Originally published on 8th June 2011
Keywords: stapled securities, business trusts, Hong Kong
On 2 June 2011, PCCW Limited (stock code 8) announced that the Hong Kong Stock Exchange has confirmed it may proceed, subject to certain conditions, with a proposed spin-off which is expected to involve stapled securities. This update provides a brief overview of stapled securities in the context of Hong Kong's regulatory regime.
A stapled security in other stock markets, such as Australia, typically comprises two components:
- a share in a company - the company undertakes development activity requiring capital expenditure resulting in a low dividend payout ratio but with the potential for capital appreciation; and
- a unit in a unit trust - the trust holds income generating assets which produce recurrent income nearly all of which flows through to unit holders i.e. a high dividend payout ratio, close to 100% after funding asset enhancement and other expenses, similar to a REIT in Hong Kong.
If the two components of a stapled security are subject to differing laws and regulations, then both sets of laws and regulations must be considered. Where one of those sets of laws and regulations is more demanding than the other, the "highest common standard" is applied for the benefit of investors.
The appeal of a stapled security is that from an existing listed entity's perspective a capital restructuring which involves the issuance of stapled securities can enable value to be unlocked to tap capital from retail and institutional investors alike.
From a shareholder's perspective, stapled securities appeal because existing investors stand to benefit from separately managed, ring fenced entities each with a distinct business focus, operations and management incentives.
Composite dividend flows can help to facilitate an appraisal and evaluation of the investment held as well as enabling existing and new investors to lock into a combination of a static recurrent income model and a dynamic growth story.
The two components of a stapled security are not traded separately on the stock exchange on which the stapled security is listed.
From an investor's perspective in Australia, stapled securities can be tax efficient because the trust's pass through distributions may give the investor the benefit of tax free or tax reduced distributions (due to depreciation allowances) as well as taxed income via dividends on the shares (which may have franking credits). From the company's perspective, additional capital can be raised from the issuance of stapled securities which can be deployed in expanding the business of the entity undertaking development activity. One set of financial statements is available which consolidates the results of the operations of the two entities and contains a certain amount of segment information on the respective business operations of the two entities. The total distribution to investors is apportioned between the two components.
However, Hong Kong's tax laws are unlikely be the driver for the development of a market for stapled securities in Hong Kong. Instead, the stapled security structure is likely to take hold to overcome regulatory concerns which may arise if a business trust were to be spun off as a separately listed entity in the form of a trust alone.
By way of background, after a spin off, the existing listed entity must satisfy the minimum profit requirement of a listing applicant and retain a sufficient level of operations and sufficient assets to support its separate listing status. There should be no adverse impact on the interests of shareholders of the existing listed entity resulting from the spin-off and clear commercial benefits. All of these Hong Kong listing rules issues arise when a listed entity seeks regulatory approval for a spin off.
The main Hong Kong regulatory concern with a business trust arises from the fact that the Securities and Futures Ordinance came into force in 2003, well before the emergence of a market for listed collective investment schemes on the Hong Kong Stock Exchange. Dealings in the shares of a company listed on the Hong Kong Stock Exchange are subject to various investor protection provisions contained in the Securities and Futures Ordinance such as those addressing insider dealing and the disclosure of interests regime. However, dealing in the units of a collective investment scheme such as a business trust listed on the Hong Kong Stock Exchange would not be subject to those provisions. A similar issue arises in relation to dealings in units of REITs in Hong Kong pending the adoption of legislative changes envisaged in the SFC's Consultation Conclusions on the extension of Parts XIII to XV of the Securities and Futures Ordinance to listed collective investment schemes.
Parts XIII and XIV of the Securities and Futures Ordinance relate to market misconduct. In addition to the prohibition of insider dealing, Parts XIII and XIV address false trading, price rigging, market manipulation and the disclosure of false and misleading information and allow market misconduct victims to seek compensation. In view of the growth of Hong Kong listed collective investment schemes in recent years, the SFC announced in June 2010 that it would propose amendments to Parts XIII and XIV to make it explicit that those provisions are equally applicable to all Hong Kong stock exchange listed collective investment schemes, in whatever form they take. This would eliminate doubts in the legislation and be consistent with the regulatory approach adopted in the UK, Australia and Singapore. Part XV relates to the disclosure to the market of interests held by directors and investors who accumulate a significant shareholding. Part XV explicitly refers to shares and debentures of a listed corporation and therefore does not apply to collective investment schemes which are constituted in the form of business trusts or other non-corporate forms, even if they are listed.
It is therefore expected that, at least until those legislative changes are made, business trusts in Hong Kong will only be approved as a component of a stapled security on the basis that dealings in stapled securities are subject to the insider dealing/market misconduct provisions and the disclosure of interests regime contained in the Securities and Futures Ordinance. In this sense, the above mentioned "highest common standard" of regulation could be applied to the two components of the stapled security to bring the provisions of the Securities and Futures Ordinance into play. While stapled securities appear to provide a new approach, it remains to be seen how the business trust regulatory regime will take shape in Hong Kong.
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