In recent years, there have been a lot of criticisms that quite a number of listed companies in Hong Kong frequently conduct deeply discounted rights issues/open offers and/or high ratio share consolidations which have resulted in unfair dilution of minority shareholders’ interests.
On 9 December 2016, the Securities and Futures Commission (“SFC”) and The Stock Exchange of Hong Kong Limited (“Exchange”) jointly announced that they are closely monitoring highly dilutive rights issue/open offers and share consolidations/subdivisions.
The Exchange published two listing decisions (HKEX-LD102-2016 and HKEX-LD103-2016), which illustrate that it would refuse to grant approval where the proposed corporate actions are not in the best interests of the shareholders as a whole.
Why would frequent, deeply discounted rights issues/open offers be detrimental to minority shareholders?
Rights issues are offers to existing shareholders to subscribe for new shares proportionate to their shareholdings. Shareholders may sell their nil paid rights in the market if they do not intend to subscribe for the rights shares. Open offers are similar to rights issues but the subscription rights are non-renounceable.
Rights issues and open offers are easy and convenient refinancing tools for issuers to raise funds and are “not inherently problematic”, said Charles Li, the Chief Executive of Hong Kong Exchanges & Clearing Ltd., in a blog post “Charles Li Direct” in September 2016 addressing Mainland investors’ questions about how Hong Kong's market works pending the launch of the Shenzhen-Hong Kong Stock Connect.
The Exchange explained that where a rights issue/open offer of shares is made at a discount to the market price, this discount represents a cost to shareholders, which is avoided to the extent a shareholder exercises his rights to subscribe for his pro-rata entitlements to new shares. However, any shareholder who does not fully participate in the offer would suffer dilution to his investment, as the value of the discount would be transferred to underwriters and other shareholders taking up those rights to subscribe new shares. The larger the discount to market price and/or the higher the subscription ratio, the larger the value transfer and dilution to the non-participating shareholders’ investment.
What is the negative effect of share consolidations/subdivisions for shareholders?
Share consolidations/subdivisions result in change in the number of shares in issue but without changing shareholders’ proportionate interests in an issuer. Such corporate actions may serve to facilitate trading activities and improve market efficiency.
The Exchange explained that such corporate actions involve costs and they would result in existing shareholders holding odd lots or fractional shares, which are usually traded at prices lower than those in complete board lots. While some issuers would arrange for intermediaries to offer matching services, this could not eliminate the negative effect of such corporate actions for the shareholders, particularly for smaller shareholders holding one or a few board lots.
SFC/Exchange’s approach in handling highly dilutive rights issue/open offers and share consolidations/subdivisions
The SFC has made enquiries into cases where the terms of the proposed offers were highly dilutive and/or where the issuers conducted fundraisings repeatedly, over a relatively short period to ascertain whether there has been a contravention of the Securities and Futures Ordinance.
The Exchange has adopted a rigorous approach to vetting the relevant draft announcements, including making enquiries where the terms of proposed offers or related transactions raised concerns about unfair dilution of non-subscribing minority shareholders' interests.
As illustrated in listing decision HKEX-LD102-2016, the Exchange has concerns where an issuer proposes a highly dilutive offer with a recent history of similar dilutive pre-emptive offer that had a low level of subscriptions by minority shareholders and had significantly diluted the interests of non-participating shareholders. The Exchange refused to grant listing approval for the proposed rights issue in that case.
Proposed rights issue in HKEX-LD102-2016 (click here):
- Immediately before the proposed rights issue, there was a proposed share consolidation of 20 existing shares into 1 consolidated share.
- The proposed rights issue was on the basis of 20 rights shares for 1 consolidated share. The proposed subscription price represented a 90% discount to the then closing share price resulting in a 85% dilution impact.
- The Exchange considered the proposed use of proceeds was unspecific - About 35% of the net proceeds of the proposed rights issue were intended for acquiring a property for redevelopment, and the balance would be used to finance its investment in listed securities, loan financing business, and general working capital.
- The issuer concerned had completed a rights issue a few months before the proposed rights Issue. That previous rights issue was undersubscribed by 52% (without taking into account the controlling shareholder) and had a dilution effect of over 80% on the interests of the non-participating shareholders.
- That previous rights issue together with the related corporate actions created considerable odd lots.
- The subscription ratio was reduced to 3 rights shares for 1 consolidated share.
- The subscription price was adjusted to one that would represent a 72% discount to then market share price, and hence the dilution impact was reduced to 55%.
- The intended use of proceeds was revised such that 62% would be used for a possible acquisition of a property and the rest for general working capital.
The revised proposal did not address the Exchange’s concerns that the dilution impact was high and unjustified.
For proposed share consolidations/subdivisions, the Exchange expects directors of issuers to consider all the relevant factors and take reasonable steps to demonstrate that the proposal can serve its intended purpose and is in the best interest of the issuer and its shareholders. The relevant factors include, among other things:
- whether the proposed action is justifiable in light of the potential costs and negative impact arising from creation of odd lots to shareholders;
- that the frequency of any share consolidation/subdivision be kept to a reasonable level to minimize the costs arising from odd lots as a result of unnecessary repeated actions;
- whether a proposed share consolidation/subdivision may have an effect of offsetting the intention of any prior, or other simultaneous corporate action (e.g. share consolidation followed by share subdivision within a relatively short time span, or share subdivision made in conjunction with an increase in board lot size);
- whether there is a sufficient demonstration period to support that the share trading price is not temporary and a proposed share consolidation/subdivision is justified (e.g. a reasonable period of high trading price to justify a proposed share subdivision); and
- whether there is any other available alternative methods (e.g. change in board lot size instead of share subdivision).
In listing decision HKEX-LD103-2016, the Exchange considered that the issuer concerned had not provided sufficient reasons to support its proposed share subdivision and therefore did not approve the proposal.
Proposed share subdivision in HKEX-LD103-2016 (click here):
- The issuer concerned proposed a 1 into 5 share subdivision.
- The issuer submitted that the purpose of the proposed share subdivision was to increase trading liquidity. However, its proposal also involved an increase in board lot size by 4 times, and the adjusted board lot value would only be slightly below the current value. The combined effects of these corporate actions might not entirely support the purported reason for proposing the actions.
- While there was recent increase in the share price to above HK$2, its shares were trading at most time during the last 6 months at the price of around HK$0.9 to HK$1 only.
- About 6 months ago, the issuer announced a rights issue of shares at a discount to the market price and then a 10 to 1 share consolidation, which were completed about 5 months after that announcement. The proposed share subdivision was proposed one month after completion of the share consolidation. It is not clear how the proposed share subdivision could be justified within a short period after the previous share consolidation.
- The issuer failed to consider the other alternatives for its intended purpose of increasing trading liquidity.
The increased scrutiny by the regulators over abusive rights issues/open offers and share consolidations/subdivisions is a welcomed move for the general investing public (including Mainland investors via the stock connects) and would hopefully enhance their confidence in investing in Hong Kong listed issuers.
Issuers are reminded that they are expected to observe and fully comply with their obligations under the Listing Rules and other regulations, including the importance of treating all shareholders fairly and equally when conducting rights issues/open offers and share consolidations/subdivisions.
Issuers should be aware that the Exchange may not grant approval for highly dilutive rights issues/open offers if it is concerned that the terms might be detrimental to minority shareholders. There is no prescribed threshold for an offer to be considered highly dilutive, and an assessment would be made case by case based on the specific circumstances of individual issuers. Therefore, early consultation with the Exchange may be necessary to avoid delay in launching the offers to meet funding needs.
When planning for share consolidations/subdivisions, issuers should also be prepared to demonstrate justifiable commercial rationale for such corporate actions.