The Fourth Asian Roundtable on Corporate Governance

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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
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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

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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

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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

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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

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Dilution - Case Study 1

• Private Placement of Convertible Preferred Stock
  at a Discount to Market Price
• Shinsegae Department Stores, Korea
• 1mn Preference Shares convertible 11 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

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Dilution - Case Study 2

• Rights Issue at a Deep Discount
• Thai Farmers Bank, Thailand
• TFB raised US800mn _at_ 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
  11 rights issue at Bt20 per share, a steep
  discount to the prevailing market price of about
  Bt70.
• Minority shareholders faced a Hobsons 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.

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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

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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 NT10
  apiece, a 98 discount to the prevailing market
  price
• The imputed value of NT8.4bn was 1.25x the
  entire net profit of NT6.7bn 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 PL
  account, masking the dilution.
• Note Both the proportion the discount are
  adjusted for a 40 stock-dividend announced
  simultaneously

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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 US1bn 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

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Equity Market Response

• Improper Dilution is usually followed by a period
  of sustained stock price under-performance
• The ensuing erosion in the firms 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

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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 Companys 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)

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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)

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No Substitute to Legal Armor

• it legal protection makes expropriation
  technology less efficientAt the extreme of no
  investor protection, the insiders can steal a
  firms 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)

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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

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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)

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.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.

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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

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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 !