Listing Rules Review Part 5: Rules Roundup
17 April 2002
|In this article|
Removal of directors
It's only once in a blue moon that the market gets consulted on amending the Listing Rules in such a major fashion, so it's a shame that there isn't an organisation like HAMS to provide a complete and thorough analysis and represent investor interests in the process.
Nevertheless, we'll have a go at picking out some of the remaining highlights from the 176-page consultation paper that we haven't previously covered, and giving our views.
The SEHK has reviewed the thresholds and conditions for classification of acquisitions or disposals by listed companies into "Discloseable" transactions (those that must be announced), "Major" transactions (those that require shareholders' approval) and "Very Substantial" (those that might be treated as a new listing), and the tests used to determine these classifications are also being revised.
The Assets Test
In the past, the Exchange has compared net assets being bought or sold with net assets of the listed company, to determine the percentage. This has led to anomalies where companies have negative net assets (as in the case of PCCW) because then every deal becomes a Major Transaction. The SEHK proposes to move to a "Total Assets" test which looks at the top half of the balance sheet to compare changes in the core business, without regard to how it is financed.
In principle, this is the right way to go. Investors are primarily concerned about the materiality of a transaction relative to the existing business of the company, excluding the effects of the capital structure (cash and debt in the balance sheet). We support the proposal to move to a "Total Assets" test, but on the following conditions:
- "Total Assets" should exclude cash, bank deposits and short-term investments held as current assets. This is because it would otherwise be easy to inflate the total assets denominator just before the year-end by borrowing large amounts of money and putting it back in the bank savings account, or into the bond or stock markets. That would then allow the company to make larger transactions in the following year without shareholders' knowledge or approval.
- "Total assets" should exclude intangible assets. This is because intangible assets are inherently less certain and realisable than fixed assets such as real estate. For example, we have seen companies in the past attach intangible asset value to their own listing (which obviously cannot itself be sold), or to their brand-names. Directors might be tempted to attach excessive value to intangible assets in order to reduce disclosure and approval requirements for company transactions.
The Consideration Test
Here, the SEHK proposes a similar amendment, to compare the consideration paid or received in a transaction with Total Assets of the listed company. That is wrong, because it compares apples and oranges - that is, the price of geared assets are compared with the value of ungeared assets. It ignores any debt or other liabilities which are acquired or removed as part of the transaction.
Therefore, the denominator should be the Total Assets of the listed company (again, excluding intangibles, cash, deposits and short-term investments) and the numerator should be the consideration plus any net debt being acquired or realised - let's call it the "Adjusted Consideration".
For example, if you are buying a company for a price of $1,000 and that company has $500 of net debt, then the Adjusted Consideration for the "ungeared" company is $1,500. Conversely, if the target company has $200 of net cash, then the Adjusted Consideration for the ungeared company is only $800.
New transaction classification thresholds
In a move which tacitly admits that shareholders have been kept in the dark, and without a say, on too many important matters, the Exchange proposes to lower the classification thresholds for Discloseable and Major Transactions.
We strongly support these proposals, which are to reduce the definition of "Discloseable" from 15% to 5%, and "Major" from 50% to 25%. What this means in practice, is that before a company can go and buy or sell 25% of your assets, it must seek shareholders' approval, and whenever it does something that varies total assets by 5%, then it must tell the public. These thresholds are in line with international practice and we urge the SEHK to proceed with them.
The Very Substantial Acquisition (VSA) threshold, at which the company may (with certain exceptions) be treated as an applicant for new listing, remains at 100% (i.e. a doubling of the total assets) and this is acceptable.
Very Substantial Disposals
The SEHK proposes a new classification of "Very Substantial Disposal" or VSD. While the paper appears silent on the consequences of a VSD classification, we presume that, in line with a VSA, it means that with certain exceptions, the company would be treated as a new applicant for listing. In that case, the rules should require that a VSD and a VSA must be made conditional on such listing being granted, otherwise it would be a handy way to force a delisting of the company without the normal procedure being followed.
We support the concept of a VSD, because it would at least provide another route to prevent major asset-stripping proposals (such as the proposed Boto Buy-out) where the remaining business may not qualify for listing due to inadequate track record.
However, the proposed threshold at which this applies is wrong. The SEHK starts on the right lines by saying:
"In a [VSA], the existing business of the issuer will constitute less than half of the enlarged business after the acquisition. Therefore, logically, a [VSD] should apply where over half of the business has been sold..."
Right so far - if a VSA is a doubling, then a VSD is a halving. But then they say:
"For practical reasons, we propose a threshold of 75% for [VSD]s"
Hello? The last time we checked with our maths professor, a half was 50%, not 75%. The SEHK does not specify any "practical reasons" and we believe that the VSD threshold should be 50%.
Loans should be treated as notifiable transactions
There is another loophole that needs closing. At present, a company can make loans of any size it likes to an independent third party, or to an associated company, without shareholders' approval. Disclosure is only required if a loan exceeds 25% of net assets, but approval is never required. This is wide open to abuse - a very substantial amount of money can be "lent" to a third party, never to be seen again when they default. Alternatively, if a loan is secured against property or other assets, the only way to get the money back may eventually be to foreclose on the assets, resulting in a "Major Transaction" in the acquisition of property which cannot be refused.
In a recent example, Interchina Holdings Ltd, a company we have written about before, announced that it had agreed to "participate and invest" in the Urban Development Scheme of Changsha New Sports City in Hunan Province, PRC. In actual fact, this deal was a loan of up to RMB480m (HK$453m) to a third party, secured on property, and the commitment amounts to 79.5% of the unaudited net assets at 30-Sep-01. Surely, such a major disposal of the company's money should be treated as a Major Transaction. But the SEHK responded to our complaint as follows:
"The co-operation agreement as disclosed in the announcement is not a notifiable transaction under Chapter 14 of the Listing Rules as it does not involve any acquisition of assets."
We submit that loans by any listed company (except for normal loans by licensed banks) should be subject to the same classification rules as any other notifiable transaction - i.e. discloseable at 5% of Total Assets, and subject to shareholder approval at 25% of Total Assets.
Ironically, if Interchina had been purchasing bonds which were secured against the same property, then that might have been treated as a Major Acquisition of assets (the bonds) rather than a loan, even though the end result, namely a loan against property, is the same.
GEM should be the same
SEHK also concludes that all the classification Rules for GEM should be the same as the main board, and we agree.
The consultation paper falls short on this. There is a discussion of the various people who escape the scope of the connected transaction rules by not being an "associate" of a director, chief executive or substantial shareholder (let's call them a "Core Person"). But then the SEHK concludes with a proposal to do nothing while listing several alternatives. We think the definition should include:
- Any settlor or beneficiary of a trust of which a Core Person or his family is a beneficiary or discretionary object, and any companies or other entity controlled by any such trust;
- In relation to a substantial corporate shareholder, any person or concert party who controls 30% or more of a corporate substantial shareholder, whether directly or through a chain of such shareholdings
To take an example, currently the trust of Li Ka-Shing (Mr Li) controls 36% of Cheung Kong (Holdings) (CKH), which as shown in this group chart, controls 49.9% of Hutchison Whampoa (HWL), which controls 84.6% of Cheung Kong Infrastructure (CKI), which controls 38.9% of Hongkong Electric (HKE). That makes CKI a connected person of HKE as a "substantial shareholder", and also HWL is a connected person of HKE because it is the holding company of CKI (or in other words, because CKI is its subsidiary). However, CKH and Mr Li (who is not a director of HKE) are not connected persons of HKE.
The amendment would recognise the reality that everyone in that chain is a connected person of HKE, and that Mr Li through CKH controls Hongkong Electric (as he is deemed to under the Takeover Code). This is important, because it means that transactions between HKE and CKH or Mr Li would be subject to disclosure or approval by HKE minority shareholders.
To take another example, for several years, Peter Woo Kwong-ching (Mr Woo), until he resumed Chairmanship on 1-Apr-02, was not a director of Wheelock & Co Ltd, and as such, the trust of which he and his family are beneficiaries (the settlor of which was his late father-in-law, the shipping tycoon Y.K. Pao) was deemed to be a substantial shareholder, but Mr Woo and his family were not "connected persons" of Wheelock and so were free to deal with the group outside the connected transaction rules. Under our proposal, any such transactions would have been covered by the rules.
Associated companies in connected transactions
The SEHK has also picked up on something we wrote about last year, namely that off-balance sheet vehicles, such as 50:50 joint ventures between Cheung Kong and Hutchison Whampoa, are outside the scope of the current connected transaction rules, so the joint ventures can engage in almost any transaction they like, even though they are ultimately controlled by the same person.
The SEHK proposes that If the listed group and connected persons together have control (meaning over 50% or the ability to control the board) of an associated company, then such associated companies shall fall "within the regulatory net for the purpose of connected transactions" and of course, since we brought this up in the first place, we support them.
But we go further than this. The rules regarding Discloseable and Major Transactions should also apply to such off-balance sheet vehicles, proportionate to the listed company's percentage interest in such vehicles. This is firstly because that makes it consistent with the proposed treatment for connected transactions, and more importantly because such deals can be just as significant to the balance sheet of the listed company as if it was a subsidiary, due to the funding provided by the listed company. Don't just take our word for it, ask Enron - it was deals by off-balance sheet partnerships that helped crash the company.
At present, there are obligations to disclose certain advances and guarantees to associated companies under Practice Note 19 (where these exceed 25% of net assets), but these deals do not get assessed by the rules for notifiable transactions. So one easy way to get money off balance sheet is first, to set up a 50:50 joint venture with a controlling shareholder, with just $2 of share capital (1 share each) and later, to shovel piles of cash into it as "advances to an associated company", with the connected party putting in its share of the loan. The associated company can then go off and do Major transactions without shareholders' approval, and this should be stopped.
De minimis thresholds
The SEHK proposes to adjust the de minimis or minimum threshold for disclosure of a connected transaction to the "higher of HK$1m or 0.01% of Total Assets". Currently the limit is the higher of $1m and 0.03% of net assets. They also propose adjusting the minimum threshold for shareholders' approval to the higher of $10m and 1% of Total Assets (currently 3% of net assets).
We agree that the test should be based on Total Assets, but again, Total Assets should exclude intangibles, cash, deposits and short-term investments. We disagree with the limit itself. The exemption is designed to remove the need for disclosure or approval if the costs of compliance would be prohibitive, but the cost of disclosure by way of preparing, approving and filing an electronic announcement (which is all that will soon be needed) is a lot less than $1m - perhaps closer to $10,000.
Accordingly, we think disclosure should be triggered at the greater of $100,000 or 0.01% of Total Assets. For companies with Total Assets under $1,000m, that means the disclosure threshold is $100,000. Under the SEHK proposal, the $1m limit would apply until Total Assets reached $10,000m - which is probably only satisfied by fewer than 50 companies.
In the case of shareholders' approval, there are additional costs of producing a printed circular, getting an opinion letter from a financial adviser, and holding the shareholders' meeting. But this should not normally exceed $200,000. Accordingly, we think the limit should be the greater of $2m or 1% of Total Assets.
Bear in mind that, for small companies, $10m is a lot of money - it could easily amount to 10% of total assets. Under the SEHK's proposal, a company would need total assets of $1,000m before the 1% figure would be higher than $10m, and this opens the door to widespread abuse.
Not only that, but we could have the bizarre circumstance of a company having a $9.9m deal with a connected party which was a Discloseable transaction (if Total Assets were less than $198m) or even a Major Transaction (if Total Assets were less than $39m) without the deal requiring independent shareholders' approval.
Post-IPO lock-up periods
The SEHK attempts to close a loophole in the Listing Rules regarding the lock-up by controlling shareholders. Currently the lock-up period begins only from the first day of dealings in the stock, which opens a window for sale in the typically 10-day period between a prospectus and the commencement of dealings. The SEHK suggests moving the start of the lock-up period to the date of the prospectus. Wrong! That still leaves a period between the "Latest Practicable Date" prior to the printing of the prospectus and the date of the prospectus itself. This can typically be 1-2 weeks, depending on bank holidays. So the lock-up should apply from the "Latest Practicable Date" onwards, to close that loophole completely.
The current black-out period for dealings by directors in the shares of their companies is 1 month prior to the board meeting for the final or interim results, and the SEHK proposes no changes to that, but to introduce a 2-week black-out period prior to quarterly results. By comparison, London rules require a 2-month black-out before the interim or annual results.
We have explained in the past that the basis of the black-out period is wrong. It provides a direct incentive for the directors to delay publishing results until the last possible moment allowed under the Listing Rules, so that they can deal on the inside information up to 1 month before those results are published. Under current rules, annual results must be out by 4 months after the year-end, which gives them 3 months to play with inside information after the year end.
Even if the reporting deadlines are shortened to 3 months, as proposed, that still allows 2 months of post-year-end insider dealing. There are almost never any prosecutions under the insider dealing laws for this, because it is impossible to prove when the directors knew that the company had taken a dive or found a gold mine.
Any company which doesn't have a good idea how much it has made or lost by the end of a financial period really should not be listed. Monthly management accounts would tell the board what they had made for the first 2, 5 or 11 months of the quarter, half-year or year,, and the final month can be extrapolated or estimated from orders in hand.
So instead of an incentive to delay the results, we call for an incentive to announce them earlier, by setting the black-out period from the end of the financial period until the results are announced. That means that directors who want more dealing time should get their results out faster.
There are insider problems with directors' pay both in diversified markets such as the UK and US, where companies normally have no controlling shareholders, and in controlled markets such as Hong Kong. Shareholders have no direct say over how much directors pay themselves with company money, but when the director in question is also a controlling shareholder, things are even worse, because minorities cannot pressure for the removal of over-paid and/or incompetent directors.
Any other contract with a director is a "connected transaction" potentially requiring shareholders' approval, but directors' employment contracts are not currently treated that way. So paradoxically, if a controlling shareholder attempts to sell an empty cardboard box to his company for $20m, then it is a connected transaction subject to independent shareholders' approval, and would be voted down, but if he simply awards himself a $20m bonus as a director (via the board he controls), then nothing stops him.
In a free market, very few investors object to the principle of paying what it takes to hire and retain the right management. That is not the issue. Look inside the annual report, and you know before you invest, what the board was paid last year. But you have no idea how much they might take this year. So there is always the risk that the board will double or even quadruple their pay without explanation, as happened with Sunday Communications in 2000.
What shareholders need is clear and advance knowledge, and the right to approve or reject, any profit-sharing or bonus schemes, or other items that might cause a significant increase in a director's remuneration in the future. We suggest "significant" should mean 20%. Put simply, anyone who thinks they deserve 20% or more increase next year for doing the same job as last year, should explain why, in what circumstances, and get approval of shareholders other than himself.
The listed companies will doubtless claim that this restricts their ability to hire and retain good directors, but that is nonsense - especially when the directors are also the controlling shareholders - they are hardly going to work elsewhere. In practice, most investors would support any scheme which incentivises good performance and doesn't look excessive by the previous standards of the company.
Many IPOs these days do include service agreements in which the directors' (controlling shareholders') bonuses are capped at a fixed percentage of profits, and sometimes subject to a minimum profit target. That's good, but the problem is, these agreements can easily be replaced after the IPO, or when they expire, without any shareholders' approval.
One of the greatest fears of investors facing a discounted privatisation offer for their shares is, "if we reject this offer, will the management screw us in future?". One of the many ways in which a controlling shareholder can legally penalise minorities is to cut the dividend and take out the profits as directors' bonuses instead.
The SEHK does not support our view, instead trotting out the idea that directors can be trusted to set their own pay, approve their own bonuses, and tell us after the fact. If we want a high quality market, then we have to get past the current regime in which the controlling shareholder sits down at the end of the year, looks in the mirror and says "how much of this profit shall I keep for myself"? Only once in history (nearly a decade ago, in the Sincere case) have the regulators intervened to persuade the board to put back excessive bonuses.
The SEHK does propose disclosure of individual directors' pay, and we support this. If you are a director and don't like the lack of privacy, then don't take your company public. By definition, a public company has to be accountable to public investors, and that includes disclosure of all directors' dealings with the company, including pay.
Removal of directors
Another matter, which is not discussed in the consultation paper but urgently needs addressing, is the procedure for shareholders to appoint or remove a director.
Under the requirements of the Listing Rules, the articles of association of a company must allow for the removal of a director by "special resolution", unless otherwise provided by law. That means a 75% majority of votes is needed to remove a director. This is wholly inconsistent with the fact that a director can be elected with an "ordinary resolution", requiring only a 50% majority of votes.
The ridiculous consequence of this is that even if someone acquires 51% ownership of a company, he cannot remove the directors. Instead he has to "flood the board" by convening a general meeting in which he nominates as many directors as there are already, plus one for a majority. Even then, the old directors might stay put.
The rules should require that all companies (including existing ones) change their articles so that any director can be removed from office by ordinary resolution of shareholders.
Maximum number of directors
Another little known fact is that many companies have a maximum number of directors, which has been set in shareholders' general meeting, sometimes before the company even went public. That number is often not published. So if you are a shareholder nominating new directors, you don't know how may will fit into the boardroom. The rules should require that the maximum number of directors be set out in every annual directors' report and announced to the SEHK if it changes.
Delays in Requisition of Meetings
The Listing Rules do not set a maximum period in which a board must respond to a requisition from shareholders for a general meeting. Nor do they set a maximum notice period. This allows entrenched management to drag things out for months and abuse the company in the process.
So the rules should require them to publish a notice of general meeting within 21 days of a requisition, and that the notice period for the meeting should not exceed 28 days. The SEHK should require companies to adopt these changes in their articles, and that all directors should abstain on the resolution to amend the articles, to stop them voting it down.
The rules should also require that delivery of a requisition to the Hong Kong principal place of business be deemed sufficient. Some companies have rejected requisitions on the grounds that they should have been sent to a brass nameplate in Bermuda or the Cayman Islands.
There are regular cases to illustrate this problem. Take King Pacific International Holdings Ltd, which has been in boardroom battles for many months. In Feb-02, according to his announcement, an outside shareholder, who held the necessary 10% of the company, tried to requisition a general meeting. 21 days later, the incumbent board had not convened a meeting, so the shareholder tried to convene one himself, publishing a notice of SGM to increase the maximum number of directors to 41 and appoint 21 new directors. The meeting was to be held on 15-Apr-02.
The incumbent board responded on 12-Apr-02 by appointing no less than 34 new directors - presumably because they thought the maximum already allowed this.
Meanwhile, on 15-Apr-02 the outside shareholder held an SGM to appoint the 21 people nominated in the notice he had previously published. So at the last count, there were about 62 directors. At the rate we are going, there will soon be more directors than shareholders in this company.
In another case, an offeror has acquired 58.45% majority ownership of Symphony Holdings Ltd, but the incumbent board has not stepped aside, so the offeror on 8-Mar-02 has requisitioned a general meeting to increase the number of directors and flood the board. However, the incumbent board on 25-Mar-02 then published a notice of General Meeting which does not take place until 28-Jun-02 - allowing for three long months of possible foot-dragging and frustrating actions such as diluting the offeror with new share issues after the offer period is over.
We need to get beyond this "rent a crowd" board battle system, and the SEHK can facilitate this with our recommended changes to the Listing Rules.
The memorandum and articles of association (M&A), which are the constitution of a company, are almost impossible to find. A summary is included in the prospectus of an IPO, but that is the last that you'll ever see. You have to be a registered shareholder (which most people are not) in order to be entitled to a copy of the M&A. Even then, you have to pay for a hard copy, or go down to the companies registry and print it off a microfiche.
Now that we have a fully electronic filing system on the SEHK web site, there is no reason to restrict the availability of these documents. The M&A of every company should be scanned into PDF format and made available for download from the SEHK web site.
Furthermore, we have the age-old "documents available for inspection" system in which important information is often buried in the "material contracts", or directors' service agreements. The only way to view these documents is to come to Hong Kong and visit the relevant place during the typical 14 days allowed for the exercise. In the past, we have gained important information, such as correctly predicting the demise of the Star TV-PCCW joint venture, by looking through these documents. We couldn't even take copies, so we had to bring a Dictaphone and a note-pad.
These documents should again be scanned and filed with the SEHK web site, and available for any investor, without discrimination as to whether they can make it to Hong Kong in time to view them. We are trying to be an international market, after all.
Well that's all we have time for folks, but don't take our silence to mean agreement with those areas of the consultation document that we have not had time to cover in detail.
If we had to make one overall remark about this consultation paper, it is that it demonstrates Hong Kong's continuing reluctance to take the big steps needed to establish a high quality market, and to install the checks and balances that are necessary when there is a predominance of controlling shareholders. Under the SEHK's proposals, unless our amendments are accepted, Hong Kong will continue to have:
- non-independent "independent directors" who are chosen and elected by controlling shareholders and are unaccountable to, and have no mandate from, independent shareholders;
- massive non-pre-emptive share issues, which repeatedly dilute ownership and voting rights;
- a rigged show-of-hands voting system on anything other than connected transactions, frustrating the fundamental principle of 1 vote per share;
- insider dealing long after financial results are known to the management, but before they are published; and
- controlling shareholders who can decide their own bonuses as directors, before paying out dividends to minorities.
More than anything, this consultation paper fails to achieve its stated goal: Hong Kong still has a long way to go to reach international best practice.
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