Tsinghua Tongfang rejects reforms

China''s A-share reforms suffer a setback, but the fall-out should be mild say specialists.

In a reversal for the government's A-share reform efforts, reports say that A-share investors have turned down the rights issue suggested by Tsinghua Tongfang, one of four companies picked for the pilot scheme to convert non-tradable shares into traded stock. Over the weekend it emerged that only 62% of public shareholders voted in favour of the reforms, compared to the 66% required.

Under the reform, accomplished by the mechanism of a rights issue, the company's majority shareholders' stake would have markedly decreased, to below 50%. A-share investors would have seen their stake in the company become an absolute majority. Under the terms of the reform, the major shareholder portion of the rights issue was to be transferred to the minority shareholders for free.

That makes the rejection of the reforms mysterious, since the computer services company's outlook should have improved. Major shareholders, managers and minority investors would all have been united, for the first time, in seeking a higher share price.

There are some possible explanations. One is that A-share investors are simply holding out for more shares. According to one Chinese banker, A- share investors have heard that the government has linked further capital raising by Tsinghua Tongfang to a resolution of the share structure issue. That puts huge pressure on management to give in to demands for more compensation.

Another explanation is that shareholders believe the company is too badly run to drive up the company's share price. However, that view is surprising because the companies picked for the reforms were supposedly good quality, with solid earnings.

If anything, the reform plan will hurt major shareholders and management. The former will see their stake diluted heavily, while the management will in some cases have to pay cash to A-share holders as compensation out of retained earnings.

If the haggling get out of hand, the CSRC may end up regretting its decision to keep out of the process of setting the price majority shareholders will pay to public investors for the privilege of changing their state-owned shares to publicly traded shares. The reason it is a privilege is that the listed A-shares are a far more effective capital raising tool than state-owned shares.

The latter may be sold, but only with reference to net asset value. In contrast, A-shares are highly priced (compared to Chinese companies abroad) because of China's dearth of investment instruments.

Several factors have put majority and minority shareholders at loggerheads.

Majority shareholders are able to make rights issues willy-nilly, at steep discounts to the existing stock price. Ownership of the company is not diluted because it is not represented by the A-shares, it is conferred by the 66% of shares that are non-tradable.

Because the company and management are judged by law on net asset value (a relict of the communist system) these share issues, however discounted, still managed to increase the company's net asset value. The company's share price is basically irrelevant.

In theory, management should welcome the change, at least if it were independent and running the company to maximize earnings. But in practice, management is appointed by the majority shareholders.

In China, managers and majority shareholders are notorious for not respecting the duty of fiduciary care to minority shareholders and other stakeholders - in other words, they treat the company like their own private plaything, rather than as an independent legal entity.

The A-share market has been declining for four years over the problem of how to cope with the massive extra supply of scrip, which the state share sell off would imply.

To prevent that, the CSRC has capped the share sell-off of by majority investors to a maximum of 10% over three years. It is significant that the CSRC should see the need to introduce such a measure, given that in the West companies rarely sell old shares to raise capital.

In China, the risk is all too great. Many listed companies have no value apart from the fact that they are listed. Provincial government who listed their worst companies under the old-style quota system in order to get retail investors to foot the bill, are likely to sell off their stakes if they lose the capital raising privileges they enjoyed on the old system.

In order to reassure investors that the supply of scrip will be limited, the CSRC has also frozen IPOs. This is not healthy for the long-term good of the market, since it prevents new blood from revitalizing the market. For example, Bank of Communications, considered the best run of the state banks, has had its domestic listing cancelled.

The stock market is riddled with very poor companies which receive an asset injection from their majority shareholder as they approach the delisting stage as a result of sagging earnings. This allows them to hang on a little longer, until further mismanagement requires a repeat of the operation.

The pace of the reforms has been deliberately set slow, but one fund manager warns this may not be sustainable.

"With a strong economy and the government owning the banks, listed SOEs can still enjoy a protected existence. But if the economy slows down, and the government loses control of the banks through overseas listings, the outlook (for poor, listed SOEs) could worsen dramatically," he warns.

It is not all bad news, however. One of the other pilot companies, Sany Heavy, pushed through its reform scheme. The results for the other two companies will be known in the next week.