Liquidity is the key determinant of success in the high stakes game of global capital. Because it’s now plentiful and easy to move around the world, global capital is advantageous to have for private firms producing goods and providing services to consumers the world over. Firms attract global capital when they issue foreign currency debt and, most often, through the stock market, as equity.
Stockbrokers, the bourse and the capital market regulator (SEC) have been obsessive in their pursuit of liquidity due to its ability to attract capital – especially from overseas – to the market. Abundant capital reduces costs and boosts productivity, makes new investment possible, creates jobs, and advances economic growth.
However, in its over-enthusiasm to force the pace of conditions required for a vibrant equity market, the regulator has seriously damaged the system with its fuzzy and confused logic.
In 2014, capital market regulator SEC introduced a new rule as part of the Continuous Listing Requirements, requiring listed firms to maintain a minimum 15% of its stock in the hands of at least 500 public shareholders by end-2015 and 20% in the hands of at least 750 shareholders by end-2016. The SEC’s definition of public shareholders excludes the parent of the listed firm and the firm’s directors, chief executive, key management members and their families. The rules also exclude from its definition of public shareholders parties controlling more than five percent of the shares of a firm, except for when it’s held by a mutual fund, any other asset manager or not a related party under the Sri Lanka Accounting Standards definition.
Companies that fail to meet this requirement by the deadline may be granted an extension to comply, and if they still fail to do so, they may be transferred to the default board where trading is suspended and they would have to delist. While the SEC is not forcing a company to leave the stock market for non-compliance with this 2014 listing rule requirement, it’s really the only choice they face. Finlays Colombo and Metropolitan Resource Holdings have commenced the delisting process, and a number of other large firms have announced they also intend to delist their shares.
[pullquote]Listings and delisting are necessity based. Companies list and offer shares to the public to raise equity and not for altruistic reasons like providing an opportunity for Sri Lankans to share in the wealth generated by their firms[/pullquote]
While liquidity is desirable, the SEC’s minimum public holdings rule is based on fuzzy and confused logic, and must be abandoned in its entirety before more damage is done.
The SEC ascribes two reasons for this rule – to create a ‘liquid and transparent market with a better price discovery mechanism’ and to ‘provide greater opportunity for citizens to share in the wealth generated by listed firms’. Clearly, these are both desirable. However, the SEC’s unilateral action to force the outcome is based on fuzzy reasoning. First, listings and delisting are necessity based. Companies list and offer shares to the public to raise equity and not for altruistic reasons like providing an opportunity for Sri Lankans to share in the wealth generated by their firms. Firms choose to delist when they no longer require new capital. The SEC’s fuzzy logic violates the compact and reasons used to encourage companies to go public in the first place.
Second, the SEC should not interfere with how private firms decide to allocate their capital. Conditions that led to a company going public can change overtime or overnight. Chief executives are responsible for meeting shareholder expectations on business and long-term earnings growth. By depressing demand for shares, markets punish firms that disappoint shareholder return expectations, which in turn drives up firms’ cost of doing business. If a chief executive or board feels the firm’s share is undervalued, they should be free to leverage that to maximize shareholder returns, unhampered by new requirements around public floats.
Third, an investor must have the unimpeded freedom to decide how much of what stock they wish to hold. It’s irrational to hold a controlling shareholder – owning more than 80% of a firm’s stock – responsible for the actions of other investors that lead to a reduction in the number of shareholders or for liquidity drying up.
The SEC’s logic is also confused and offers a false dilemma about liquidity, transparency and efficient price discovery. Clearly, these are all desirable outcomes. Sri Lanka’s stock market is a weak economic barometer because many of the country’s most important industries and firms are unlisted. Half the financial sector – three state banks – is unlisted. Public utilities, a large government-owned and economically critical sector is unrepresented. Sri Lanka’s largest industries like ready-made clothes for export, technology firms and ports are also outside the market. Listed company market capitalization equal to 30% of gross domestic product here is far lower than even India, where it surpasses 70%.
The Sri Lankan market’s relative liquidity woes are the result of not having large firms that do business here, listed. These firms are staying away from equity from public markets either because they don’t want the additional burden or because the valuations they can command aren’t attractive enough compared to existing funding options.
Capital-starved, government-owned firms lack the robust corporate governance necessary for a public listing. Even if governance can be fixed, privatizing these organizations must become public policy before they can be listed. So, to pin liquidity woes on shareholders of some public firms whose controlling interest exceeds 80% is a false dilemma.
Similarly, to claim that enforcing minimum public floats leads to better transparency is confused logic. Transparency is a result of good corporate governance and the enforcement of disclosure rules, not minimum public floats. Corporate governance requirements and disclosure rules apply indiscriminately to every listed company, irrespective of whether the publicly-held portion of its stock is 5% or 90%.
Greater liquidity aids efficient price discovery and reduces the cost of capital for listed firms. Controlling shareholders holding a large chunk of the ownership in a firm will realize that their approach increases the cost of capital for the firm. Shareholders have all the incentive to make the best choices for themselves.
A minimum float rule will also coddle investors into thinking it’s the SEC’s duty to protect them from market risk. If an investor wants to invest in a firm with a low public float, then that investor must be aware of the risk of not being able to exit easily enough. To still invest is his choice. Ultimately, any free market will easily deal with illiquidity, transparency and any perceived inefficiency in price discovery by determining the appropriate risk premiums.
This is part of the normal functioning of any market for stocks or any other asset class. Some investors may also find that risks are unacceptably high and stay out, while others may determine that volatility is great for them to profit by.
[pullquote]To claim that enforcing minimum public floats leads to better transparency is confused logic. Transparency is a result of good corporate governance and the enforcement of disclosure rules, not minimum public floats[/pullquote]
There is no burden on the market or the stock exchange from shares of some firms being relatively illiquid. The SEC’s attempt to improve liquidity by enforcing minimum liquidity rules has backfired. In addition to Finlays Colombo and Metropolitan Resource Holdings delisting, Carson Cumberbatch-controlled oil palm firms Selinsing (market cap of Rs9.3 billion), Shalimar (Rs15.7 billion), Indo-Malay (Rs11.6 billion) and Good Hope (Rs9.8 billion) are all to be delisted according to their parent after restructuring. Overall, the market will be even less of an economic barometer when these firms, many of which raised equity here decades ago, cease to be listed.
Carson’s Equity Two PLC and Pegasus Hotels (PEG) will be transferred to a secondary board where the minimum float requirement is just 10% by end-2016. Royal Palms Beach Hotels (RPBH), Colombo Investment Trust (CIT) and John Keells PLC (JKL) have also requested to be transferred to the secondary board, but it is not clear whether the minimum float was the reason.
The burden on a chief executive whose firm is not meeting SEC-imposed liquidity limits or skirting on the brink of them would be enormous. Three choices face the chief executive: convince the dominating shareholder to sell a chunk of their holding, undertake a big enough issue of new shares to the public or abandon the listing. No chief executive would want new equity; they don’t require it in the first place. If the firm required new equity, naturally it would first request its existing shareholders to provide it through a rights issue. A chief executive who has to request a shareholder to dilute his holding or recommend the company go private, would be in a curious and difficult position.
The stock exchange, which is fighting to get more firms to list, will find it difficult to explain to prospective customers the warped logic and false dilemmas posed by the SEC in its requirement of public holdings.
A top SEC official is reported to have now cast doubts about the rule’s effectiveness in its current form, saying, “We will revisit this rule and hold public consultations during the first quarter of 2016. There are calls for some relaxation on the minimum public float.”
It’s not a relaxation, but a tactful and quick withdrawal that the SEC must pursue.
Corrected: An earlier version of this story said secondary Diri Savi Board listed companies had to only submit interim financial reports half yearly. Diri Savi Board companies must submit financial reports quarterly.