The market has been conducting a post-mortem on the Henderson Investment deal, so by popular request we are jumping in. We highlight loopholes and propose improvements in the Takeover Code, the disclosure law and the Listing Rules, but fundamentally, HLD only has itself to blame for not delivering a knock-out bid and reaching out to all HI shareholders. There's nothing wrong with voting shares you hold, whether or not they are borrowed.

Henderson Investment, Post Mortem
25 January 2006

In the last few days, there has been a lot of unsubstantiated rumour that one or more hedge funds may have "caused" the failure of the bid by Henderson Land Development Ltd (HLD, 0012) to privatise Henderson Investment Ltd (HI, 0097). They didn't cause it, HLD did, by not making a sufficiently attractive offer and reaching out to all shareholders to vote for it, as we'll explain.

The rules

The criteria for success in such a privatisation bid, known in law as a "scheme of arrangement", are 3-fold:

An important principle is at stake: the right to private property. A scheme of arrangement, if passed, amounts to a compulsory purchase of shares from those who are not in favour of it. That is why the threshold of objection is set so low, because someone can be deprived of their property (the shares) without consent. So an offer must be attractive enough that the objection is minimal. The last criterion ensures this.

The theory

The theory goes that hedge funds could borrow at least 10% of the publicly held shares and vote them against a privatisation, ensuring its failure. Equivalently, they could sell the borrowed shares in the market, and buy the same number of shares in the market, and vote the purchased shares against the deal.

That equivalence demonstrates that there is no difference between a borrowed share and a share you own. It is just a share, and if you hold it then you should have the right to vote it, whether or not it is borrowed. Similarly, if you sell a borrowed share, the buyer has the right to vote it. The share he bought does not have a label on it saying "I am a borrowed share". It is just a share. The buyer doesn't even know that the seller borrowed it. Of course, a lender can always call in the loan, and then the borrower has to return them, buying shares from the market if necessary.

However, in order to profit from such a situation, the hedge funds betting against the deal would need to have a net short position, meaning they had sold more shares than they bought, so that when a bid fails, they could buy them back at a lower price and make a profit. This means that they would have to borrow more than 10% of the publicly held shares - each additional share giving a gross profit, before paying the borrowing fee and other transaction costs.

Now this is theoretically possible, but every borrowed share has a lender, and it means that there must be holders of that many shares willing to lend them out. What kind of investor would do that? Well, we can broadly categorise investors in an offeree into 3 types: those who want the bid to succeed, those who want the bid to fail, and those who don't care which way it goes.

Those investors who want a bid to succeed or fail should vote in favour or against it accordingly. If they are greedy enough or stupid enough to lend out their shares for a bit of extra income, then they should not be surprised if the borrower votes the other way. The borrower would only have two reasons to borrow - either to vote the shares (for or against), or to sell them in the market, creating a short position, which is a bet that the offer will fail. He may also hold shares which he will vote against the bid.

If the borrower has borrowed only for the voting rights, then it might be someone who is in favour of the bid, and wants to increase the chance of success without increasing his economic exposure to failure, or it might be someone who is against the bid, and wants to increase the chance of failure. The borrower who votes against may be a net long investor who regard the bid as too low and doesn't want his shares to be compulsorily purchased, or it might be a hedge fund who wants to profit from being net short.

As for investors who don't care which way the bid goes, such as index funds who don't always care about the performance of the stocks they hold (although they should, if they want people to keep investing in the index), some of these funds lend out stock routinely to create extra income and improve their performance. People who borrow that stock might vote in favour of the bid, to increase the chance of success, or against, to increase the chance of failure.

The only thing we can reliably conclude is that stock lending increases the chance of those shares being voted, because they will be passed from those who don't care enough to vote themselves, to those who do care which way the offer goes.

Of course, it is not just privatisations where stock lending can affect voting. Any shareholders' meeting, particularly where a controlling shareholder is prohibited from voting (such as on connected transactions), could be affected by the votes of borrowed shares.

People also borrow shares for other reasons - for example, to dry up the lending market and stop other people borrowing them and hence make it impossible or prohibitively expensive to short-sell. That is particularly important if you are trying to sustain the share price of an offeror during a share-exchange takeover bid.

Henderson Investment's case

In any specific case, it will be impossible to know how many shares voted in favour or against a proposal were borrowed shares, but we think it very unlikely that all of the shares against HLD's bid for HI were borrowed shares. Even if they were, HLD should blame itself for failure to table such a compelling offer that almost nobody would lend their shares and almost everyone would be in favour. If they try again, they should make a more attractive offer and make sure they reach all their shareholders.

Ironically, HLD's strategy was probably itself dependent on the assistance of hedge funds. On both occasions (2002 and 2005), they made a 1-2 offer - that is, the first offer "shakes loose" those shareholders who are ambivalent about the company and just want to take the money in the market, and puts the shares "into play". The hedge funds then pile in and buy the shares, hoping to make a small profit when the increased offer comes along. HLD duly obliges, with a 4% increase in the exchange ratio (3.4% in the cash bid in 2002), or what the hedge industry calls a "bump". That's just enough to make most merger-arbitrage funds happy, and of course, they will vote in favour. So by pandering to the greed of short-term hedge funds rather than satisfying long-term investors with a knock-out bid, HLD gambled and lost.

Gap in disclosure law

There is a lack of symmetry in our law on disclosure of interests that should be rectified. The Securities and Futures Ordinance requires long holdings of 5% or more to be disclosed, but it only requires disclosure of short positions exceeding 1% if you have a long interest of 5% or more. That means that if you hold less than 5% of the shares, then you can also be short more than 5% and nobody else would know. The law should be symmetric, and gross long or short positions over 5% should be discloseable.

As a member of the SFC's Public Shareholders Group, your editor made this point to the SFC before their latest consultation on amending the law was published in 2005, but no change was proposed or made.

Gap in Takeover Code

Having said that, in the case of a privatisation or takeover bid, holdings much smaller than 5% of the company can affect the outcome. If the public float is only 25%, then it only takes 2.5% of the issued shares to block the deal. For this reason, believes that the Hong Kong Takeover Code should be brought into line with the London Takeover Code, which requires that dealings during an offer period by holders of 1% or more of the company's shares should be disclosed. Such a person would have to disclose all their dealings, long and short. This would improve the transparency of the system and make it possible for the market to better judge the risk of a deal failing and to respond accordingly. Disclosure: your editor is a member of the SFC's Takeovers and Mergers Panel which advises the SFC on changes to the code.

Unfortunately, the Takeover Code does not carry any statutory backing, so you can't be fined or jailed for breaking it, but a person in breach of it can be blacklisted by the SFC from dealing with brokerages (known as a "cold shoulder order"), so in the case of hedge funds it provides some deterrent.

Loophole in the settlement system

Hong Kong has a "T+2" settlement timetable, which means that if you sell shares on day T, then you don't actually deliver them to the buyer until 2 trading days later. In order to settle a sale made on the Exchange, the shares must be in Hong Kong's Central Clearing and Automated Settlement System, or CCASS. As a result, the vast majority of publicly held shares are registered in the name of HKSCC Nominees Ltd (a subsidiary of HKEx), the nominee of the clearing company which runs CCASS. Even with recent improvements to its operations timetable, CCASS has to set a voting cut-off based on stock balances the day before the meeting, and then send someone to the meeting to vote the shares in respect of which it has instructions.

That means it is possible to sell shares in the market in the last 2 days before a shareholder meeting, and still have legal ownership of them on the date at which voting rights are determined for the meeting, and vote those shares. In a nutshell, it allows someone to vote against a privatisation with shares he has already sold but not yet delivered. Based on queries has received from hedge funds in the past, we have good reason to believe that this loophole is being exploited. However, in the particular case of Henderson Investment, turnover in the last 2 days before the meeting was only about 1% of the public shares, so even in the unlikely case that all of that turnover was shares previously voted, they didn't have a major impact.

To close this loophole, if there is a shareholder meeting the outcome of which may reasonably be regarded as price sensitive (including, but not limited to, privatisations) then the SFC or Stock Exchange should suspend trading in the shares for 2 days before the voting cut-off, so that nobody can vote shares they have already sold. If the voting cut-off date is the day before the meeting, then that means the suspension should run for the 2 days before the meeting, and possibly also the third day before the meeting if CCASS runs its voting cut-off program before its settlement program on T+2. We'll leave the details up to HKSCC to figure out.

Loophole in the entitlement system

While on this subject of timing, we also repeat our call on the Exchange to amend the Listing Rules so that the ex-entitlement date (when trading in the shares begins without the entitlement) for any dividend, rights issue or other distribution should not occur before the date of the meeting held to consider it. In other words, the registrar's record date for entitlements to the distribution should occur at least 3 trading days after the meeting date, so that the ex-entitlement date is not earlier than the day after the meeting. Otherwise you are open to the possibility of people buying shares ex-entitlement and then voting them against and blocking the distribution, getting a free gain when the shares they have bought go up to reflect the retained entitlement.

©, 2006

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