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The Fourth Asian Roundtable on Corporate Governance Mumbai, India, 11-12 November 2002. Shareholder Rights and the Equitable Treatment of Shareholders. Manish Singhai Vice President & Portfolio Manager Alliance Capital Management, Singapore.

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The Fourth Asian Roundtable on Corporate Governance Mumbai, India, 11-12 November 2002


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The Fourth Asian Roundtable on Corporate Governance

Mumbai, India, 11-12 November 2002

Shareholder Rights and the Equitable Treatment of Shareholders

Manish Singhai

Vice President & Portfolio Manager

Alliance Capital Management, Singapore

Protecting Minority Shareholders from Improper Dilution

The views expressed in this paper are those of the author and do not necessarily represent the opinions of the OECD or its Member countries, the ADB or the World Bank

expropriation
Expropriation

The Risk of Expropriation is the Major Principal-Agent Problem for Listed Companies !

Three Common Modes Employed by the “Insiders” (Controlling Shareholders & Managers)

  • Profit Appropriation
  • Tunnelling of Assets
  • Improper Dilution

Manish_Singhai@acml.com

profit expropriation
Profit Expropriation
  • Transaction of Goods or Services with Affiliates at Non-Market prices
  • Improper Selection of Related Companies as Vendors
  • Disproportionate Allocation of Shared Revenues/Costs to Affiliates
  • Outright Theft or Fraud

Manish_Singhai@acml.com

tunnelling of assets
Tunnelling of Assets
  • Transfer of Assets at Non-Market Prices
  • Value-Destroying Acquisitions & Investments to help Related Companies
  • Off-Balance Sheet Loan Guarantees
  • Expropriation of Corporate Opportunities by Related Companies

Manish_Singhai@acml.com

improper dilution
Improper Dilution
  • Exclusive Issuance at a Discount to a Sub-set of Investors
  • Deeply Discounted Rights Issues
  • Excessive Executive Compensation by Issuing Shares at a Steep Discount
  • Using Shares to pay for Acquisition of Unlisted Entities at Inflated Valuations
  • Massive Dilution Induced by Financial Distress

Manish_Singhai@acml.com

dilution case study 1
Dilution - Case Study 1

Private Placement of Convertible Preferred Stock at a Discount to Market Price

Shinsegae Department Stores, Korea

  • 1mn Preference Shares convertible 1:1 into ordinary shares 3 years from the issue date of 31-Dec-01
  • The issue price of W65,000 reflected a 14% discount to the closing price of similar preferred shares on 17-Dec-01 (the announcement date), despite the new shares carrying a higher dividend rate (15%) than the old (10%)
  • The choice of instrument and the manner of placement led to serious market speculation that the issuance was intended to shore up the controlling shareholders’ stake in the firm at a relatively lower cost

Manish_Singhai@acml.com

dilution case study 2
Dilution - Case Study 2

Rights Issue at a Deep Discount

Thai Farmers Bank, Thailand

  • TFB raised US$800mn @ Bt88 apiece in 1998 to re-capitalize its balance sheet. At the time, it claimed that it would not need to raise any further capital. A year later, TFB announced a 1:1 rights issue at Bt20 per share, a steep discount to the prevailing market price of about Bt70.
  • Minority shareholders faced a Hobson’s Choice - invest more money to maintain stake, or face a massive dilution since the ex-rights market price was bound to be significantly lower.
  • Several minority shareholders did not want to invest more money in TFB. Worse still, several others were not able to participate since the rights offer did not meet all the requirements under the US securities law.

Manish_Singhai@acml.com

dilution case study 3
Dilution - Case Study 3

Over-payment for an Unlisted Acquisition Hyundai Mobis, Korea

  • Hyundai Mobis’ proposed the purchase of a 50%+ stake in Bontec from the family of its own controlling shareholder, MK Chung.
  • Hyundai Mobis was to pay for the acquisition with its own shares.
  • MK Chung had purchased the stake in Bontec in Oct-2001 at a price of W13,000 per share, and the sale to Hyundai Mobis at an estimated price of W60,000 per share represented a capital gain of 360% in a 9 month period
  • Negative market reaction forced the management to seek investor feedback; the transaction was subsequently scrapped

Manish_Singhai@acml.com

dilution case study 4
Dilution - Case Study 4

Employee Bonus Share Issue

Mediatek, Taiwan

  • 18mn shares (4.1% of total outstanding shares) granted to employees at the par value of NT$10 apiece, a 98% discount to the prevailing market price **
  • The imputed value of NT$8.4bn was 1.25x the entire net profit of NT$6.7bn earned by the company in FY2001
  • Employees had been granted 12.3mn shares in 2000 & 12.5mn shares in 1999
  • This is a common occurrence in the Taiwanese high-tech companies. Taiwan GAAP does not require companies to expense the compensation paid in the form of such employee share grants in the P&L account, masking the dilution.

Note: ** Both the proportion & the discount are adjusted for a 40% stock-dividend announced simultaneously

Manish_Singhai@acml.com

dilution case study 5
Dilution - Case Study 5

Financial Distress Leading to Massive Dilution

Hanvit Bank, Korea

  • Formed by the merger of two state-owned banks to become the largest domestic bank in Korea, post-1997 crisis
  • Re-capitalized in Sep-99 with a US$1bn GDR offering to international investors; foreign shareholders owned about 12% of the company in 1Q00
  • However, at the end of 2000, following continuous deterioration in asset quality and increase in loan losses, total capital was wiped out
  • After 100% capital reduction, the government re-capitalized the bank with a W2.8bn injection

Manish_Singhai@acml.com

equity market response
Equity Market Response
  • Improper Dilution is usually followed by a period of sustained stock price under-performance
  • The ensuing erosion in the firm’s market value may significantly exceed the immediate dilution, to price in the risk of future recurrence (de-rating!)
  • In other words, the market raises the implicit cost of equity financing for the firm
  • At the macro level, such instances highlight the lack of protection for minority shareholders, and may raise the cost of equity for the particular market as a whole

Manish_Singhai@acml.com

extra legal mitigation
Extra-Legal Mitigation
  • Firms are Forced to Build a Reputation if they want Repetitive Access to Capital Markets(e.g. Paying Dividends, Listing ADRs to show commitment to greater disclosure, Frequent Interaction with Minority Investors)
  • Voluntary Adoption of “Majority Approval by Shareholders” Clause in Company’s Articles
  • Influence by Large Non-Management Share-holders(e.g. Foreign Institutions or Strategic Investors)
  • Extra-Legal Suasion by the Government(e.g. threat of withdrawal of tax incentives or operating licenses)

Manish_Singhai@acml.com

stress testing the measures
Stress-Testing The Measures

“If a firm in a weak legal system promises to treat investors well but then suffers an adverse shock, the manager who controls the firm has an incentive to renege on this promise. Ultimately, the only way to enforce a contract between managers and shareholders is through legal action of some kind. ” (Johnson & Shleifer)

“The trouble is that ADRs may help companies opt into a regime of greater disclosure, but they do not stop expropriation as long as it is disclosed” (Johnson & Shleifer)

“The outside investors are more vulnerable to expropriation, and more dependent on the law than either employees or suppliers, who remain continually useful to the firm” (La Porta, Lopez-de-Silanes, Shleifer & Vishny, 1998)

“Governments may also say that that they want to protect investors, but in a sharp downturn find that they would rather protect entrepreneurs….,…e.g. Malaysia” (Johnson & Shleifer)

Manish_Singhai@acml.com

no substitute to legal armor
No Substitute to Legal Armor

“…it [legal protection] makes expropriation technology less efficient……At the extreme of no investor protection, the insiders can steal a firm’s profits perfectly efficiently. As investor protection improves, the insiders must engage in more distorted and wasteful diversion practices such as setting up intermediary companies into which they channel profits….When investor protection is very good, the most the insiders can do is overpay themselves, put relatives in management, and undertake some wasteful projects. After a point, it may be better just to pay dividends. As the diversion technology becomes less efficient the insiders expropriate less, and their private benefits of control diminish.”

(Investor Protection & Corporate Governance -

La Porta, Lopez-de-Silanes, Shleifer & Vishny, 2000)

Manish_Singhai@acml.com

have laws will enforce
Have Laws - Will Enforce !

Effective Legal, Institutional & Regulatory Framework is an Essential Pre-requisite

  • Strong Judiciary, Tough & Fair Regulator, Alert Stock-Exchanges
  • Appropriate, Comprehensive & Clearly Defined Regulations & Laws
  • Enforcement at Reasonable Cost & within an Acceptable Time-Frame

Manish_Singhai@acml.com

specific legal safeguards
Specific Legal Safeguards ….

To Protect against Improper Dilution, the Company & Security Laws or Commercial Code should Specifically Provide for :

  • Preemptive Rights
    • Existing shareholders have the first opportunity to buy new issues of stock
    • This right can only be waived by a majority vote of all shareholders
  • Oppressed Minority Mechanisms
    • Judicial venue to challenge the management decisions e.g. File a Class Action Suit (as in the US) or Petition the Courts/Company with a Complaint
    • Right to exit the firm by requiring it to purchase the minorities’ shares when they object to fundamental changes such as mergers and asset sales (as in Korea)

Manish_Singhai@acml.com

within a broader framework
….Within a Broader Framework

Anti-Expropriation Elements are Integral to a Broader Legal & Regulatory Structure for Good Corporate Governance:

  • Convergence of Ownership (Cash-Flow Rights) & Control (Voting Rights)
  • Independent, Effective, and Accountable Board
  • Audit Committee chaired by an Independent Director
  • Accounting & Audit Integrity
  • Accurate & Timely Disclosure of Material Information about Ownership, Conflicts of Interest, Related-Party Issues, etc.

Manish_Singhai@acml.com

alliance capital corporate governance
Alliance Capital & Corporate Governance

As a leading global institutional investor, the firm is highly cognizant of its responsibility in helping improve governance standards in the markets and companies where it invests

  • Conscientiously exercises its voting rights
  • One of the few, if not the only firm to institute a formal CG rating as a component of our in-house investment research process in Emerging Markets
    • Analysts complete a questionnaire in conjunction with the company management, which is used to arrive at a CG Rating
    • Periodical review helps to establish directional indicators for each company
  • Collaborates with other investors and not-for-profit share-holder activist groups in specific instances of anti-minority behavior

Manish_Singhai@acml.com

references
References
  • La Porta & Lopez-de-Silanes, “Capital Markets & Legal Institutions”
  • La Porta, Lopez-de-Silanes, Shleifer & Vishny, “Investor Protection & Corporate Governance”
  • La Porta, Lopez-de-Silanes, Shleifer & Vishny, “Investor Protection & Corporate Valuation”
  • Johnson, La Porta, Lopez-de-Silanes & Shleifer, “Tunnelling”
  • Johnson & Shleifer, “Coase and Corporate Governance in Development”
  • Bebchuk, Kraakman & Triantis, “Stock Pyramids, Cross-Ownership, and Dual Class Equity”
  • IIF Equity Advisory Group, “Policies for Corporate Governance and Transparency in Emerging Markets”
  • Clasessens, Djankov, Fan & Lang, “Expropriation of Minority Shareholders in East Asia”

I would also like to thank the associates and friends in the Investment Banking Industry with whom I have had several thought-provoking discussions leading up to this paper but who have requested that they not be named !

Manish_Singhai@acml.com