Webb-site Reports

Minsheng Bank (1988) just grabbed RMB115.6m from H-share holders and paid it to the Government with no good reason. We explain why bonus share issues by PRC issuers are not just silly but damaging to shareholder value. We also look at the conflict of interest for HKEx, which recently signed a strategic MoU with Minsheng and is pursuing relationships with other banks while acting as their listing regulator. The SFC should now take over regulation of these listings, but has declined to do so.

Minsheng tax grab, HKEx conflicts
30 June 2014

China Minsheng Banking Corp., Ltd. (Minsheng, 1988) has just taken RMB115.6m (HK$145.8m) from H-share holders and paid it to the Central People's Government without any good reason, as we will explain.

With the 2013 results, Minsheng announced "2 shares of stock dividends for every 10 shares", or what it called "Bonus Shares", to be "paid" out of the retained profit of the Bank as of 31-Dec-2013. That was alongside a real cash dividend of RMB 1 for every 10 shares, before withholding tax. Incidentally you will notice that in quirky China, Minsheng and some other companies are in the habit of defining distributions "per 10 shares" rather than per share, and using unsimplified ratios like 2 for 10 rather than 1 for 5.

As we've said before, even when there are no tax implications, issuing bonus shares is a pointless waste of administrative costs. A bonus issue does not give any value to shareholders, it just subdivides what they already own into a larger number of shares, similar to a stock split. Same pizza, more slices.

But in mainland China, there are tax implications which make some bonus issues not just silly but destructive of shareholder value. When a PRC company transfers part of its reserves from the "retained profit" account to the "share capital" account in the balance sheet, this is deemed to be a "distribution" of profits to shareholders, equivalent to the par value (normally RMB 1) for each bonus share issued, even though shareholders aren't actually receiving any value.

So, although the Minsheng cash dividend was only RMB 0.1 per share, shareholders are also deemed to have been "paid" RMB 0.2 per share, in the form of bonus shares, for a total of RMB 0.3 per share.

Now, for "Non-resident Enterprise" (NRE) registered holders of H-shares, an "Enterprise Income Tax" of 10% is withheld from the distribution, and for individuals in HK, a PRC "Individual Income Tax" of 10% is withheld. Under PRC law, NREs include nominees, so HKSCC Nominees Ltd (HKSCCN), the registered holder for all shares in the HK clearing system run by HKEx, is an NRE. HKSCCN held 99.38% of all H-shares before the bonus issue.

The tax of 10% on RMB 0.3 reduces the cash dividend from RMB 0.10 per share to RMB 0.07 per share, and in effect it is a 30% withholding tax on the dividend, not 10%.

Based on the 5,777,982,840 H-shares outstanding before the bonus issue, the extra tax of RMB 0.02 per share amounts to RMB115.6m (HK$145.8m). The situation for non-enterprise A-share holders (mainland individuals) is worse, because they are taxed at 20%, so the tax on the bonus issue reduces their dividend from RMB 0.10 to RMB 0.04, an effective tax of 60%. That's also the case for any H-share holder with a registered address in a country that has no tax treaty with China, although there are probably none, because as we said, most of the H-shares are held by HKSCCN. Dividends between mainland-resident enterprises are not taxable, so Minsheng's PRC corporate shareholders won't lose anything.

The extra tax of RMB0.02 (about HK$0.025) per share is entirely avoidable, because Minsheng did not have to make the bonus issue and it serves no economic purpose. At the closing price of HK$8.16 per H-share before they went ex-distribution, this is a reduction in shareholder value of about 0.31%. If they did that every year, the compounding effect would mean that the deemed distribution would be (per current share), RMB0.2 this year, RMB0.24 next year, RMB0.288 the year after and so on, and the extra tax would be 10% of those amounts.

If any of this sounds familiar, that's because we wrote about the problem three years ago, when Bank of Communications Co., Ltd. (3328) declared a bonus issue which took 50% off the final dividend for 2010 and paid it to the Government.

Not their first time

Minsheng should have been aware of this problem, because they have done this before. In 2010, they made a bonus issue of 2 shares for every 10 held, and the closing price on the day before the ex-date was HK$8.43. This reduced the cash dividend from RMB0.05 per share (before tax) to RMB0.025, an effective tax rate of 50%. The extra tax of RMB0.02 (then HK$0.0228) destroyed about 0.27% of shareholder value. So with this second bonus share issue, the board has now destroyed about 0.6% of shareholder value in 4 years. The tax was the subject of an announcement on 9-Jul-2010 in which the board said:

"Apart from the dividends to be distributed, the bonus shares converted from the retained profits of the Company represent income from equity investment on the part of shareholders shall also be at the same time subject to the above tax laws, and an enterprise income tax shall be levied on the face value of the bonus shares distributed to non-resident enterprise H Shareholders at the tax rate of 10%."

So why on Earth do it again? The circular proposing the 2014 bonus issue gives the following statement of reasons:

"The Board believes that the proposed Bonus Issue enables the Shareholders to share the business growth of the Company. In addition, the Bonus Issue will also enlarge the share capital of the Company and increase the liquidity of Shares in the market."

and in the 2010 circular they said:

"The Board believes that the proposed Bonus Issue will allow the Shareholders to participate in the growth of the Company. In addition, it will provide the Company with a wider share capital base and therefore increase the marketability of the Shares."

This is, in layman's terms, complete and utter hogwash. Shareholders already "share the business growth" with their existing shares, and cutting the farm into smaller fields does not make the farm bigger. On the share capital point, converting retained earnings into share capital just reduces the amount of earnings that could in future be distributed as cash dividends, so that is not in shareholders' interests either. Finally, for the liquidity and marketability argument, when you have a board lot of 500 shares worth only about HK$4,000, you are not going to make the stock materially more accessible by splitting it, because minimum brokerage fees make purchases at that size uneconomic.

In fact, the bonus issue creates "odd lots" of shares which are more difficult to dispose of (at a discount) and increases some transaction costs which are charged per-board-lot (particularly scrip fees), because you have 20% more board lots than before with the same total value value (minus the tax hit). HKEx, as operator of the central depository, is one of the main beneficiaries of scrip fees.

But the "reasons" statements in the circulars are worse than hogwash, because they failed to warn shareholders that the bonus issues would actually result in a reduction in the net cash dividend and therefore be damaging to shareholder value. We regard the statements to be false and misleading by omission.

Who's the regulator?

You might be tempted to write to the Stock Exchange, as the "front-line regulator" of listings, complaining that the circular didn't warn you about the negative tax consequences before you voted in favour of the bonus issue. But before you write to them, you might want to look at this photo:

Yes, that is Charles Li Xiao Jia, CEO and unelected director of Hong Kong Exchanges and Clearing Ltd (HKEx, 0388), shaking hands with the President and Vice Chairman of Minsheng, Mr Hong Qi after signing a Memorandum Of Understanding between HKEx and Minsheng for "strategic cooperation on solutions for market users and product development". Amongst other things, the MOU would "give HKEx access to Minsheng's large client base for product marketing."

Now, as a for-profit business, HKEx should of course pursue its commercial interests. But that puts it in direct conflict with its role as Listing regulator, via its wholly-owned subsidiary, The Stock Exchange of Hong Kong Ltd (the Exchange). If last year's dreams of winning the Alibaba deal by lowering governance standards weren't enough to convince you that HKEx should get out of regulation and pass the role back to the SFC, then perhaps this will help, because if HKEx is signing, or seeking to sign, MOUs with listed companies that it regulates, then it is inherently conflicted.

There is actually a provision in the Listing Rules, Chapter 38, which allows for the SFC to take over regulation of a particular issuer where:

"Conflicts of interest may arise between the Exchange and persons whom the Exchange regulates, including applicants for listing and listed issuers".

One case where this has occurred is United Company RUSAL Plc (0486), which is in litigation against an HKEx subsidiary, London Metal Exchange, and the only other case we know of is First China Financial Network Holdings Ltd (FCFN, 8123), since its 2002 GEM listing. In its prospectus, FCFN said that "HKEx has indicated its intention to enter into the back office support services business and may thus compete with the Group".

Listing Rule 38.14 states that any person who considers that a conflict of interest may exist "should bring the facts of the matter to the attention of the Executive Director in charge of the Corporate Finance Division" of the SFC. So Webb-site wrote to Brian Ho Yin Tung, who holds that office, asserting the conflict of interest. We asked that the SFC take over the Listing regulation of Minsheng for as long as it was pursuing "strategic cooperation" with HKEx under the MOU. The response on his behalf was not encouraging:

"The press release of 23rd April makes it clear that the MOU between HKEx and China Minsheng Bank is the beginning of HKEx's collaboration with Chinese banks (plural). Having considered the nature of the arrangements between HKEx and China Minsheng Bank, we do not consider that there is a conflict of interest or potential conflict of interest issue as defined in paragraph 3 of Appendix 3 to the Memorandum of Understanding for the Listing of HKEx on the Stock Exchange dated 22 August 2001 as referred to in Listing Rule 38.02."

So far as we know, Minsheng is the only bank that has signed such an MOU with HKEx, but the SFC really makes our point that HKEx is likely to pursue "collaboration with Chinese banks (plural)" - so how can it be trying to make nice with the banks, many of which are listed in HK, while maintaining its vigilance for their compliance with the Listing Rules? How exactly does pursuing relationships with multiple banks have any bearing on whether a relationship with the first one is a conflict of interest? We call on the SFC to think again. Whether the conflict is perceived or real, the position of the listing regulator should be beyond doubt. The current situation undermines market confidence.

Guangdong Yueyun

At least holders of one small H-share issuer have had the sense to veto their board's proposal, saving themselves from a 1.5% value destruction, as explained in our second article today.

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Minsheng tax grab, HKEx conflicts 30 June 2014