whether people are still willing to pay a large premium for a 29.9% stake, and whether they can effectively control the board at that level. If "takeunders" persist, then the SFC should take another look at the trigger. Part of this depends on the extent to which other shareholders mobilise our creaky voting system against 29.9% shareholders.
There will always be shareholders who fraudulently dodge the Takeover Code by failing to disclose their holdings above the trigger, but we doubt that the frequency of dishonesty is related to the level of the trigger, rather it is related to the chance of getting caught and the likely penalty, in other words, the deterrent. That's a whole different subject, and one which the SFC Bill currently before the Legislative Council should go some way to addressing in terms of greater powers of investigation for the SFC.
The "creeper" sets a speed limit on the amount by which a shareholder who has less than 50% (but more than the trigger) is allowed to "creep" their shareholding upwards in any given period, which in HK is currently 5% in 12 months. This obviously allows someone at just above the current trigger of 35% to achieve majority (50%) control within 3 years. In practice, this has not happened very often but we believe it should not be permitted.
The age-old argument in HK has been that the creeper allows controlling shareholders to "make a market" in their stocks, somehow benefiting all humanity with increased liquidity. However, that argument is flawed on several grounds:
- Controlling shareholders should not support (or depress) a stock at a price which would not otherwise persist, since that is illegal and is known as making a "false market". Incidentally, this is what the Government did by ramping stocks in August 1998, although they declared sovereign immunity from the law.
- Given point (1), any shareholder who makes a bid-offer spread in his stock should see very little change in his overall holding, because if he finds he is materially increasing his stake, then that means his bid is being repeatedly hit, and he should lower his bid and offer the stock back to the market on the other side of the quote. If he fails to do so, and keeps increasing his stake, then he is supporting the price and making a false market.
- Controlling shareholders are very often directors of the company too, in which case they are required to disclose each and every transaction. But historic disclosure of directors' dealings shows a very low frequency of transactions by such persons - even the most active controller-directors do not trade daily. In fact, activity tends to come only in short bursts when they think a stock is too low or too high - in other words, they are not making a market for humanity but trading in their own self-interest.
From point (2) we see that even a generous shareholder who wishes to improve liquidity, should not need much "wiggle room" to do so since his shareholding should not materially change in the process. And from point (3) we see that this often-claimed liquidity-providing role seldom happens. The UK Takeover Panel in 1998 scrapped the creeper altogether, having reduced it from 2% to 1% in 1993. There is no evidence that this has measurably reduced liquidity in the UK market.
Monitoring the creeper is itself an administrative headache since the SFC has to keep track of rolling 12-month changes to controlling shareholdings of hundreds of companies in the "creeper zone" between the trigger and 50%, to see whether anyone has breached the speed limit. Changes in the numbers of shares in issue must also be taken into account. This exercise is costly and we suspect the SFC in practice relies on companies and their advisers to self-police.
The SFC proposes to cut the HK creeper from 5% to 2% increase in any 12 month period. This is a step in the right direction, since it makes it much harder to creep to control (it would take 10 years to reach 50% from 30%). However, we would favour scrapping the creeper altogether (that is, setting it at 0%). Anyone who had more than the trigger cannot increase their stake without making a general offer. This would greatly simplify matters and reduce the monitoring burden. It would bring HK into line with latest international practice.
Whenever you move a trigger, there is the question of what happens to shareholders who hold a stake which is less than the old trigger (35%) and more than the new trigger (30%). They key problem is to avoid a rush of people trying to get their stakes into the "twilight zone" of 30-35% before the new rule takes effect, thereby getting themselves above the new trigger without ever making a general offer.
The SFC proposes that these shareholders be "grandfathered" and permitted to move up to just below 35%, but required to bid if their stake reaches or exceeds that. If they ever drop below 30%, then the new trigger would apply. The SFC proposes that the creeper would not apply so long as they are in the twilight zone. The SFC is undecided about whether this arrangement should last forever or for a fixed period of time, which they suggest would be 10 years.
The problem with this method is that it incentivises everyone who is currently below 35% to get up above 30% before the new rules come into effect so that they are "grandfathered" and can bounce around in the twilight zone unrestricted..
Webb-site.com believes a better approach is that any holder in the twilight zone at the implementation date should be "capped" and should not be permitted to increase their stake without making an offer. If they reduce their stake, then the cap reduces until it hits 30%.
If the creeper were scrapped, as we recommend, then this cap would happen automatically. If the creeper is not scrapped, then our proposal in effect means that the creeper should be 0% for anyone who is in the twilight zone on the implementation date.
This is much fairer when you compare this with shareholders who will be below 30% - they will be capped by the 30% trigger - so why should others be rewarded with flexibility to increase by 5% in return for getting above 30% before D-Day?
Our proposal is also fairer when compared with shareholders who in future go through 30% and make an offer which lapses. They would be stuck at 30% and subject to the 2% creeper. In that case, why shouldn't the creeper apply to grandfathered stocks? At the very least, the creeper should apply to grandfathered stocks too. So a shareholder at 30.1% on D-Day cannot increase beyond 32.1% in the next year without making an offer.
The right to know
Whatever the SFC decides, it is important that any stock which has a grandfathered shareholder should be clearly identifiable by the public. Indeed, there has always been a problem for investors to know whether a shareholder is "capped" by the trigger or creeper as part of a "concert party" of shareholders. This is particularly difficult when there is more than one family represented in the boardroom. It would increase HK's transparency if information on any such grandfathers and concert parties were required to be registered, and a list kept on the SFC web site and open to the public. Then we would know where we stand.
In addition, such information should be disclosed in every results announcement and annual or interim report of each affected company, alongside the shareholding data.
Schemes of Arrangement
The SFC proposes to amend the approval criteria (Rule 2.10) for a privatisation by scheme of arrangement (SoA). An SoA is when a plan is put to a vote, and if passed, then it is binding on everybody, resulting in a 100% takeover.
The current rule requires a 90% approval of those who voted, together with a "no" vote of not more than 2.5% of the company. The SFC proposes to replace that with a requirement for 75% approval of those who vote (which is required by law anyway), together with a "no" vote of not more than 10% of the public "disinterested" shares.
In addition, the rule will now apply not just to privatisations but to any scheme of arrangement (except redomiciles which don't affect shareholders' economic interests). This rule, if it had been in place last summer, would have allowed minority shareholders much greater say in the PCCW takeover of HKT, which used an SoA. In that deal, only about 3% of the public bothered to vote because Cable & Wireless, China Telecom and the HK Government had about 75% between them, and only a 75% approval was required. As a result, a lot of people got a lot of PCCW shares and had no choice in the matter.
Webb-site.com is in favour of this proposal, because it brings the SoA into line with the general offer method of takeover, whereby a company cannot compulsorily purchase the outstanding shareholding unless it reaches 90%. The SFC also proposes to make clear (in Rule 2.11) that this 90% is calculated on the basis of public "disinterested" shares not held by the offeror and its concert parties.
In our article Hobson's Choice on Privatisations (14-Jan-01) we pointed out how some controlling shareholders have used the very aggressive tactic of proposing a resolution to delist the company while at the same time extending a mediocre privatisation offer. The simple message was "take the offer or get stuck with an unlisted stock". They were taking advantage of the lower criteria (75% of those voting) needed to approve a delisting compared with the level of approval or acceptance needed in a privatisation.
We are pleased to see that the SFC has picked up on this point, and proposes that delistings must be subject to the same approval criteria as privatisations. However, this does not go far enough.
Apart from privatisations which result in 100% ownership by one party (or group), there is no conceivable circumstance in which it is in the interests of public shareholders to have a listing cancelled, as it strips them of regulatory protection and a visible marketplace for their stock. Therefore the SEHK Listing Rules (Rule 6.12 and the GEM equivalent) which allow this delisting should be replaced with a simple rule which says:
"when all shareholders unanimously agree, then a listing shall be cancelled".
That would allow a person (or group of persons) who have bought 100% of the company to rightfully do what they like, because at that point it is private. This change would still permit the possibility of a listed company migrating to an overseas Stock Exchange using Listing Rule 6.11.
If the SFC does not agree with this, then the more logical way of achieving what they propose is to amend the Stock Exchange Listing Rules (specifically rule 6.12 and the GEM equivalent) so that the privatisation criteria apply in any circumstance in which a company is to be delisted and in which there is no alternative listing.
This once again spotlights the fact that the SEHK listing division should be brought into the SFC, but in the meantime the SFC should require the SEHK to make these rule changes rather than put them into the Takeover Code.
Share Repurchase Offers
The SFC has also closed a loophole by extensively revising the Code on Share Repurchases. Last year, the Kwok family which controls Wing On International Holdings Ltd managed to privatise it by the legal but unconventional route of arranging for the company to make a general offer to repurchase the 16.29% that the family didn't already control. The offer was at a whopping 48% discount to pro forma net asset value. Independent financial adviser Anglo Chinese Corporate Finance Ltd recommended the deal.
After obtaining a 75% approval (of those shares which were voted) for delisting and the share repurchase offer, they went ahead, and the last announcement said that when the Repurchase Offer closed, 83.20% of the public had accepted. There was no word on what happened to the remaining shareholders in the now unlisted company. Incidentally, one of the family directors, Bill Kwok, is the Chairman of the Hong Kong Securities Institute so he must know his stuff.
The SFC proposes that Share Repurchase Offers shall be deemed to be Offers under the Takeover Code, and in particular in the case of privatisations will impose the same approval requirements as for a Scheme of Arrangement, closing the loophole. Webb-site.com supports this proposal.
The current Takeover Code includes a note which waives the requirement to make a general offer by a controlling shareholder who has temporarily dipped under the trigger by placing out "old" shares and then gone back above the trigger by subscribing for new shares, known as a "top-up". Under the current rule, the controlling shareholder can raise his holding up to the previous percentage he held, by subscribing for more shares than he sold.
For example, if there are 100m shares in issue, and the controller owns 40m, he might sell 12m old shares and then subscribe 20m new shares, dipping from 40% down to 28% and then back up to 40% without making an offer. In this scenario, the controlling shareholder gets to maintain his percentage through this "dilution protection" while everybody else gets diluted. It is blatantly unfair.
The SFC proposes that a bid waiver will be granted only if the top-up is not more than the number of shares sold. So in our example, the controlling shareholder could only subscribe 12m shares, taking his holding back up to 35.7%, and suffering the same dilution as everyone else.
Webb-site.com supports this proposal, but it should go further. If the SFC sees it this way, then they should require the Stock Exchange to amend its Listing Rules on connected transactions, which grant a waiver for top-up placings based on the "dilution protection" for controlling shareholders. The Listing Rules should be brought into line with the new Takeover Code.
In any event, we have always been opposed to the placing system which allows companies to dilute public shareholders with non-pre-emptive share issues over and over again. The placings can be arranged with people (or BVI companies) who act as secret nominees for the controlling shareholders, and it is very difficult to get caught doing this. We believe all issues of shares for cash should be done by rights issue unless the approval of minority shareholders is obtained in general meeting.
What is a Public Unlisted Company?
A seldom noted fact is that the Codes apply to "public companies in Hong Kong" and companies with a primary listing in Hong Kong. If you were here in 1993 then you may know what this is all about. Jardines, which in our view has one of the worst corporate governance records of any large group in HK, decided to delist all but one of its companies and claim that it was then outside of the scope of the Takeover Code. The SFC at the time claimed that since the companies were widely held in HK, they were still public companies, and still subject to the Code.
The companies (Jardine Matheson Holdings Ltd, Jardine Strategic Holdings Ltd, Hongkong Land Holdings Ltd, Dairy Farm International Holdings Ltd, and Mandarin Oriental International Ltd) moved their primary listings to London, where as Bermuda-incorporated companies, they are not subject to the UK Takeover Code. Then they passed into law their own takeover codes in Bermuda (one for each company) which have never yet been put to the test (but that may yet happen - watch this space).
The wording in the Consultation Paper seeks to specify what a "public company in Hong Kong" is, but it comes out so ambiguously as to be of little help, talking of an "economic or commercial test" (which is it?) and "taking into account primarily the number of Hong Kong shareholders and the extent of share trading in Hong Kong".
This is somewhat puzzling when you consider that the SEHK has a monopoly on "share trading in Hong Kong", and we are talking about unlisted companies. How is the SFC going to know about unlisted share trading?
The SFC goes on to consider "other factors" including the location of the company's head office, the location of its business and assets, and:
"the existence or absence of protection available to Hong Kong shareholders given by any statute or code regulating takeovers and mergers outside Hong Kong".
Reading between the lines, the new wording opens the door for the SFC to admit (if the question ever arises) that Jardine group is now beyond the reach of the non-statutory Hong Kong takeover code by treating the Jardine-sponsored Bermuda takeover codes as adequate. On the other hand, they might find that there are still a lot of HK shareholders on the Singapore branch registers where trading takes place in this time zone.
Having been through a number of HK takeovers as a shareholder, Webb-site.com is painfully aware of how inadequate the role of the Independent Financial Adviser (IFA) really is.
Many takeovers in Hong Kong are "friendly" privatisation offers rather than hostile bids. As a consequence, the situation often involves an offeror who already controls the board of the offeree. What they then do is look around for an IFA who is willing to call the deal "fair and reasonable" and then appoint them to advise the so-called independent board committee (IBC). This is known in the trade as "opinion shopping". The IBC is usually just 2 people who are rubber stamps because they were appointed by the executive directors who represent the controlling shareholder.
The IFA, once appointed, knows why they got the job. To justify their favourable recommendation, they find as many comparable transactions as possible, then discard the ones which give unfavourable comparisons (those which make the current offer look cheap). That usually leaves a bunch of transactions which they and their peers in the IFA community have previously recommended at big discounts to fair value. In short, minority shareholders are not getting good advice.
IFAs also like to say things like "given that there is a controlling shareholder, the chance of another offer from a third party is minimal". But having no other offer is not a reason to accept a cheap offer when the alternative is to hold the stock for future returns or demand more.
We have also noted that the role of the IFAs is limited (by Rule 2.1) to providing a "fair and reasonable" opinion, and does not follow the much wider role under the UK Takeover Code. For example, in the UK, if an offeror asks the Panel for an extension of the timetable, the IFA would normally oppose that if it looked like the offeror was dragging his feet.
In Hong Kong, public shareholders often don't even know the identity of the IFA until the offeree document is posted, so they cannot make representations to the IFA. There have been occasions when Webb-site.com as a shareholder, has had to approach the SFC directly in relation to the offer timetable when a document has been delayed.
Proposal: Jury Pool
We propose that this problem be addressed by way of a "Jury Pool" of IFAs. Each IFA, if they are willing to serve in the pool, must commit to advise on any transaction they are given unless they have a conflict of interest. Transactions would be allocated by transparent random draw - for example, take the last 3 digits of that day's stock market turnover, divide by the number of IFAs and take the remainder as the IFA advisor number. If that IFA has a conflict of interest, then take the next one on the list.
The quality of IFAs would be reviewed by noting when shareholders vote against their advice. If a persistent pattern of ignored advice emerges, then the IFA would be removed from the pool.
This Jury Pool system, with its random selection, substantially reduces the chance of an IFA pandering to the needs of the offeror, although in a small town like HK, it cannot remove that risk altogether. The transaction fee (paid by the offeree) would be the same in each case, set at a level which attracts sufficient IFAs to sign up for the pool each year. Some deals would involve less work than others, but the IFAs would only sign up if the expected long-run average was profitable. A standard engagement letter would be used.
The SFC would announce the identity and contact details of the IFA as soon as they were selected. Shareholders could then make their views known to the IFA whenever they wanted, not just after the offeree document is published, by which time it is often too late. The Takeover Code should be modified to require the IFA to advise the IBC on all aspects of the offer, including the timetable and level of disclosure in the circular, not just whether the terms are fair and reasonable.
Webb-site.com believes this same Jury Pool system should also be implemented for IFAs in "connected transactions" under the SEHK Listing Rules. In 10 years in Hong Kong, we can recall only one occasion when an IFA said a connected transaction was not fair and reasonable - and that was the Mansion House case in which the company had breached the listing rules and was later censured for it.
Opinion shopping is a major problem in Hong Kong and steps must be taken to stop it, failing which shareholders will continue to be fed a diet of poor "rent-a-scribe" independent advice.
Now click here to SUBMIT YOUR VIEW to the SFC using our special form. If you want these proposals to be adopted, you're going to have to tell them!
© Webb-site.com, 2001