Out of Sight
29 May 2001

Have you ever wondered why Cheung Kong (Holdings) Ltd (CKH) owns 49.9% of Hutchison Whampoa Ltd (Hutchison), and not a fraction more?

Readers with long memories (or good archives) will recall that in early 1997, near the height of the mainland infrastructure boom, the two companies restructured their infrastructure holdings. Hutchison sold its 35% stake in Hongkong Electric to Cheung Kong Infrastructure Holdings Ltd (CKI), while CKH sold its 85% stake in CKI to Hutchison in exchange for new shares in Hutchison and HK$5.6bn in cash. As a result, CKH's stake in Hutchison increased to 48.95%, which represented a 5% increase in the preceding 12 months, the maximum then allowed under the takeover code "creeper" limit without making a general offer. The result is the structure you see today.

In the circular on that deal on 15-Feb-97, CKH Chairman Li Ka-shing (Mr Li) wrote:

"Under the Takeovers Code...the CKH Group could still increase its interest in Hutchison over a period of time. The CKH Group would be able to increase its shareholding percentage to over 50 per cent. by 1st May 1997."

"Would be able to"? A bit vague, you might think, but in a clarification announcement dated the same day as the circular, Mr Li wrote on behalf of the board:

"The directors of CKH wish to state that, subject to regulatory requirements, it is the intention of CKH to increase its shareholding in Hutchison to beyond 50 per cent. as soon as possible after implementation of the Transactions and once it is free to do so under the creeper provisions of the Hong Kong Code on Takeovers and Mergers." (emphasis added).

So why have they not fulfilled this intention, more than four years later, having been free to do so since 1-May-97? We will give you some possible reasons. But first, some necessary jargon.

Terminology

Under standard accounting rules, if your company owns at least 20% of another company, but not more than 50%, then you normally treat it as an "associated company" or "associate" for short. Your votes give you "significant influence" over the associate. A similar type of company, where financial and operating policies are contractual with fellow investors, is known as a "jointly controlled entity".

By comparison, if your company owns more than 50% of the other company, then you normally have what is known as "statutory control" because you have a simple majority of the votes. You therefore normally treat it as a "subsidiary company" or just a "subsidiary". The difference is crucial in many respects.

Related Party Transactions

Under the Listing Rules of the Stock Exchange of Hong Kong Ltd, there are special rules known as "connected transaction rules" which govern the dealings of listed companies with their directors, substantial shareholders and their related parties. The related parties include certain relatives and companies in which the director or substantial shareholder has a 35% or more interest. All these persons are called "connected persons" of the listed company.

Subject to certain exemptions, including the de minimus exemption for small transactions, these rules require that when such a deal occurs, it must be presented to independent shareholders for approval.

However, those rules only apply to transactions by listed companies and their subsidiaries, but not to transactions by their associated companies. Rule 14.23(1) begins:

"A connected transaction is...any transaction between a listed issuer or any of its subsidiaries and a connected person..." (emphasis added)

That means that anything which your associated companies or jointly controlled entities do is deemed to be outside your control, and hence not something that can be treated as a connected transaction. You might well think it reasonable that when you lack majority voting power, the associated company cannot actually be stopped from doing anything so why ask your shareholders to vote on it? Unfortunately life is never that simple, as we will show.

Out of Sight

Now consider this, what if you are a listed company and you, and your listed controlling shareholder, both have large shareholdings in the associate, up to 50% each? Then you end up with something like this:

Now clearly, A-co and B-co between them control more than 50% (in this case, 100%) of Out of Sight Ltd (OSL), so they can determine all the actions of OSL. And since A-co has effective (but not statutory) control over B-co, it effectively controls 100% of OSL. But crucially, OSL is not a subsidiary of A-co or B-co.

A-co is a substantial shareholder of B-co and since OSL is more than 35% owned by A-co, that means that both A-co and OSL are connected persons of B-co. So any dealings between B-co and OSL would be subject to the connected transaction rules.

Loophole 1

Dealings between OSL and directors of B-co would not be covered by this, since that would just be dealings between two connected persons of B-co.

Loophole 2

Since OSL is not a subsidiary of A-co, its dealings with A-co or with any of A-co's directors or controlling shareholders are outside the scope of the connected transaction rules. This opens the door to "pyramid" benefits where A-co can use its effective control over B-co to extract benefits from OSL such as project management contracts, asset transactions, or favourable supplies of raw materials or purchases of finished goods, either for itself or related parties. Of course this is just a theoretical case, and we're not accusing anyone of doing this, but the opportunity is there for the taking in such structures, because they are outside the scope of the listing rules.

If A-co were to take another 0.2% of B-co, then B-co would become a 50.1% subsidiary of A-co, and hence the two interests in OSL would be combined and OSL would also become a subsidiary of A-co, instantly becoming subject to the connected transaction rules as applied to A-co.

So here's the "connected transactions" table:

The CKH-Hutchison Structure

There are, and have been, many such "double-associate" structures in the CKH-Hutchison pairing, partly because the two listed companies have a habit of jointly bidding in government land sales. A brief inspection of the list of associates and "jointly controlled entities" of both companies provides the following sample:

These are not small businesses. Amongst the current 50:50 joint ventures of CKH and Hutchison, there is the 672,000 sq ft Harbourfront Landmark in Hunghom, the 1.4m sq ft "Metropolis" project near the KCR Station in Hunghom, and a 4.4m sq ft development at Tung Chung Station Package 3. Another project, the 1.0m sq ft Victoria Tower in Canton Road, Kowloon, is 42.5% owned by each of CKH and Hutchison so that is probably owned by Konorus Investment Ltd in our table above. Another joint project is the 1.9m sq ft development at Huangsha Metro Station, Guangzhou, PRC. You get the picture.

Tracking all this down involves comparing the lists of properties in the accounts of CKH and Hutchison, which is not made easier by the inconsistent treatment of the projects between the two companies. CKH accounts in square metres while HWL accounts in square feet! Some of the projects are subject to profit sharing arrangements with joint venture partners such as the MTRC and KCRC. In that case, CKH does not state its percentage interest in those projects, whereas Hutchison does. CKH just lists them under "properties in which the group has a development interest".

It is also worth noting that, despite the close relationship between CKH and Hutchison, they maintain separate auditors. Deloitte Touche Tohmatsu audits CKH, while PricewaterhouseCoopers audits Hutchison. That means that neither of them has to look at the two companies on a combined basis.

Transparency and Opacity

The accounting treatment of a subsidiary is very different to that of an associate in your group accounts. For a subsidiary, you combine all the assets and liabilities into your group balance sheet, one line at a time, and then deduct a "minority interest" for the share of the total which belongs to the outside shareholders of the subsidiary. This process is known as "consolidation" and you also adjust for any inter-company loans.

For example, if the parent has $100 of bank debt and the subsidiary has $100 of bank debt, then the group balance sheet has $200 of bank debt. But if the parent has lent money to subsidiary, then this asset and liability (respectively) disappears when you consolidate the two balance sheets.

By contrast to the transparent treatment of a subsidiary, when accounting for an associate, you record only your share of the net assets of that associate, in a single line in your group balance sheet, in which all such associates are grouped together.

Similarly when preparing the consolidated profit and loss account, for a subsidiary, the revenue and expenses are combined with the parent one line at a time, whereas for an associate, you only include "share of profits or losses of associates" as a single line. 

In the case of all the joint ventures of CKH and Hutchison mentioned above, both listed companies just include them as associates in their accounts. There is no way for you to know how much debt, assets or liabilities are held by the associates, or what their sales or expenses are. It make it impossible to know what is the total debt and overall gearing of the group (including associates 100% owned between the pair) or what the overall profit margins really are.

Conclusion

So there you have it, with a bit of an accounting lesson thrown in, you now have at least two possible reasons why CKH has not executed its intention, stated in Feb-97, to make Hutchison a subsidiary.

There's nothing we can do about the accounting treatment at this stage, which complies with accounting standards. But the Listing Rules should certainly be amended to bring transactions by such "double associates" into their scope. If a company is deemed to be a controlling shareholder (by owning 35% or more) of a second company, then all their interests in a common associate should be combined for the purpose of determining whether they control more than 50% of the associate. And if they do control more than 50% of the associate, then clearly that associate should be brought inside the scope of the connected transaction rules.

© Webb-site.com, 2001

Organisations in this story

• CK Hutchison Holdings Limited
• Hutchison Whampoa Limited

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