MONITOR
Tom Holland
Apr 07, 2009
It goes against the grain to applaud Richard Li Tzar-kai for anything, but in one way at least Hong Kong owes the PCCW (SEHK: 0008) chairman a vote of thanks.
If he hadn't launched his bid to take PCCW private through a so-called "scheme of arrangement", none of the subsequent allegations of an attempt to rig the shareholders' vote in favour of his proposal would have arisen.
Without those allegations of skullduggery, and the Securities and Futures Commission investigation that followed, most of us would never have realised just how full of holes the regulations governing such schemes of arrangement in Hong Kong really are.
Instead, thanks to Mr Li, our regulatory shortcomings have been stripped bare and exposed to the harsh glare of public scrutiny.
It should be obvious to the city's policymakers that the rules governing buyouts through schemes of arrangement are not only woefully inadequate, they actually invite manipulation.
Schemes of arrangement, in which proposals are put to an all-or-nothing vote, were never really meant to decide buyouts. They were supposed to be used for agreeing settlements between insolvent companies and their creditors.
But they also come in handy for clinching the approval of minority shareholders in takeover deals. Unlike a general offer, which can be time-consuming - and therefore expensive to finance - schemes of arrangement can be concluded much more quickly and cheaply, although they may carry a higher risk of failure.
Under a scheme of arrangement, the proposed buyout is put to a vote of minority shareholders. To win, a proposal must gain the support of 75 per cent of the shares voted by value, with no more than 10 per cent of all eligible shares voting against.
But schemes of arrangement must also satisfy a third condition, originally intended to protect small creditors from being steam-rollered by larger ones in a debt workout.
Known as the headcount rule, this states that to succeed, a proposal must also win the approval of at least half the number of voters present at the meeting, regardless of the value of their holdings.
In other words, 50 people each with 1,000 shares voting against a deal can defeat 49 shareholders each with a million shares voting in favour.
This sort of provision might make sense in agreeing a debt workout, but because of a quirk in the way things work in Hong Kong, when it comes to approving shareholder buyouts, it leaves the process vulnerable to all sorts of knavish tricks.
That's because very few shareholders are actually registered as the owners of their shares. Most minority shares - 94 per cent in the case of PCCW stock - are held in electronic form in accounts at the Central Clearing and Settlement System (CCASS) and registered as belonging to Hong Kong Securities Clearing Company.
Usually this isn't a problem. In a normal vote, shareholders forward their voting intention to CCASS, which sorts the shares it holds into two blocks - one for yes, one for no - which it then votes according to the owners' wishes.
But when it comes to a headcount vote, it's a huge problem. Because the registered owner of their shares is Hong Kong Securities Clearing, all the thousands of individual investors who hold their shares through CCASS count as just two shareholders under the headcount rule, one voting in favour and one voting against. Those two votes cancel each other out, which means most investors who own electronic shares have no say under the headcount rule.
That makes headcount votes laughably easy to manipulate. So, for example, if you are a large investor who wants to ensure the success of a deal threatened by opposition from small shareholders, all you have to do is buy a chunk of stock and parcel it out to several hundred of your friends, family and employees. You ensure their names are entered in the register as the shares' owners, and get them to sign proxy forms nominating you to wield their shares in the vote.
You then toddle on down to the shareholders' meeting, where as the nominee of several hundred registered shareholders, you get to exercise several hundred votes when it comes to the headcount.
The chances are that because only a tiny minority of shares are registered in owners names rather than as belonging to Hong Kong Securities Clearing, you will win the headcount by a landslide, ensuring the deal goes through.
In most cases this tactic, known as share-splitting, is perfectly legal. In fact, it is commonly used by hedge funds arbitraging between the market price and the bid price in takeover deals.
But if the shares are handed out and voted at the instigation of someone connected to the buyout proposal, it is highly illegal.
That is pretty much what the SFC alleges happened in the case of Mr Li's proposed buyout of PCCW.
The judge disagreed yesterday in the Court of First Instance, and whether the appeal court judges will decide differently remains to be seen.
In any case, it is clear that the rules governing headcount votes in schemes of arrangement are seriously flawed and should be changed.
Most observers argue that the answer is to get rid of the headcount vote altogether.
But the rule is there for a reason: to protect small shareholders. Far better would be to change the way shares are held by CCASS so that their ultimate owners can be registered by name. That way the headcount vote would reflect the wishes of all voting shareholders, not just a tiny minority.
Either way, ultimately it was Mr Li who highlighted the deficiency of the regulations, so we really should offer him a vote of thanks - except of course someone would probably try to rig it.
tom.holland@scmp.com
