Tunneling, Propping and Expropriation: Evidence from Connected Party Transactions in Hong Kong

1. Tunneling, Propping and Expropriation: Evidence from Connected Party Transactions in Hong Kong by Stephen Yan-leung Cheung Department of Economics and Finance City University of Hong Kong

2. “...China Logistics Group (00217) to confess that millions of dollars has gone missing from its coffers.... The bulk of the cash is suspected to have vanished across the border.... A HK$ 200 million deposit paid out for the acquisition of Shanghai Pudong CNCC Logistics Development was missing... while the money left China logistics, it was allegedly never received by the vendor.” South China Morning Post, 18 September 2002. City University of Hong Kong

3. Independence and performance Shareholder environment Concentrated ownership “Insider boards” Reliance on family and state finance Incentives aligned with core shareholders INSTITUTIONAL CONTEXT Underdeveloped and illiquid investmentmarket Inefficient corporate governance Limited disclosure CORPORATE CONTEXT Limited market for corporate control Inadequate minority protection Transparency and accountability Capital market liquidity Corporate Governance in Asia Source: McKinsey, 2001 City University of Hong Kong

4. Introduction Companies with concentrated ownership: • extract case by selling assets, goods, or services • obtain loans on preferential terms • assets transfer • dilute the minority shareholders’ interests City University of Hong Kong

5. Rules in Hong Kong • A connected transaction is defined as any transaction between a company (or any of its subsidiaries) and a connected person. • Connected persons are the listed firm’s (or the subsidiary’s) substantial shareholders, the directors (current directors or anyone who held this position at any time during the preceding 12 months), the chief executive and their associates, including any company where the above hold a substantial shareholding. • The definition also applies to any person co-habiting with the above and relatives (such as spouses, parents, step-parents, brothers/sisters, step-brothers/sisters, and in-laws). City University of Hong Kong

6. Rules in Hong Kong • For all transactions more than HK$10 million, in addition to a public announcement, the listed company must also notify the exchange by making a filing. • The minutes of the board meeting where the transaction was approved, noting also the views of the company’s independent non-executive directors, must be submitted to the exchange. • Within three weeks of such notification, the listed company must send a circular to shareholders providing full details of the transaction, including an opinion by an independent expert. • This is to be followed by approval of the transaction by shareholders in a general meeting, where any connected person interested in the transaction should abstain from voting. City University of Hong Kong

7. Objectives • What are the valuation effects of different types of connected transactions? • What are the characteristics of firms more likely to expropriate? • What should be done? City University of Hong Kong

8. Observations 1) There were 328 connected transactions worth at least HK$116 billion during 1998-2000. The value of the median transaction was HK$ 106 million, representing 17.5% of firm’s market capitalization. City University of Hong Kong

9. Types of connected transactions • Asset acquisition • Asset sales • Equity sales • Trading relationships • Cash payments • Cash receipts • Subsidiary relationships • Takeover & joint-ventures • J V stake acquisition • J V stake sales City University of Hong Kong

10. Observations 2) 2 times more assets acquisition than asset sales; cash from listed companies to its controlling owners 3) 3.5 times more in providing cash assistance to third parties as opposed to receiving assistance 4) Terms are unfavorable (acquiring at a premium or selling at a discount) for most deals when information are available City University of Hong Kong

11. Observations 5) 15% did not disclose the value of transaction in filing. 6) 2.7% did not attach a report by independent financial advisors 7) 3.4% violated a previously granted waiver 8) 7% had taken place in the past but had not disclosed to the exchange 9) 4.9% constitute an outright breach of listing rules City University of Hong Kong

12. Case: Dickson Concepts International Ltd (I) • Background • It trades in luxury goods • Bvlgari watches • Lighters, pens • Jewellery, fashion products • Warner Bros. Products • The operations of the group mainly base in Hong Kong, Asia, UK, European countries and in North America. City University of Hong Kong

13. Case: Dickson Concepts International Ltd (II) • Unusual Transaction • On 30th December, 1999, the company entered into a consultancy agreement with a related company which is wholly controlled by the director himself. • It was said to be for the design, development, construction, and technological infrastructure of the “Cybermall”. • The fixed fee was HK$130 million. City University of Hong Kong

14. Case: Dickson Concepts International Ltd (III) • Market Reaction • It was clear to be a related party transaction • The director was being criticized for failure to disclose the agreement. • No records of work done for the consultancy • No approval initially from independent shareholders, but was later ratified by them. • The company argued that this was a service contract not a transaction. City University of Hong Kong

15. Results Short-term, • Average of -3.4% during a period of 10 days after announcement City University of Hong Kong

16. Long term, • Average of -12.6% during a period of 12 months after announcements City University of Hong Kong

17. City University of Hong Kong Blue: Size & MB adjusted CARs Red: Size adjusted CARs

18. Returns are • negatively related to percentage ownerships by the main shareholders • negatively related to proxies for information disclosure • value of transaction • independent financial advisor • Big 5 as auditing firm City University of Hong Kong

19. likelihood of undertaking connected transactions is higher • ultimate owners can be traced to mainland China • likelihood of not disclosing the value of the deal and likelihood of violating the listing rules are higher for • Mainland China ownership • Concentrated ownership City University of Hong Kong

20. Variable of Corporate governance do not have any impact • audit committee • number of independent non-executive directors • CEO duality City University of Hong Kong

21. Discussion • The quality of independent non-executive directors • Information disclosure • Regulatory framework City University of Hong Kong

22. The Legal Approach to Corporate Governance • The law and its enforcement are key mechanisms of investor protection. • When investors finance firms, they receive rights or powers in exchange. Without an ability to enforce rights, investors might end up with nothing. • Implication: Strong investor protection leads to deeper financial markets & better financing terms for firms. • Company Law • Bankruptcy Law • Securities Law • Takeover Law • Courts & Regulators • Protect Shareholders & Creditors • Force timely disclosure of accurate information City University of Hong Kong

23. Challenges Ahead • But more importantly, the evidence raised here suggests that there are 3 essential ingredients for the system to work in the long run: • Better investor rights in corporate laws, strong regulation on disclosure and accounting standards. • Regulations and laws that facilitate shareholder actions and private enforcement. • A well functioning judicial system which allows the functioning of financial markets and business transactions in general. City University of Hong Kong

24. ~END~ City University of Hong Kong