Views on the GEM consultation
26 June 2000
1. The lock-up (moratorium period)
The Exchange proposes to reduce the lock-up period for Controlling Shareholders from 2 years to 6 months after listing. In the second 6 months, Controlling Shareholders must retain at least 35% of the company, while "Initial Management Shareholders" may dispose of up to 50% of their original shareholding.
A Controlling Shareholder is one or more persons who control at least 35% of the issuer, while an Initial Management Shareholder is one who owns at least 5% and is able, as a practical matter, to direct or influence the management of the issuer. All Controlling Shareholders are deemed to be Initial Management Shareholders.
A certain amount of misinformation has been spread suggesting that the current rules prevent venture capitalists who hold 5% or more, from disposing of their shares for 2 years, but this is only true if they are represented on the board. Otherwise, they are only "Significant Shareholders" and are subject to a 6-month lock-up, no worse than underwriters typically require on Nasdaq.
The Exchange's proposal on lock-ups should be viewed in the context of its proposal (see below) to reduce the track record requirement from 2 years to 1 year of active business pursuits prior to listing. Previously, a company had to be 4 years old (2 years pre-listing, plus the 2-year lock-up) before management could start to sell out (except as part of the IPO). This meant that companies were likely to be more mature and less reliant on their management when they started to sell.
But if the track record is shortened to 1 year and management can start to sell only 6 months after listing, then the company might only be 18 months old when the management starts to unload.
We don't think that this is fair to public investors who have put their money into a company, often at much higher prices than management ever paid. The Exchange offers the spurious reason that management shareholders might want to "exchange shares with other investors whose investment is beneficial to the new applicant". We believe that objective can be met by the issuer issuing new shares in a share swap rather than allowing management shareholders to be the source of the swap.
We note that the consultation paper does not mention the requirements for the Alternative Investment Market (AIM) in London. AIM requires that if a company has been generating revenue from its main activity for less than 2 years prior to joining AIM, then directors and employees may not sell their shares for 1 year after admission.
Our proposal is that initial management shareholders should continue to be entitled to dispose of shares as part of an IPO (because the public has notice of this before deciding to invest), but that after listing, they should be locked in for at least 1 year. After that time, for a further year, any initial management shareholder wishing to dispose of shares should give 5 clear business days' public notice of the maximum amount of shares that they intend to dispose of, and may then dispose of up to that amount within a 10 business day period. After that, the window is closed and new notice must be given of any further intended disposals. Full disclosure of the notice and resulting disposal (including the prices) should be made public through announcement on the GEM web site.
Although the disclosure of an intention to dispose may negatively affect the share price, we believe this is fair because the mere fact that an initial management shareholder is intending to dispose of stock should be regarded as price-sensitive information which the company should be required to disclose. If the Exchange takes the view that this information is not price-sensitive, then they should have no problem with disclosing it in advance!
Management should not be entitled to deal before that information has been absorbed into the market, hence the proposed 1-week notice period.
2. Share issues within 6 months after listing
The Exchange is proposing to lift the ban on new issues of shares within the first 6 months of listing, subject to certain safeguards. The shares could only be issued "for the purpose of an acquisition of a business or assets which would complement the focused line of business of the issuer". We believe that these words are open to wide interpretation. For example, would Timeless Software's purchase of property after its IPO have qualified if it had been made in return for new shares? It would seem so.
The safeguards include a lock-up on the new shares if the recipient owns 5% or more of the issuer, and the obtaining of independent shareholders' approval.
There is a risk that listings will be "engineered" simply for the purpose of establishing a shell into which businesses or assets which have been excluded from the IPO can be injected immediately afterwards, thus escaping the scrutiny of a prospectus.
We therefore believe that transactions involving share issues in the first 6 months after listing should only be permitted if they would not constitute "Major Transactions" within the meaning of the Listing Rules. In essence, this limits the assets acquired to less than 50% of the existing assets, and the shares to be issued shall be less than 50% of the existing issued shares (or 33% of the enlarged issued shares) of the company.
We propose an additional requirement that the vote of independent shareholders must be held on a poll, not on a show of hands, regardless of whether the transaction is a connected transaction or not. We've explained why before. This requirement already applies to connected transactions on the GEM, but not on the main board.
The auditor of the company should also be required to attend the meeting and certify the result of the poll and confirm that those shares excluded from voting have in fact not voted .
3. The track record ("active business pursuits")
The Exchange proposes to reduce the track record of active business pursuits from 2 years to 1 year.
The Exchange has already made a mockery of the track record requirement by allowing companies such as Tom.com and Sunevision (both of which launched their portals only in the last few months before listing) to list by transferring older subsidiaries into their listing vehicle and then calling that a track record.
Tom.com did it by acquiring a Shenzhen developer of software for electronic customs documentation, and Sunevision included a company which installs satellite dishes on the roofs of apartment blocks. Neither of these had much to do with the core businesses on which the stocks were promoted, and you would struggle to find a public investor (other than our readers) who could identify where the track records came from.
The GEM market was not designed to be a market for seed capital. One-year-old start-ups are highly risky investments, and a line has to be drawn between helping to fund young companies and protecting public investors from "over-aggressive issuers and promoters" in the Exchange's own words (May-98 consultation paper).
Venture capitalists are experienced investors and are probably a better judge of start-ups than the mass market. The VC industry in Hong Kong has been developing rapidly on the back of the technology boom, and any firm which cannot raise sufficient venture capital to survive its first 2 years, probably does not deserve to be taking public money. We therefore believe the requirement for a 2-year trading record should stay and should be more rigorously enforced.
4. Accountants' report
The Exchange proposes that if the minimum track record period is reduced to 1 year, then the minimum accountant's report will be reduced to the track record period or 2 years (whichever is greater).
As noted above, we believe that the track record period should remain at 2 years, so no amendment would then be needed to the coverage period of the accountants' report. However, we believe that the accountants' report should be expanded to include cash flow statements and balance sheets rather than just net asset statements. This would bring them into line with the recent amendments to the main board listing rules (update 51, 16-May-00).
We also take the opportunity to propose that the requirements in relation to the contents of quarterly reports on GEM be brought into line with the new requirements for interim reports on the main board (update 51), namely that they should include a balance sheet and cash flow statement and be reviewed by an issuer's auditors or audit committee. It is simply unacceptable to see the balance sheet of a growth company only once a year. US standards (which the Exchange is so fond of quoting) are quarterly balance sheets and cash flow statements.
5. Share Option Schemes
The Exchange is proposing a wide-scale relaxation of the rules relating to option schemes. This is a complicated issue which we will respond to in sections.
5.1 Option schemes of unlisted subsidiaries
The Exchange proposes that share schemes of unlisted subsidiaries will no longer be governed by the listing rules (Chapter 23).
We oppose this for a simple reason - if the option schemes of subsidiaries are not regulated, then it opens a loophole for listed issuers. An issuer could avoid regulation by holding all of its assets and subsidiaries through an unlisted direct subsidiary. That subsidiary would then have an unregulated option scheme and would issue options to whomever and in whatever quantities and terms it pleases (including, presumably, to executive directors of the listed issuer).
The Exchange may consider that these options, which convert into unlisted shares, are worthless, or pose no threat to public shareholders of the listed issuer - but that is untrue - they dilute the economic interest of the listed company in its own business. Utlimately, in order to recover its economic interest, the listed issuer may be forced to make an offer to buy out the new shares in its unlisted subsidiary, and that offer may be in new shares - effectively taking the options back into listed shares. It's a two-step side-step of the listing rules. So we believe the listing rules should apply to share schemes of any subsidiary.
5.2 Adoption of a new scheme
At present, the rules require that anyone who might receive share options under a share scheme is banned from voting on whether the company should adopt the new scheme. The Exchange proposes to lift that ban, so that management shareholders (who often control the company) would be able to vote on schemes from which they would benefit.
We oppose the amendment. The Exchange attempts to justify its move by saying "in respect of the dilution effect which relates to all shareholders, the Exchange is of the view that all shareholders should be allowed to vote..." but of course this is nonsense. If you are granted options under a scheme, your fully-diluted shareholding after the grant of options to you will always be higher than before the grant. Although you will be diluted by the grant of options to other parties, you will always be better off than a shareholder who receives no options at all.
We believe that public shareholders will not hesitate to approve a share scheme which motivates the management of their company, but if they are not given the right to do so (by being outvoted by controlling or management shareholders) then they are bound to suffer cases of abuse.
In any event, most GEM candidates come to market with pre-approved share option schemes, so there should be only rare occasions when a new scheme needs to be adopted (or amended). The vote should be held on a poll.
5.3 Eligible Participants
Under current rules, share options can only be granted to full-time employees of the issuer or of a subsidiary. The Exchange proposes to remove that restriction and require only that the issuer should "define the participants" before the scheme is approved. This would allow issuers to use options to reward suppliers, customers, independent directors and so on.
We support the amendment. We believe that the issuer should be free to use whatever instruments (cash, securities, options or otherwise) it chooses in transactions. Independent directors may be more motivated to enhance shareholder value if they are given share options as part of their remuneration.
However, a poorly-recognised aspect of options is that they are not granted at "no-cost" to the issuer. It is true that they do not involve the outlay of cash by the company (and indeed, cash is received if the options are exercised). However, the company bears the cost through future dilution of the equity interests (and voting rights) of existing shareholders. These costs are not recognised in the main profit and loss account, but will eventually show up as lower earnings per share when the options are exercised, creating new shares at below market price.
Taken to a theoretical extreme, a company could pay for all its inputs (goods, services, labour, power and so on) using share options, recognising no expenses at all. Every dollar of revenue would become a dollar of profit, but earnings per share would trend towards zero as the number of shares increased towards infinity.
There is a real danger that investors will overlook this area, and we believe it should be addressed by requiring a numeric breakdown of the "fully diluted earnings per share" figures in the profit and loss account to show how much of the dilution (in $ per share) arises from outstanding share options, convertible securities, warrants and so on.
It is also high time that issuers should be required to set out in their financial reports the net tangible assets per share and a fully-diluted version of the same, with a breakdown quantifying the dilutive effect of share options. At the moment, we have to work it out for ourselves.
5.4 Mandate for Granting Options
The current rules limit the grant of options under a scheme (aggregated with all other schemes) to 10% of the issued shares from time to time. The Exchange proposes to raise this limit by allowing shareholders to grant general mandates in 10% chunks, up to a limit of 30%. The Exchange also proposes to allow specific approval for the grant of options in excess of the 10% limit of each tranche.
We agree that the 10% limit may be overly restrictive in certain cases, and believe that public shareholders should be able to approve an increase in that limit (on a poll). A renewable general mandate is a sensible way to achieve this.
Consistent with our views under para 5.2 above, we believe that any party who might receive (or has received) options under the scheme should be prohibited from voting on the award of a general mandate. Otherwise, it would be possible for directors (who usually control a company) to repeatedly exhaust and renew the general mandate in their own discretion. This self-mandating process has been seen many times in the case of the placing general mandate - see our article The Placing Game.
We doubt that public shareholders will object if there is a justifiable need to renew the mandate. It is in their interest to approve mandates if the overall effect on earnings is likely to exceed the dilutive effect of the options. However, if they are dissatisfied with the way the previous mandate has been used (or abused) then they should be able to block further mandates.
When companies tap the public market for funds by going to GEM, then they must expect to offer certain basic protections to minority shareholders from abuse. This is one such protection.
On the second leg of the proposal, we see no need to allow for specific approvals for grants in excess of the 10% limit. Instead, companies should seek a new 10% mandate and grant the options from that tranche.
5.5 Total limit on options
The Exchange proposes that the original 10% limit on the options which may be granted under a scheme (aggregated with all other schemes) be increased to 30%.
Provided that there are safeguards on the number of options which may be granted to individuals (see below), and provided that the potential recipients of options are prohibited from voting on general mandates as we propose above, then we believe that there is no need to impose a total scheme limit.
However, if the Exchange does not implement these safeguards, then the limit should remain at 10%, as this sets a cap on the potential abuse of minority shareholders.
5.6 Limit on options granted to an individual participant
The existing rules limit each participant to 25% of the securities which are subject to the share scheme over a 10 year period. The Exchange proposes to introduce an annual limit for each participant of "0.5% of the securities subject to the share scheme for a 12-month period".
Perhaps the GEM consultation paper misstated the proposal. The main board is currently in a consultation process over options, but the proposals on the GEM and main board appear to differ. On the main board, the proposal is 0.5% of the existing issued shares per year, not 0.5% of the securities subject to the scheme. Obviously if the scheme only covers 10% of the company then the GEM proposal amounts to 0.05% of the company.
We believe the limit should be framed not in terms of the scheme but in terms of the issued share capital. Furthermore, we believe that a limit of 0.5% of the company (i.e. the issued shares) per year is appropriate. It allows one individual to receive options over 5% of the company in a 10-year period.
If an exceptional talent requires a better package, then it can be put to public shareholders for approval. To remove concerns of reciprocity in the boardroom, all the other directors should abstain from voting on such approval. Otherwise we'll have everyone agreeing that everyone else is an exceptional talent.
5.7 Granting of options to connected persons
The Exchange proposes that any grant of options to a connected person should be approved by the independent non-executive directors (INEDs).
In addition, the Exchange proposes that if the connected person is also a substantial shareholder or an INED, and the options in the previous 12 months exceed 0.1% of the company and exceed $5m in value, then the option should be subject to shareholders' approval with all connected persons abstaining.
As we have explained before (see our article - Hong Kong's not so independent directors) these people are seldom truly independent and are not representative of minority shareholders, who are powerless to appoint or remove INEDs since these appointments are made in the boardroom and voted on at the AGM by controlling shareholders.
We have previously proposed that INEDs can be made representative by removing the ability of controlling shareholders and directors to vote on their appointment and removal. This would effectively mean that public shareholders as a class would have representatives on the board. If they are not happy with the INEDs, they can be replaced. The vote could be held at each AGM. INEDs would be given space in the annual report to report on their work prior to the next election.
Unless the Exchange adopts these proposals, public shareholders should not be asked to delegate responsibility to people who are often just rubber stamps for the executive directors, and who lack accountability to public shareholders.
We believe that the limits on individual participants as proposed in (5.6) above (0.5% of the company per annum per director) are sufficient and that INEDs can be included as participants. As noted in (5.6), we believe that independent shareholders should approve grants in excess of that limit. This includes grants to executive directors.
As regards substantial shareholders who are not full-time executive directors (and are not associates of them), we see no reason why they should be granted options at all, but if they are granted options, then the transaction should be treated as a connected transaction in the normal way. So the Exchange would need to remove the exemption set out in Note 1 to Rule 19.59(1) so that Rules 20.54 to 20.58 will apply.
5.8 Disclosure of options granted
The Exchange proposes to require disclosure of the options granted to connected persons (incuding directors) and to certain other categories of person. The disclosure should incude a "fair value" and the method used to calculate such fair value.
We are in favour of the proposed disclosure requirements, save as follows. The fair value of options changes constantly. Most option models take into account the market price, exercise price, volatility of the market price, expected dividends, the risk-free interest rate and the time to expiry. The proposal is silent on the time at which the fair value would be calculated. Is this to be the date of grant?
Some of the assumptions in a typical valuation model (such as future dividends and future volatility) are subjective, and the management would often have no comparable instruments (such as exchange-traded options) from which to infer market expectations.
We therefore believe that the statement of option values offers limited benefit and may prove impractical or costly for companies to implement. Instead, we propose a more detailed breakdown of the dilution in "fully-diluted earnings per share" and fully-diluted net tangible assets per share as explained in para (5.3).
While we are on this subject, as stated in a previous submission on the main board, the Exchange should take a look at the Securities (Disclosure of Interests) summary statements which it publishes daily. The section dealing with directors' options is currently useless because it is impossible to distinguish between newly granted options and previously disclosed options, both of which are marked "G" for grant. Previously disclosed options seem to be re-disclosed each time a director's shareholding changes. The grant of an option is a significant event (effectively a directors' dealing under the model code) and therefore it would be nice to know when this happens. The solution is to include the date of grant in the printout against each option.
6. Revenue or Profit Requirement
The Exchange proposes no change to the current rules which do not require any specific level of revenue or profits to qualify for a listing on GEM.
We agree. GEM was designed to be a risky market for young "emerging" companies, and some companies may take years before they can record revenues - for example a biotech company researching and testing a new drug. However, we refer also to our view in para (3) that the track record requirement for "active business pursuits" should remain at 2 years.
7. Offering Mechanism
The Exchange proposes a requirement that a minimum of 10% of each IPO should be made available by public offer rather than placing with selected investors.
We are against the proposal. One of the design features of GEM was intended to be a reduced cost of getting to market. Public offers add to this cost, for example, by requiring more printing, a receiving bank, and newspaper advertisements. Some GEM offers may be so small (as little as HK$30m) that it would not be worthwhile to include a 10% public offer.
We suspect the proposal is being driven by concern over the way certain GEM listings (which have been done by placing only) have subsequently seen their shares very tightly held and may have been subject to upward price manipulation. We do not believe a 10% public tranche would cure this, since it would still leave the possibility of 90% of the public float in the hands of a few placees.
Public investors simply need to be aware that this may happen, and the Exchange can help by requiring disclosure of the breakdown of placees in terms of the numbers of shares allotted (without names).
To preserve the original spirit of the GEM design, companies and their sponsors should be free to determine the best method of marketing their IPO. If they believe that the company will benefit (in terms of price, proceeds or profile) from making a public offer, then they will surely do so.
8. Additional Matters
We refer the Exchange to our article No Exceptions in which we pointed out that certain issuers continue to benefit from waivers which exceed even the terms proposed in the consultation paper. We urge the Exchange to bring these waivers, granted to Tom.com and Hongkong.com, back into line, before the Exchange makes any further claim to be running a level playing field.
Update: the consultation period has now closed. Read the results here.
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