Preventing cash shells
3 March 2016
There were, once again, a number of abusive transactions in HK last year, including wholesale disposals by listed companies of their core businesses without distributing the proceeds, and cases in which companies take the proceeds and deploy them into a completely new line of business without minority shareholders having any say in the matter. This is a huge deviation from the founding principles of the joint-stock company, in which investors pooled their capital in "association", usually with limited liability and with a particular set of "objects" to pursue a joint enterprise.
There are also some companies that squat on vast amounts of surplus capital not needed in their core business, often accumulated from retained earnings (having paid no dividends or insufficient dividends), asset disposals, or from raising excessive amounts of cash in placements, open offers or rights issues for vague purposes such as "general working capital" when the real purpose is to position votes or discounted shares in friendly hands or to dilute other shareholders who have started to exercise their ownership rights. In HK, boards choose shareholders, not the other way around.
Unfortunately, there is nothing in the Listing Rules which will prevent a company from behaving this way. The risk that they will do so, particularly after management changes, results in even good companies being discounted for the risk of going bad, increasing the cost of capital for the economy, because their share prices are lower than they would be in a more trustworthy market.
Rather than address these problems, which occur on both the Main Board and GEM and at all size levels, the for-profit regulator, Hong Kong Exchanges and Clearing Ltd (HKEx, 0388), is now proposing a "Third Board". HKEx is rather like a village that refuses to build a proper sewerage system and instead digs another cesspit to accommodate a larger population, ignoring the fact that eventually nobody wants to live in a disease-ridden village. We'd rather build a proper sanitation system.
In a market where the vast majority of companies have a controlling shareholder, investors invest in a company in order to participate in its stated business. They accept that they will not have much influence over how that business is pursued, but they do at least expect that the company will pursue it, and will distribute any profits or excess capital that it does not need for that business rather than launch into something else, speculate in the markets, or simply hoard it in the bank.
So here's what we propose, to build the sanitation system:
- At each Annual General Meeting, any company whose net cash exceeds 50% of its net tangible assets (the "Cash Shell Limit"), must propose an ordinary resolution to distribute at least the excess amount, and controlling shareholders, directors and their associates shall be prohibited from voting on that resolution.
- "net cash" means cash, deposits, bonds and financial assets (including listed investments) minus interest-bearing obligations after deducting net cash attributable to minority interests in subsidiaries.
- "net tangible assets" are those attributable to shareholders after deducting minority interests in subsidiaries.
- Any Notifiable Transaction or Share Transaction which would result in a company breaching the Cash Shell Limit must be made conditional on shareholders' approval of a distribution to bring it below the limit. All shareholders would be permitted to vote on that distribution, so that controlling shareholders can still direct strategy if they approve the distribution.
- In each case, the distribution must be paid in cash within 60 days after the AGM/EGM or completion of the transaction which triggers the breach, whichever is later.
- No issue of equity for cash will be permitted if it will result in a company breaching the Cash Shell Limit. To prevent avoidance, this prohibition will also apply to convertible bonds, subscription warrants, options or other instruments carrying equity rights, whether or not they are listed.
- Banks, licensed deposit-taking companies, insurers and securities and futures brokers (and their holding companies) would have a qualified exemption if they can show that a statutory regulation requires them to keep or achieve a level of capital that exceeds the Cash Shell Limit.
- Chapter 21 "investment companies" would be exempt from the AGM vote until the first AGM that falls at least 12 months after listing, to give them time to invest their initial fund-raising.
Now, before anyone cries that this will make their shell-peddling business harder, let's be clear that it won't cure all ills. It will still allow creative acquisitions that do not trigger the reverse takeover rules because they don't produce a new controlling shareholder. However, the Cash Shell Limit will at least fix one major problem, and introduce a new level of equity discipline to the market. The Cash Shell Limit is expressed in terms of attributable net cash and attributable net tangible assets, not gross assets, because it aligns with the equity owned by shareholders.
The Cash Shell Limit is a bright-line test that everyone, including listed companies and their advisers, can understand. It removes some of the fog from the Listing Rules and reduces the need for subjective judgment by the Stock Exchange and Listing Committee which opens it to allegations of favouritism or negative bias when reviewing proposed transactions. It should also accelerate the transaction process. We would expect regulators, the Listing Committee, issuers and their advisers to be in favour of that.
The AGM vote will allow companies and boards with good reasons for cash retention to make their case to minority shareholders that they should leave the cash in the company by voting against the distribution.
There is ample precedent in our Listing Rules for giving minority shareholders a say over equity structure. Under existing rules, no company can conduct a rights issue or open offer larger than 1 for 2 without minority shareholders' approval. Refreshments of the 20% general mandate to issue new shares, other than the AGM approval, also require minority shareholders' approval.
This generous limit will also not impede the healthy development of businesses, some of which need to retain all their profits in order to expand, building new factories, investing in research and development, or making acquisitions. It will simply stop mature companies from hoarding cash that could be more usefully deployed by investors elsewhere in the economy.
To have any substantive impact, the Cash Shell Limit must apply to the whole market, not just to new companies or on a new board. You cannot fix the sewerage problem that way.
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