The Chronicles of a Capitalist Lawyer: Securities Law

Showing posts with label Securities Law. Show all posts

Here is a very interesting article from Prof. Stephen M. Bainbridge on the absurdity of the new SEC's Shareholder Proposal Policy which basically gives the right to minority shareholders of a publicly listed company to force a vote in a general meeting of shareholders. The absurdity lies in the fact that according to a US court precedent, the tests for granting the validity of such proposal include matters on ethical and social significance, and not only economic matters.

Of course this would be problematic for companies as this is the same with providing the minority shareholders with the ammunition to control the company for matters which are not directly related to its financial and business performance. In this case, I fully agree with Prof. Bainbridge analysis on the importance of materiality principle in securities laws. If the shareholders want to be involved in the company's management, it should be done only for material transactions that may economically affect the investment value of the relevant shareholders in such company. If the shareholders can actively use the company for their own personal and political needs, why bother to have the concept of limited liabilities?

Luckily, Indonesia does not adopt this kind of rule, though I am surprised that the development of shareholders protection law in the United States has already reached a position where it is difficult to differentiate the role of shareholders and management.

If I could only complain one thing on the process of doing an initial public offering of shares in Indonesia, that must be the requirement for a proposed listed company to obtain from its creditors a waiver of any restriction on such company's capacity to pay dividends to its shareholders or any restriction of dividends payment on the subsidiaries level, provided that the proposed listed company income depends on the payment of dividends from its subsidiaries.

You will be amazed to know that this is not based on a strict regulation, rather it came from an unwritten policy of the Indonesian Capital Market and Financial Institution Supervisory Agency ("Bapepam-LK"). According to Bapepam-LK officials, when a company is trying to raise funds from the public, such company should be able to pay dividends to its shareholders since such dividends will become the main source of income for its shareholders. Therefore, any restrictions for dividend payment should be eliminated as well.

Okay, to certain extent the argument makes sense, but such argument is too simple to be used as a reason for forcing those proposed listed companies to obtain a waiver of their dividend payment restrictions. As far as I know, from the investors perspective, there are two main ways to obtain income from the capital market: (i) payment of dividends, or (ii) capital gain, i.e. buy low, sell high. In other words, dividend is not the only source of income, and in practice, not all investors focus on getting the dividends.

Furthermore, waiving the restriction of such dividend payment may significantly affect the possibility of securing a financing from financial institutions. As you may be aware, for companies, there are three ways of raising funds, i.e. (i) debt financing, (ii) equity financing, and (iii) hybrid financing (the combination of debt and equity financing). Some financial institutions would require its debtors to limit their payment of dividends to ensure that the debtors could have sufficient funds to repay their debts to these financial institutions. From my experience, there were some cases where the proposed listed company had to repay its debts because its creditors did not agree to waive the dividend restriction. If the debt is not huge, than that wouldn't be a problem, but if the amount is huge, the company will face a serious problem as getting the creditors approval might not be easy and the financial condition of the company may also be compromised.

I always believe that capital market regulations should focus on transparency, on how disclosures about the condition of publicly listed companies should be made, not on how they should perform or doing its business activities, that is the role of the management and that is why they are being paid. Forcing proposed listed companies to waive their dividend restrictions is essentially the same with limiting their choices between debt and equity financing, and I am sure that this is not efficient!

In my opinion, the most important thing is that the proposed listed companies have disclosed in their prospectuses that they have several debts and in those debts, they are being limited to pay dividends (fully or partly). If proper disclosures have been made, it is up to the investors decision on whether to invest in such companies or not. That would be the ideal things to have in Indonesia.

Unfortunately, this Bapepam-LK unwritten policy has not been revoked until today. The only thing that we could do now is to lobby Bapepam-LK and make them understand on this issue. Protecting Indonesian investors is very important, but we should also do that in a proper way, not by limiting the options of publicly listed companies, which in some cases, is actually counterproductive.

American law firms never cease to amuse me. After working together with other firms in producing a 40 pages comment to an SEC regulation, now Davis Polk & Wardwell LLP, a very respectable US law firm provides an impressive 279 pages of financial crisis manual. You can read the manual here and its quick summary here. In general, it discusses the current regulatory issues related to the US financial crisis and the effect of such regulations to US financial institutions. I haven't read the manual, but the table of contents shows a very promising product.

Nevertheless, the most interesting part of this manual is not about the content or the quality of such manual as I am quite sure that the manual has been prepared in a professional manner, but the fact that 21 partners and counsels of Davis Polk are the ones that have prepared this manual. Given the latest news on how US law firms are trying to survive in the crisis, I have no doubt now that the crisis has really affected such law firms.

While it is true that from time to time law firms publish certain materials for the purpose of marketing and promotion, in normal circumstances, it is hard to believe that a law firm can produce a manual that is very huge and comprehensive, how in the world that they can find a spare time to write the manual? I'm afraid this time I might need to assume that such opportunity exists because of the crisis, i.e. less work, less billable hours, more promotional time.

Well, I hope that I'm wrong though. Maybe in the United States, it is usual for law firms to issue this kind of manual. After all, they have many resources for doing that.

Let me start this article by explaining the basic concept of the Negative List. It is a regulation issued by the President of the Republic of Indonesia stipulating the area of business which are opened (with certain requirements) or closed to foreign investment in Indonesia. The main reason for Indonesia in having this Negative List is to close or limit any foreign investments in industries which: (i) are being prohibited in Indonesia, such as gambling; (ii) are being considered as strategic for the interest of Indonesia; and (iii) are being reserved for small to mid scale business players.

In short, except for point (i), the Negative List can be considered as a protection mechanism imposed by the Government of Indonesia. Is it good? I must admit that I'm not a huge supporter of the Negative List, as I don't believe that restriction of ownership would be effective to protect the what so called interest of the people of Indonesia.

Up until today, it is generally assumed that the Negative List is not applicable for publicly listed companies. The Negative List is not quite clear on this issue, but at least Law No. 25/2007 on Capital Investment ("Investment Law") states that the provisions of the Investment Law are not applicable for any indirect or portfolio investments, whereas the majority of Indonesian legal scholars interpret that indirect or portfolio investments refer to investment in the capital market, i.e. in publicly listed companies. Therefore, as a logical consequence of this interpretation, the Negative List (in its capacity as one of the implementing regulations of the Investment Law) should not be applicable to publicly listed companies.

However, recently I've heard a shocking news, i.e. there are some discussions within Government officials that the Negative List will be revised in order to cover publicly listed companies. If such plan is executed, foreign investment limitations will also be applied to publicly listed companies. Clearly, I oppose this plan and my reasons shall be further discussed below.

First of all, how can the Government limits foreign ownership in the shares of publicly listed companies? Those shares are listed on the Indonesia Stock Exchange and are effectively being traded (at least most of them). Some of the most active shares are even being traded by each second. While it is possible to control the sale of shares in an Initial Public Offering, it is almost impossible, if not entirely impossible, for someone to control or limit parties in purchasing the shares of a publicly listed company in the secondary market, unless such purchase is considered as a change of control, i.e. takeover.

Even if it is somehow possible to limit the foreign ownership in the secondary market, any attempt to maintain such limitation would be mostly inefficient since it will require a great monitoring mechanism. Under the current technology, such mechanism would be very costly. You want to supervise all transactions and then impose a system which will limit the purchase of shares by foreigners if certain thresholds have been satisfied? And then you want the monitoring system to operate on per second basis? I say, tough luck.

A possible restriction mechanism that can be applied is by limiting the amount of shares that can be offered to the public. However, this is not recommended because such restriction may negatively affect the liquidity of the shares of such company and as a result of which, the public may suffer unnecessary losses.

Second, an attempt to limit foreign investments in the capital market might cause a turbulence within the capital market. I understand that some people might regard this risk as a theoretical risk rather than an actual risk, but I wouldn't be too confident if I were them. Like or not, in most of the time, capital market is driven by fear and greed. Announcing to the public that foreign investment limitations will be applied to publicly listed companies is a very good way to cause unnecessary fear within market players. And believe me, the imaginations are unlimited, foreign investors may think that the market condition is not conducive anymore, some of them will think that their investments will be reduced or they will be forced to divest their shares, etc. In any case, it wouldn't be good for most of the time!

Third, with respect to foreign investments, most Indonesian regulations do not differentiate the ultimate ownership of foreign entities who made investment in Indonesia, i.e. whether the ultimate owners of such foreign entities are truly foreigners or Indonesians. You may be aware that many Indonesian business entities use foreign companies as their investment vehicle in the capital market, which is mainly done for tax purposes.

As a result of the above policy, any investment made by foreign entities in Indonesia will be considered as foreign investments regardless of the ultimate ownership of such entities. Applying this limitation to publicly listed companies would be counterproductive because it may also jeopardize the interest of Indonesians who made their investments through foreign entities.

In addition, as stated above, is having an ownership restriction would be an effective way to protect the interest of the Indonesian people? By all means, capital investment, whether made by foreign or domestic entities should be good for the development. If we want to have the full benefit of such investment, forget about the ownership, or at least put it as the last issue to be considered. The most important issue that we need to achieve through foreign investments is how we can actually "force" those foreign investors to transfer their knowledge to their Indonesian counterparts and how these foreign investments will contribute to the greater good of the society, i.e. creating job opportunities and establishing infrastructure for stronger industry in Indonesia. Shares ownership would be useless if the Indonesian counterparts are not capable to conduct the business as they will end up as puppets of the foreign investors. Surely, this is not something that we want.

Now, if the Government insists that this new regulation will be applied, I will suggest that: (i) the limitation will only be applied to publicly listed companies established after the enactment of such regulation, so all publicly listed companies prior to the enactment will be exempted and their shares are free from any foreign ownership limitations; (ii) the limitation (if any) should only be applied to foreign investors who clearly control the relevant publicly listed companies (under the current Bapepam-LK regulation, a party will be deemed as a controller of a publicly listed company if it owns at least 50% of the shares of such company).

My advice to the Government, stop trying to make politically correct acts, you won the election with a considerable support from the voters, so please focus on making the best policy available rather than trying to look like a populist government which is a shame.

Related to my post on 18 August 2009 where I discussed how US lawyers and law professors make comments on a proposed regulation, after seeing another recommendations from several professors from Harvard Business School and Harvard Law School on the proposed amendment to an SEC Rule which would allow shareholders of publicly listed companies to have greater influence in deciding the composition of the board of directors and commissioners ("SEC Regulation"), I'm getting pretty interested with the actual content of this SEC Regulation.

You can read the 250 pages of the SEC Regulation (which include the proposed amendments and a thorough review of such regulation from the SEC team complete with list of detailed questions asking for public comments) here, and if you are also interested to read the US lawyers' comments on that SEC Regulation for some additional insights, you may read the 40 pages comments here. Be warned however, considering the total pages of those documents and the fact that they deal with complicated US securities regulation, it would be wise if you don't waste your time to read them unless you have a legal background, consider long and complicated reading materials as entertaining, and have absolutely nothing important to do :). Of course, you can simply read a quick summary of the main issues of such regulation below.

Summary of the SEC Regulation

Okay, since this SEC Regulation also deals with certain issues which might only be applicable to US Laws, the summary below will only cover the main issues which might be relevant for Indonesian corporate law, i.e.:

the main purpose of the SEC Regulation is to increase public shareholders participation in determining management candidates for the relevant publicly listed company and to increase information transparency of the candidates themselves;
to satisfy the above purpose, the SEC Regulation requires publicly listed companies to provide information on the candidates in the proxy materials for the shareholders with respect to a general meeting of shareholders; and
the SEC Regulation also tries to determine the qualification of shareholders who can propose candidates of management members, which include having a minimum percentage of shareholding and a minimum period for holding the shares in case their proposed candidates are successfully being elected as the management of the company.

With respect to the above proposed provisions, the Professors from HBS and HLS recommend the SEC to adopt such regulation with the following recommendations:

the minimum amount of shareholding percentage for proposing candidates of directors and commissioners shouldn't be too small (the SEC Regulation proposes 1% but this amount will also depend on the total capitalization of the relevant publicly listed company), as it may cause too many competing candidates for leading the company;
the main point of this SEC Regulation is to have more information on the candidates and if possible, new people on the board of management, not for the sake of making trivial contests, therefore, the threshold for proposing candidates should be increased, say around 5-10% provided that this threshold can be further reviewed in the future in accordance with the relevant situation and condition; and
there should be a minimum period for holding the shares of the relevant publicly listed company after the appointment of the relevant shareholders' proposed candidates is successful, say at least 1 year, just to make sure that the appointed directors/commissioners and the shareholders are serious with the long term development of the company.

Why am I Interested with this Particular SEC Regulation?

It's quite simple though, until today, Indonesia does not have a specific law which deals on how public shareholders of a publicly listed company can propose candidates for the directors and commissioners of such company and when the information on such candidates should be available to the public.

Under the current Indonesian Company Law, any shareholder(s) having at least 10% of the total shareholding of a company (unless the articles of association of the company provide a lower threshold) would be able to propose a general meeting of shareholders (including proposal of the agenda of such meeting). So in theory, if you satisfy the 10% threshold, you should be able to propose your own candidates. However, I haven't heard the actual application of this concept in publicly listed companies.

In addition, it is almost becoming a general practice that the information on the management candidates will only be provided on the date of the general meeting of shareholders. As a result of which, shareholders often do not have the privilege to review the candidates competency beforehand and may not have complete information in determining the best candidates for the management position.

Having said the above, I would like to analyze whether at this current stage Indonesia should be required to have a similar regulation with the above one. Of course, I don't expect that we will have a detailed and sophisticated regulation like in the US, we're talking about the principles only. The drafting of such regulation should only be discussed after we can clearly agree that the regulation itself is needed.

The Necessity of Having Better Transparency and Fairness to All Shareholders

Balancing the relationship between the management and shareholders of a company will always involve some problems, particularly because there are no perfect guidelines on how the management should maintain the relationship with the shareholders. Some legal theorists argue that the management is, to certain extent, acting as the agent of the shareholders, and therefore must act for the benefit of such shareholders. But then again, some of them also argue that the management should act to the best interest of the company, whereas, the interest of the company may differ from the interest of the shareholders.

While we can talk anything in theory, in practice we would need to understand that since the management is appointed by the shareholders (and of course they can always be replaced by the shareholders), there would always be an incentive for the management not to acting in the best interest of the company, particularly when such action might cause them to lose their position or possible remuneration. As a result of which, when a company is being massively controlled by certain controlling shareholders, the possibility of management breaching their fiduciary duty to the company would be most likely increased.

However, the case can also be turned the other way around, that is, if the shareholders of the company are too diversified and no one has majority control over the company (such as in certain publicly listed companies), the management of those companies would be in a stronger position to determine their own actions and rewards and will have less incentives for having better accountability toward the shareholders.

In both cases, the victim would mostly be the public shareholders, i.e. those who cannot be considered as the controlling shareholders. Indeed, Indonesian laws have provided some form of protections for these kind of shareholders, such as the right to request the company (or any third parties appointed by the company) to purchase their shares with a fair price in case they suffer losses due to decisions made by the general meeting of shareholders or the management of such company. For publicly listed companies, the case would be easier. If the company's shares are liquid, the shareholders who don't agree with the company's decision could simply sell their shares in the market.

While this protection mechanism can be considered as a good policy, it has one significant problem, i.e. it encourages public shareholders to leave the company instead to stay for a longer period. What happen if those shareholders actually believe that in the long term the company has a very good prospect, but because of the current condition, they are "forced" to sell their shares? And how about institutional investors who may have quite a huge amount of shares though they are not yet considered as controlling shareholders? They may face some difficulties in selling their shares in the market.

Further, the most important question is why we penalize the company to purchase the shares of the public shareholders who don't agree with the decisions made by the organ of the company? Wouldn't that be counter productive for the growth of the company itself?

I always believe that giving more choices to the public would benefit us all. Therefore, it would also be better if we can have a regulation which can increase public shareholders' participation in determining candidates of the management of the publicly listed companies, including better transparency with respect to information on the management candidates and fairness to any shareholders to propose their own candidates (provided that they satisfy the minimum threshold for shareholding). In this case, adopting a similar regulation with the SEC Regulation would be recommended by me. Further comments from the HBS and HLS professors should also be considered as those comments are very relevant in ensuring that the regulation is workable enough in

One question remain though, what would be the use of giving the opportunity to public shareholders to propose their own management candidates if in the end they will not have sufficient votes to approve the appointment of their candidates since the controlling shareholders do not agree with the candidates? This is particularly relevant in Indonesia where it is very rare to find a publicly listed company which does not have any controlling shareholders.

To solve this issue, it may be possible that the threshold of appointing candidates proposed by public shareholders shall be reduced to allow voting by minority shareholders or that the controlling shareholders shall have no votes with respect to the appointment of such candidates. (as if in a conflict of interest transaction). Further discussion on this issue would be definitely useful.

To end this article, it is important to note that while having better transparency and fairness for public shareholders in determining the management candidates might help a company to increase its performance, it wouldn't be quite effective unless there are other incentives which may directly affect the behavior of the management. In this case, I refer to the remuneration system of the management. To see my proposal on this issue, I recommend you to read my post on 17 August 2009, where I discussed the use of independent committee in determining the remuneration of the management.

I'm quite amazed with how lawyers and law professors in the United States involved in the discussion on a new draft of securities regulation. Based on the fact that 7 big law firms would cooperate to produce a 40 page of comments, I can safely assume that the US Securities and Exchange Commission (SEC), the equivalent of Bapepam-LK, the Indonesian Capital Market and Financial Institutions Supervisory Agency, is really paying attention to the comments of practitioners. Because if they don't care, I'm certain that those law firms would not even think to waste their precious billable hours for making such comments. Or, might this be a sign that those firms have some leisure time due to the decline of their jobs? Now, I wonder when would we do the same? I know that Bapepam-LK has already started to ask for public comments before they issue a new regulation, but I haven't seen any notably public comments to such draft regulation.