Submission to HKEx on Weighted Voting Rights
21 November 2014
To: The Stock Exchange of Hong Kong Limited (SEHK), a wholly-owned subsidiary of Hong Kong Exchanges and Clearing Limited (HKEx)
We are today launching a petition at this link to keep 1-share-1-vote (保留一股一票), and urge readers to sign it.
Conflict of interests
The Concept Paper is unnecessary given the clear weight of public opinion from many sectors in the lengthy run-up to its publication. For almost a year prior to the Concept Paper, in various forums, it was clear that there is strong opposition to departing from the 1-share-1-vote principle that HK has maintained since the issue was last discussed in 1987. This lead-up was in effect a "soft consultation", and normally with such a negative result, that would have been the end of it, without proceeding to a formal paper.
The naked self-interest of HKEx in continuing to push for weakening our regulatory standards in the interest of its own profitability once again exposes the conflict of interests between being a regulator and a for-profit company. The Exchange has no profit incentive to care about quality, only about volume. Listing regulation should be transferred to the Securities and Futures Commission and the Listing Division should be merged with the Corporate Finance Division of the SFC (which already administers the Takeovers Code), producing a consistent and holistic set of regulations under a new "Listings and Takeovers Authority". This would also remove the bizarre "dual-filing" system in which we have two air-traffic controllers in the same airspace - resulting in clashes over companies such as the suspended-resumed-suspended-again China High Precision Automation Group Ltd (0591).
Removal of the regulatory role would free SEHK to pursue its commercial interests as an exchange, hopefully in competition with newer more innovative exchanges. Incidentally, abolition of your statutory monopoly on running a stock market would also drive down your obscene profit margins through lower transaction costs and result in better services, such as staying open during lunchtime and reducing minimum bid-offer spreads. HKEx could also then get the Government off its board as the Government would no longer have a regulatory excuse to be there.
Increasing ability to abuse minorities
Corporate governance in HK-listed companies is bad enough already, without making the abuse of minority shareholders even easier. At present, controlling shareholders have to put a proportionate amount of money at risk; their equity is the same as their voting rights. Therefore, if they are minded to benefit themselves with over-priced acquisitions, under-priced disposals, continuing supplies or sales of goods and services, or over-paying themselves as directors, then they will only benefit from the minority interest in each transaction. For example, if a controller has 51% of the equity, then when he will only get 49% of the benefit of each dollar extracted from the company, because the other 51% screws himself rather than the minorities. If we allow second-class shares, then a controller could have 51% of the voting rights but only a vanishingly small portion of the equity, and would therefore attain much closer to 100% of the benefits.
So if there is to be any discussion at all about differential voting rights, then we should be going the other way - for example, by requiring that new applicants have no shareholder or concert party with more than 30% of the voting rights, if necessary by converting some of their equity into non-voting shares, thereby reducing the dominance of controlling shareholders in our market, and requiring that anyone who wishes to take control must make a general offer and succeed in buying out the whole company. So the status quo is not "one extreme" as your Chief Executive put it in his blog on 24-Oct-2013, but sets a parity between equity and voting rights. We could go the other way.
Insider dealing and commitment
Second-class shares would facilitate greater insider dealing by controlling shareholders. They could easily vary their equity stake without materially changing their voting stake. For example, suppose that each A-share has 10 votes and each B-share has 1 vote, but each share has the same economic interest in equity. Then if a controller has positive inside information, he can buy 10 B-shares and sell 1 A-share, increasing his equity by 9 shares without changing his voting rights. For shareholders just below the 30% threshold, this would avoid triggering a general offer under the Takeovers Code when buying shares. For those between 30% and 50%, it would allow them to buy as much equity as they liked without breaching the 2% creeper limit (the maximum increase in voting rights in 1 year without triggering a general offer) under the Takeovers Code.
Conversely, if a controller has negative inside information, then she can sell B-shares and buy A-shares, maintaining her voting rights but cutting her economic stake in the company. For a controller just above the 30% voting threshold, this would allow her to later increase her equity stake without triggering an offer.
By comparison, in a 1-share-1-vote structure, controllers are more committed not to sell shares, so that they stay above 30% or 50% in order to avoid being subject to the 30% trigger or the 50% creeper on subsequent purchases.
The generation of inside information is not just driven by external factors or business performance. A controller who is minded to depress a share price by, for example, cutting or ceasing dividend payments, or increasing his pay as a director, or causing the company to make an over-priced acquisition from a disguised related party, can cut his equity stake before proceeding with these intentions and before they are made known to the board. A controller who is looking to privatize a company will first undermine the share price with such measures (often over a period of years) before making a low-ball offer to the public shareholders. If he can depress the price after first dumping his equity while maintaining his votes, then he will benefit even more.
Second-class shares would also allow a controller to increase his equity stake up to the free-float limit set by the Listing Rules (between 75% and 85% of the second-class shares), before making a general offer at a premium to buy out the remainder. For example, if A-shares represent 10% of the equity but 90% of the votes and B-shares represent 90% of the equity but 10% of the votes, then a person with half of the A-shares and no B-shares would start out with 45% voting control and 5% of the equity. If the minimum public float is 15% of the B-shares, then within a year he could buy 85% of the B-shares (carrying 8.5% of the votes) and sell 7.23% of the A-shares (carrying 6.51% of the votes). This would increase his equity from 5% to 80.78% at market prices without triggering a general offer, as his voting stake would only increase by 1.99%. To complete the privatisation, he would only have to pay a premium on the remaining 19.22% equity stake.
Second-class shares would allow potentially limitless equity fund-raising without loss of control. Even in a financial crisis, the controller could retain control while calling on outside shareholders to contribute further equity. This would make it harder for market forces to play a corrective role. By comparison, in a 1-share-1-vote structure, management votes are often diluted in a restructuring, and new management can more easily take over.
In Chapter 5 of your paper you have suggested other possible structures in which the voting rights or other governance provisions are distorted by the Articles of Association or constitution of the company, or in which special rights are conferred on persons who may or may not be shareholders to nominate or appoint a certain proportion or majority of the board.
In any market, the regulations on listed companies tend to impose obligations (such as the frequency, speed and depth of financial reporting) and governance provisions (such as board composition) which are higher than those imposed by company law and have regard to the dispersed nature of public ownership. In construction terms, the regulations build a firm ground floor that protects investors from falling into the basement. However, this ground floor only has value if it is the same in all buildings in that city. If some buildings have installed trap-doors in their structure through which investors can fall, then the investors would need to have detailed knowledge of the architectural blue-prints, or constitution, in order to know where the trap-doors may appear and how much they undermine the value. This destroys the benefits of having a common framework on which buyers can rely.
Those who argue for this caveat emptor approach are missing the point of Listing Rules, which provide a common minimum standard to which all applicants subscribe and which investors should be able to take for granted. If we allow listing applicants to opt out of selected listing rules via their constitutions, then we undermine the very fabric of the market. Investors would have to attach a discount to the whole market for the risk that companies will adopt such structures, or what we call "trapdoor articles".
Restriction to new applicants is infeasible
You have suggested that second-class shares, or trapdoor articles, might only apply to new listings. This is infeasible because any listed company (call it "OldCo") can transfer assets into a new subsidiary (call it "NewCo"), distribute the shares of NewCo to OldCo shareholders, and then NewCo can apply for a listing with its second-class shares or trapdoor articles, so it is impractical to somehow create a lower standard which only applies to new applicants without undermining the whole market.
It is a no-brainer that if investors are asked to choose between two otherwise-identical companies, one of which has, or could install, these trapdoors, and one of which has not, and could not install, these trapdoors, then the investors will pay more for the one which is safer.
As you know, I am a Deputy Chairman of the Takeovers Panel and have served as a member since 2001. It is clear that the Code can accommodate second-class shares and it has done in the past - in fact, I was the person who temporarily blocked the Lane Crawford privatisation in 1999 by buying enough of the B-shares of that company to veto the deal. However, as noted above, if second-class shares are allowed than the Code will often only come into play at a later stage in proceedings after a controller has already acquired a majority of the equity without triggering an offer.
However, it is difficult to see how the Codes could consistently be applied in cases where trapdoor articles have changed the way a board of directors is constituted, and therefore the way in which control over a company is maintained or changed. By "control" I mean the ability to change the majority of the board and thereby to take majority decisions in the board which affect the company's business. The Takeovers Code interpretation of "control", meaning 30% or more of the voting rights, would cease to be effective if board control can be attained or maintained by other means. For example, if a designated group of persons can nominate a majority of the board, then even if someone else buys 51% of the voting rights, he could not change the majority of the board and obtain de facto control.
Therefore the result of trapdoor articles would in effect mean that the Takeovers Executive of the SFC would be faced with frequent difficulties interpreting how the Code should be applied, and would often have to refer the cases to the Takeovers Panel, or its decisions would be appealed to the Panel. Like any law or regulation, the Code should have certainty and predictability, which benefits both shareholders and issuers. The difficulty of interpretation may be so great as to make the Code unworkable, and it may be necessary instead to exempt all companies with trapdoor articles from the Code and label them clearly as belonging to a second-tier market.
The competitive issue for HK
Your Chief Executive's proposition that HK risks "losing a generation of companies from China's new economy" is a false one. Good regulation improves the value added by markets, and investors will pay for that value. Companies which are willing to sign up to standards will get a higher price for their shares than they would in a market with lower standards, and the flip side of this is a lower cost of capital for the companies, both existing and new. There will always be exceptions to this overall outcome, but it is the overall outcome that matters. HK should be focusing on improving its legal and regulatory framework, not degrading it.
The vast majority of listing applicants and existing listed companies already have a controlling shareholder with at least 30% of the equity. They don't need their companies (or spin-offs) to issue second-class shares or pervert their constitution to cement their position. For the remainder with management who have been diluted by pre-IPO financing, most would have enough self-confidence in their abilities as managers that they would not need protections against removal, knowing that investors will only seek change in extreme circumstances and if they consider that new management can offer better value. This is just as true for "technology" companies as for any other industry, and the fact that shareholders have the reserve power to be able to change bad or stale management in itself provides a higher valuation than if they did not have that power.
David M Webb
To our readers: if you want to keep 1-share-1-vote (保留一股一票) then please sign the petition to HKEx.
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