The Placing Game
17 May 1999
In a bold move, Templeton Emerging Markets has announced that it will, as standard procedure, vote against the "general mandate" resolutions which give directors of HK-listed companies the power to issue new shares in the company without first offering them to existing shareholders. Sit up and take notice, because Templeton is probably the second largest investor in Hong Kong behind the Hong Kong government. We commend the move and urge all investors, including the government, to follow suit. Here we explain why.
Under the SEHK listing agreement, the general mandate may cover new shares equal to 20% of the existing issued share capital of a company, and the power continues in force until the conclusion of the next annual general meeting.
Company directors are inclined to argue that having this flexibility is in the best interests of shareholders, because it allows the company to tap the equity markets when they feel the price is right, reducing the cost of equity. Placings avoid the longer timetable which is needed for a rights issue (a rights issue is when each shareholder is offered shares in proportion to his shareholding).
Some are more equal than others
Last week Hong Kong Electric, which became the first target of Templeton's policy, argued that the dilutive effect of placings affects both majority and minority shareholders, and therefore minority shareholders are not disadvantaged. However, this is not true.
Under SEHK Listing Rules, a controlling shareholder may participate in a placing under the general mandate so long as they do not increase their percentage interest in the company. This allows them to do what is known as "new for old" placing where they sell existing shares and subscribe for new ones, to save time waiting for the new shares to be printed and listed. For example, if a company has 100m shares in issue, and a shareholder owns 50%, then he might sell 10m shares and subscribe for 20m new shares, raising his holding to 60m shares, but maintaining his percentage at 50% of the enlarged 120m shares.
The special privilege allows companies to ensure that their controlling shareholders maintain their stake, but does not prevent other shareholders from being diluted, unless they are lucky enough to be offered shares in the placing.
Furthermore, the privilege allows issuers to offer a large discount which can dilute minority shareholders' equity interests without affecting that of the controlling shareholder, since he is offered the same discount.
By contrast, a rights issue extends the discount to everyone, and thereby cancels out its dilutive effect. The discount then has no effect on the equity interest, for a given amount of funds being raised. For example, if a company does a 1 for 10 rights issue (1 new share for every 10 held) at 50 cents per share, that has the same end-result on shareholder wealth as a 1 for 5 rights issue at 25 cents.
For these two reasons it is time to ban the exemption, and treat placings with substantial (10%+) shareholders as connected transactions which require approval of minority shareholders. This may seem harsh, but if controlling shareholders are worried about dilution by not being allowed to participate in a placing, then they should turn it onto a rights issue instead. That's what control is all about.
Why it matters
The unfortunate fact in Hong Kong is that the general mandate is regularly abused. Firstly, as soon as it has been used, it is common practice to convene a general meeting and seek a new general mandate. Controlling shareholders are allowed to vote on such mandates, so they nearly always win a new mandate, and minority shareholders have no say. It is not unusual for smaller companies to exhaust 2 or 3 general mandates in a year. This makes a mockery of the 20% limit.
Secondly, there is very little transparency involved. Companies get away with simply declaring, or allowing placing agents to declare, that placees are independent of controlling shareholders and directors. On one occasion just last week, a company didn't even name the placing agent. We were simply asked to accept their word that the agent was independent. There are literally hundreds of companies which act as placing agents and assurances they give are often of little credibility. On other occasions, the placees are named, but they are BVI companies where you have no hope of identifying the owners.
We have to accept that it will never be possible to find out who the placees of an issue really are, if they don't want to be known. Even if real names were given, they might be acting as nominees for another person. The general mandate can therefore be used by a company to gradually dilute minority shareholders' interests in the equity and earnings of a company, while passing new shares to controlling shareholders or related parties. Yes, we know that's against the rules, but rules in themselves are not a deterrent, getting caught is, and that's unlikely.
By contrast, a rights issue will always allow existing shareholders the choice of whether to subscribe or allow themselves to be diluted. There is no reason why rights issues need to be underwritten. They can be done at deep discounts, to ensure that the rights are highly likely to be exercised, and the company will then get its funds, or they can be underwritten by controlling shareholders, who are usually the driving force behind the cash call in the first place. Therefor the expenses involved need not be great. In practice, we are talking about a small difference, since placing agents often charge almost the same fees as underwriters.
A Middle Ground
Last week HSBC Holdings plc issued shares equal to about 3.1% of its existing capital. That is within the UK framework, which (the last time we looked) allows for:
a maximum of 5% in any one year
a maximum of 7.5% in any three year period
a maximum discount of 5% to the market price
This is perhaps a reasonable compromise which will stop small companies "printing wallpaper" by repeated general mandate issues, while still allowing all issuers the flexibility for small issues in exceptional circumstances.
We call upon the Stock Exchange to bring Hong Kong's policy in this area up to scratch with modern corporate governance. In Singapore, the limit is 10% per year, with a maximum 5% discount, and no shares may be placed with directors or substantial shareholders. At the very least, we should meet these standards.
© Webb-site.com, 1999