A Review of Chinese Bonus Shares Practice: A Comparative
Study between Bonus Shares and DRPs
Yameng Wang (12611123)
E-mail: yameng.wang1003@gmail.com
Supervisor: Maryam Malakotipour
Universiteit van Amsterdam (LLM Law and Finance)
ABSTRACT
Bonus shares constitute important parts of the dividend distribution policy in China's capital market. They have significant positive effects on corporate governance, such as sending signals to investors and enhancing stock liquidity. However, considering the problems that China's listed companies are facing in the process of issuing bonus shares, such as inside trading and agency conflicts, it is not an effective and efficient system for the Chinese capital market. It is necessary to reform it to some extent. To find a more suitable solution, this thesis studies the characteristics, advantages and disadvantages of Dividend Reinvestment Plans (DRPs), a system similar to bonus shares, adopted by European countries and the United States. Then, through a comparative study between DRPs and bonus shares, it is found that DRPs can make up for some shortcomings of bonus shares while maintaining the advantages, which is of great reference significance for the reform of bonus shares. Therefore, this thesis believes that it will be helpful to find some solutions from DRPs for the bonus shares reform in China.
CONTENT
1. INTRODUCTION ... 3
2. WHY ARE STOCK DIVIDENDS IMPORTANT? ... 4
2.1 CHARACTERISTICS OF STOCK DIVIDENDS — A COMPARISON WITH CASH DIVIDENDS ... 4
2.2 THE BENEFITS OF STOCK DIVIDENDS TO CORPORATE GOVERNANCE ... 6
2.2.a Signalling ... 6
2.2.b Retained earnings ... 8
2.2.c Enhanced liquidity ... 9
2.2.d Cash substitution ... 10
3. CHINA’S STOCK DIVIDEND DISTRIBUTION SYSTEM: BONUS SHARES ... 11
3.1 BACKGROUND ... 11
3.2 DEFINITION AND SCOPE ... 13
4. PROBLEMS EXISTING IN BONUS SHARES ... 17
4.1 NO SUBSTANTIAL RETURN FOR SHAREHOLDERS ... 17
4.2 FREE CASH FLOW: AGENCYPROBLEMSBETWEEN MANAGERS AND SHAREHOLDERS ... 18
4.3 INSIDER TRADING: AGENCYPROBLEMSBETWEEN CONTROLLING SHAREHOLDERS AND MINORITY SHAREHOLDERS ... 20
4.3.a Case study: insider trading by issuing high-ratio bonus shares ... 21
4.3.b Regulatory measures of the CSRC and their effects ... 22
5. FOREIGN SYSTEMS: DIVIDEND REINVESTMENT PLANS (DRPS) ... 26
5.1 DRPS IN THE EUROPEAN UNION AND THE UNITED STATES ... 26
5.1.a The new-issue DRPs (i.e. scrip dividend schemes) ... 27
5.1.b The open-market DRPs ... 29
5.2 THE COMPARISON BETWEEN DRPS AND BONUS SHARES ... 31
5.1.a Advantages of DRPs over bonus shares ... 31
5.2.b Disadvantages of DRPs ... 34
6. WHAT KIND OF REGIME IS MORE SUITABLE FOR CHINA? ... 35
6.1. FIND SOLUTIONS FROM DRPS ... 35
6.1.a DRPs are helpful to solve the three problems existing in bonus shares ... 35
6.2.b The open-market DRPs are more suitable for China ... 38
6.2. USE BONUS SHARES TO ENHANCE STOCK LIQUIDITY ... 39
7. CONCLUSION ... 41
1. Introduction
One of the characteristics of for-profit companies is that they can issue shares and distribute the profits they made to shareholders. The earnings that a company distributes to its shareholders (of the firm’s common stock and/or preferred stock) 1
are called dividends, which can be distributed in diversified forms. Diamond and Williams categorise dividends paid by companies into cash dividends, stock or share dividends, and property dividends, among which cash dividends and stock dividends are two kinds of dividend distribution methods that are most widely adopted.2
The capital market in China originated in the late 1980s. For a long time, the willingness of distributing cash dividends is generally low in China’s listed companies, and the bonus shares play the role of stock dividends that can effectively avoid cash dividends. Theoretically, appropriate stock dividend distribution policies have positive effects on the diversification of dividend distribution forms and the stability of the capital market, which should take into account the interests of both the listed companies and the shareholders, especially minority shareholders. However, due to the characteristics and accounting treatments of bonus shares, as well as the lack of supervision, China's bonus shares have some significant shortcomings in the practice. Then it triggers agency conflicts between shareholders and management, and between controlling shareholders and minority shareholders, which brings negative effects on China's capital market. This thesis will review the practice of bonus shares in China to comprehensively understand the advantages and problems of China's bonus shares. Moreover, to solve the problems existing in bonus shares and improve the practice in China, this thesis does a comparative study between bonus shares and DRPs, a system similar to bonus shares adopted in Europe and the United States. Through analysing whether DRPs can solve the main problems of bonus shares while maintaining the advantages, this thesis
1 Chen-Few Lee and Alice C Lee, Encyclopedia of Finance (Springer US 2006) 91.
2 Michael R Diamond and Julie L Williams, How to Incorporate : A Handbook for Entrepreneurs and
finds out that it is feasible to acquire some useful solutions for the reform of China's bonus shares from the DRPs.
This thesis proceeds as follows. Section 2 discusses the importance and benefits of stock dividends for corporate governance. Section 3 presents the status of China’s stock dividends policy and section 4 analyses the problems existing in bonus shares. Section 5 introduces another system named DRPs which are commonly used in the European Union and the United States, and then makes a comparative analysis of bonus shares and DRPs. According to the previous sections, there are some suggestions for China’s stock dividend distribution policy in section 6, followed by the conclusion in section 7.
2. Why Are Stock Dividends Important?
2.1 Characteristics of stock dividends — a comparison with cash dividends
Cash dividend, the prerequisite and foundation for the shareholding system to be successful, is the most common form of dividend distribution and is used by most U.S. listed companies. It refers to profits from a company to pay the dividends of their owners (i.e., the shareholders). Shareholders who accept this distribution form will directly receive cash in accordance with a rate fixed in advance, based on the number of shares they own. By contrast, stock dividends, another commonly used dividend distribution form by listed companies, refers to a dividend paid to shareholders in the form of shares instead of cash. Shareholders who accept this distribution form will receive the company's stock in proportion (i.e., usually a few percent of the number of shares owned by shareholders) as dividends. In the high-ratio issues of bonus shares in China's A-share market, which will be discussed later in this thesis, shareholders even receive more stock dividends than their original shareholding.3 In this form of dividend
3 Liu Jing and Xu Meng, ‘An Analysis of the Reasons and Effects of the High-Ratio Bonus Shares of
Chinese Listed Companies’ [2020] Financial Management Research 29
<https://kns.cnki.net/KCMS/detail/detail.aspx?dbcode=CJFD&dbname=CJFDLAST2020&filename=C WGL202005007&v=MDY5ODZZUzdEaDFUM3FUcldNMUZyQ1VSN3FmWU9kb0ZpemhWNy9L SmpyTVlyRzRITkhNcW85Rlk0UjhlWDFMdXg=&UID=WEEvREcwSlJHSldTTEYzWEpEZktmaVJ GSzNnTTdEWWdINU45QndMK1g1az0%25> accessed 16 July 2020.
distribution, companies actually issue new shares and these new shares are subscribed by all original shareholders at the same ratio. However, the original shareholders do not have to pay anything for these new shares they got. Therefore, it reduces the cost of issuing new shares to the company while maintaining the proportion of original shareholders' shares in the company.
Cash dividends are essentially a transfer of economic value from a company to its shareholders. By this way, shareholders are provided with the opportunity to receive regular investment income and capital appreciation, which also sends a signal at the same time to the potential outside investors that the company is flush with cash and in good financial status. However, if shareholders choose cash dividends, they are liable to pay tax on the distributed value, thereby reducing the value of the distributed profits they eventually get. Moreover, after distributing the cash to shareholders, a company's asset structure will change, the debt-to-equity ratio will increase, the solvency will decline, and the company will hold fewer funds available for operation and investment.4
In addition to potential financial risks, another problem is that when encountering good investment projects, the company may not be able to raise enough money to invest. The significant benefit of stock dividends over cash dividends to shareholders is that shareholders do not have to pay taxes on it for the time being, unless they sell the stock dividends to others or receive cash dividends from the stock dividends. For companies, they can benefit the most from reducing cash requirements to regain their financial health when they are weak financially and unable to generate enough profits to be distributed among shareholders.5 At other times, they can benefit from leaving more
money in the company to capitalise on profitable growth opportunities (i.e., investments).6 Besides, although shareholders cannot get cash income immediately,
they may earn a better rate of return in the future due to the increase in the company’s
4 Muhammad Nadeem Khan and Moona Shamim, ‘A Sectoral Analysis of Dividend Payment
Behavior’ (2017) 7 SAGE Open 215824401668229
<http://journals.sagepub.com/doi/10.1177/2158244016682291> accessed 8 June 2020.
5 Cahit Adaoglu and Meziane Lasfer, ‘Why Do Companies Pay Stock Dividends? The Case of Bonus
Distributions in an Inflationary Environment’ (2011) 38 Journal of Business Finance & Accounting 601 <http://doi.wiley.com/10.1111/j.1468-5957.2011.02233.x> accessed 8 June 2020.
profits. However, it cannot be ignored that the expected return of shareholders is also volatile and uncertain since it depends on the future performance of the company. Therefore, when a company has predictable recurring revenue to support the daily operation and does not have a considerable number of investment opportunities to invest with its free cash flow, it is more likely to pay cash dividends. In contrast, for a growing company that expects a large amount of money to invest in the future, or one that does not have adequate cash on hand, stock dividends may be a better bet.
2.2 The benefits of stock dividends to corporate governance
Apart from the above mentioned positive functions of stock dividends — helping financially weak companies to restore financial health or helping growing companies to take advantage of profitable investments — stock dividends have many substantial impacts worth exploring. From the perspective of corporate governance, this thesis will discuss the impacts of stock dividends on corporate operations and shareholders' rights, to understand their significance for the stability and development of the financial market as a whole.
Current research on stock dividends mainly involves four hypotheses regarding the influence of stock dividend on corporate governance: (i) signalling, (ii) retained earnings, (iii) enhanced liquidity, and (iv) cash substitution.
2.2.a Signalling
The signalling hypothesis is based on the information asymmetry. In the imperfect market, information asymmetry exists between managers of listed companies and their external investors. Specifically, managers of a company, compared to external investors, have more real information that can reflect the value of the company, including both the current profitability and its growth potential in the future. Information asymmetry leads to the risk and uncertainty of economic behaviour. In particular, in capital markets where the regulatory authorities have low requirements on the information disclosure of listed companies and the willingness of listed companies to disclose information
voluntarily is also low, the opacity of listed companies greatly increases the investment risk. Therefore, when necessary, such as when the value of a company is undervalued by the market, managers will take some measures to disclose information to external investors, so that to adjust the market reaction. Meanwhile, investors will also capture signals (i.e. internal information) from major decisions and policy changes made by listed companies, to speculate on companies' financial status and development potential.7 Among them, dividend policy is one of the important sources for investors
to capture signals about the company's prospects.8
Dividend policy is a common signalling mechanism: by announcing dividend distribution policies, managers convey the internal information of listed companies to the market participates, helping external investors to predict the future earnings and future cash flow of companies and then evaluate the investment risk. This mechanism is helpful to reduce information asymmetry between managers and investors and alleviate investment problems caused by asymmetric information.
However, in the common forms of dividend distribution, the signal transmission function of stock dividends is questioned by Feng et al., who argue that cash dividends have a real signalling function compared with stock dividends.9 Feng et al. believe only
signals that require cost are credible. Since issuing stock dividends do not need to increase the cash outflow of listed companies, which means it hardly brings costs to listed companies, stock dividends do not actually realise the signal transmission. In contrast, the payment of cash dividends results in an actual outflow of cash, so only the increase of cash dividends can predict the good performance of listed companies in the
7 Under information asymmetry, there are three common signals for listed companies to transmit
internal information to the outside market: (i) profit announcement; (ii) dividend announcement; (iii) financing announcement.
8 Louis TW Cheng, Hung-Gay Fung and Tak Yan Leung, ‘Dividend Preference of Tradable-Share and
Non-Tradable-Share Holders in Mainland China’ (2009) 49 Accounting & Finance 291 <http://doi.wiley.com/10.1111/j.1467-629X.2008.00284.x> accessed 9 June 2020.
9 Ke Feng, Hong Liu and Li He, ‘Study of Signal Effect of High Percentage Stock Dividend on the
Future Profitability in China’ (2012) 192 Journal of Zhongnan University of Economics and Law 3 <https://kns.cnki.net/KCMS/detail/detail.aspx?dbcode=CJFQ&dbname=CJFD2012&filename=ZLCJ2 01203001&v=MDc1NTdyL09QeUhJWkxHNEg5UE1ySTlGWllSOGVYMUx1eFlTN0RoMVQzcVR yV00xRnJDVVI3cWZZK2R0Rnk3aFc=&UID=WEEvREcwSlJHSldTTEYzVTFPV2k0N0tPTlh4MUt ZZTlCOEFXM2FVTVV1Zz0%253D> accessed 9 June 2020.
future, giving a positive signal to the market investors. This doubt can be explained in the next section, where the specific transmission mechanism, through which companies release signals by issuing stock dividends, will be discussed.
2.2.b Retained earnings
The retained earnings hypothesis involves the accounting treatment of stock distribution: the accounting treatment of stock dividend distribution on the balance sheet has an important impact on the market response to the distribution announcement.10
Reflected in the balance sheet, the payment of stock dividends neither reduces the balance of a listed company’s asset account nor changes the total amount of shareholders’ equity account. However, since the accounting treatment of issuing stock dividends does not change the par value per share, the amount of share capital increases due to the distribution of stock dividends. At the same time, in order to keep the total amount of shareholders' equity unchanged, the aforementioned added value needs to be offset by the reduction of other items, such as retained earnings.11 Therefore, the
accounting treatment of stock dividends is essentially the adjustment of the internal structure of shareholders' equity, that is, to convert the company's retained earnings into equity capital. In the process, despite no actual cash outflow, the reduction in retained earnings actually reduces the company's ability to pay cash dividends in the future.12
In a sense, this is the cost of companies issuing stock dividends.
Specifically speaking, if the company has a good business prospect, it can use future earnings to make up for the current reduced capacity of paying cash dividends. However, if the company has a poor business prospect, it will be in great difficulty
10 Dean Crawford, Diana R Franz and Gerald J Lobo, ‘Signaling Managerial Optimism through Stock
Dividends and Stock Splits: A Reexamination of the Retained Earnings Hypothesis’, vol 40 (2005) <https://about.jstor.org/terms> accessed 9 June 2020.
11 Jason E Heavilin and Hilmi Songur, ‘Stock Distributions and the Retained Earnings Hypothesis
Revisited’ (2019) 30 Finance Research Letters 240.
12 Talat Afza and Hammad Hassan Mirza, ‘Ownership Structure and Cash Flows As Determinants of
because the retained earnings are not enough to pay cash dividends.13 That is to say, if
the managers of a listed company pay stock dividends when they know the company's business prospects are not good and its expected earnings are low, it is very risky. The company may get into financial difficulties in the future. Therefore, under normal circumstances, investors regard the issuance of stock dividends as a favourable signal, which conveys the optimistic expectation of the managers for the listed companies (i.e., the substantial growth of the performance and earnings in the future).14 At this time,
stock dividends typically generate positive market reactions, such as the influx of capital financed from investments, which increases companies’ stock price and also benefits shareholders.
This is the specific transmission mechanism of the signalling hypothesis about stock dividends, which reveals the cost that listed companies have to bear in essence when they send signals through stock dividends. Thus, it is not cost-free for companies to send signals through stock dividends. On the contrary, the cost can be very high.
2.2.c Enhanced liquidity
Besides, another function of stock dividends on corporate governance is related to the enhanced liquidity hypothesis.
Liquidity refers to the degree of difficulty in buying and selling securities without affecting asset prices, which reflects the ability of assets to be realized. Stocks with high liquidity are relatively low risk because investors can clear positions with the market price at any time, in order to lock up profits in time and avoid the risks and losses caused by the decline of the market price. On the contrary, when the liquidity is low, it will be riskier due to the difficulty for investors to realize their assets.15
13 Jiaxin Yang, ‘Research on Accounting Policies of Stock Dividends’ [2000] Accounting Research
48.
14 Adaoglu and Lasfer (n 5).
There is a close relationship between liquidity and stock price. According to the trading range hypothesis, companies are more likely to keep their stock prices within a specific (lower) price range, where stocks are likely to be more liquid than in other price ranges.16
For example, when the per stock price of a company is too high, investors have to invest more money to buy the same number of shares, which may impede trading and restrict the liquidity of the stock. At this point, in order to reduce the stock price and then improve liquidity, listed companies need to take some measures, such as issuing stock dividends. Issuing a stock dividend will increase the number of shares outstanding in the listed company, which will cause the price of each share to fall and move to the more liquid trading range mentioned above, thus attracting more investors and increasing liquidity.17
2.2.d Cash substitution
Contrary to the above three hypotheses, the cash substitution hypothesis predicts a negative market reaction brought by stock dividends.18 On the one hand, since
managers leave more cash in the company, the problem of free cash flow increases. On the other hand, satisfying shareholders by distributing stock dividends may weaken the regulatory function of shareholders.19 Both issues will be argued more extensively in
section 4.2, but mainly about the former one.
16 David Easley, Maureen O’hara and Gideon Saar, ‘How Stock Splits Affect Trading: A
Microstructure Approach’, vol 36 (2001). Easley et al. also states that the customers attracted by this specific (lower) price range are usually uninformed investors and small investors.
17 Adaoglu and Lasfer (n 5).
18 Jianan Guo, ‘Dividend Payout Policy in the Chinese Equity Market’ (Deakin University 2013). 19 Adaoglu and Lasfer (n 5).
3. China’s Stock Dividend Distribution System: Bonus Shares
3.1 Background
The Chinese Company Law stipulates that shareholders have the right to obtain dividends in accordance with the proportion of shares they hold, but there is no regulation on the forms and amount of dividends, nor other mandatory requirements. The law confers Chinese listed companies a substantial degree of discretion in deciding their dividend distribution policies.20
In fact, cash dividends have always been the most important form of profit distribution for listed companies, playing an important role in the stability and development of the capital market that no other form of profit distribution can match.21 Therefore, even
though the listed companies have the right to free choice, regulatory authorities have mostly emphasised the importance of cash dividends in practice and focused on cash dividends in market supervision. Since the establishment of China's capital market, the state council of the People's Republic of China and the China Securities Regulatory Commission (CSRC) have published a series of regulatory policies, gradually standardising the payment standard of cash dividends as well as the consequences of violation. Among them, the following two documents play a key role in forming the existing layout of distributing cash dividend and stock dividend in China's listed companies.
In 2008, the [CSRC Decree No. 57] Notice on Amendment in Regulations for Listed Companies’ Cash Dividend22 changed the provision that “The accumulatively
distributed profits in cash or stocks in the recent 3 years shall not be less than 20% of the average annual distributable profits realized in the recent 3 years” into “The
20 Bao Yang, Heng Zhuang and Zilu Gan, ‘The Puzzle of Cash Dividend in China’s Securities Market’
[2017] Securities Market Herald 26.
21 Michael J. Barclay and Clifford W. Smith, ‘Corporate Payout Policy. Cash Dividends versus
Open-Market Repurchases’ (1988) 22 Journal of Financial Economics 61.
22 Notice on Amendment in Regulations for Listed Companies’ Cash Dividend [CSRC Decree No.57]
accumulatively distributed profit in cash in the recent 3 years shall not be less than 30% of the average annual distributable profits realized in the recent 3 years”. In 2013, the No.3 Guideline for the Supervision of Listed Companies - Cash Dividend Distribution of Listed Companies23 required that listed companies sufficiently comply with the
comments and requests of independent directors and small and medium-sized shareholders in making dividend distribution decisions. Meanwhile, it made clear that cash dividends take precedence over stock dividends in the profit distribution methods and put forward differentiated cash dividend policies, that is, the minimum proportion of cash dividends in the profit distribution plan of different companies in different situations.
These policies, in a very tough way, have rapidly pushed forward the distribution of cash dividends of listed companies in China and correspondingly reduced the decision-making space for companies to distribute stock dividends. Driven by the above policies, since 2010, the proportion of companies paying dividends and the dividend payment ratio24 among Chinese listed companies that have disclosed annual reports have
gradually increased.25 For example, in terms of the overall proportion of profits
distributed by listed companies, the cumulative cash dividends paid by listed companies as a percentage of the net profits realised in the current year (i.e., the dividend payout ratio) have also continued to rise.26 From 2010 to 2012, the overall dividend payout
ratios of listed companies in China were 18%, 20%, and 24%, respectively. From 2013 to 2017, the overall dividend payout ratios of companies listed on the Shanghai Stock
23 No.3 Guideline for the Supervision of Listed Companies - Cash Dividend Distribution of Listed
Companies 2013.
24 The proportion of companies paying dividends and the dividend payout ratio are two indexes that
are more determined by the subjective intention of listed companies. The dividend payout ratio is the ratio of the total amount of dividends paid to shareholders to the company's net income. From the perspective of investors, a ratio of 35% to 55% is considered to be in a healthy and appropriate range.
25 CSRC, ‘The Comparison of Profit Distribution of Listed Companies at Home and Abroad’ (CSRC,
2012) <http://www.csrc.gov.cn/shenzhen/xxfw/tzzsyd/zqtz/201306/t20130604_228980.htm> accessed 9 June 2020.
26 Another example can be found in terms of the number of companies, since 2001, the proportion of
listed companies carrying out cash distribution plans has risen from less than a third of the total number of listed companies to more than two-thirds. Among them, from 2010 to 2012, the number of listed companies that implemented cash dividends in China accounted for 50%, 58% and 68% of the total number respectively. From 2013 to 2017, the proportion of companies listed on the Shanghai Stock Exchange remained stable at about 70%, despite fluctuations.
Exchange were all above 30%, which was basically flat. In 2018, the overall dividend payout ratio of companies listed on the Shanghai Stock Exchange was 41%, reaching the range of healthy dividend payout ratio (i.e., 35%-55%) for the first time.27
Based on the above market data, the subjective willingness of China’s listed companies to pay cash dividends is increasing, and the dividend level is also rising.28 Accordingly,
the living space of the stock dividends is squeezed. However, a phenomenon that cannot be ignored is that the dividend payment level of different listed companies in China's capital market is slightly different.29 There are still a large number of listed companies
that do not pay or only pay a low proportion of cash dividends due to various reasons. In the dividend distribution of these companies, stock dividends play a very important role. Attaching importance to this form of dividend distribution (i.e., stock dividends) and strengthening its supervision are conducive to better regulating the order of the whole capital market.
3.2 Definition and scope
In China, stock dividends are referred to as bonus shares in practice (hereinafter used to replace the expression of stock dividends in the context of China’s listed companies)30. Specifically speaking, bonus shares means that a listed company adds its
after-tax profit into share capital in case of expectation for profits or actual profits, and distributes the new share capital to the original shareholders according to the original shareholding ratio or a distribution ratio set by itself. After the issuance of bonus shares, the overall structure of the company's assets, liabilities and shareholders' equity will not
27 Data Sources: Overview and Analysis on Annual Reports of SSE-Listed Companies.
For example, Shanghai Stock Exchange, ‘Overview and Analysis on 2018 Annual Reports of SSE-Listed Companies’ (2019) <http://english.sse.com.cn/news/newsrelease/c/4945813.shtml> accessed 9 June 2020.
28 CSRC (n 30).
29 No.3 Guideline for the Supervision of Listed Companies - Cash Dividend Distribution of Listed
Companies notes as follows: “Under the effect of economic, institutional and financial environment factors, cash dividend distribution of Chinese listed companies still has many problems which include but are not limited to: cash dividend distribution is highly concentrated in a minority of high-quality companies.”
change, and only the internal structure of shareholders' equity will be adjusted — the after-tax profit will decrease while the total share capital will increase.
In addition, bonus shares actually contain another market behaviour, namely capitalisation of surplus reserves. Surplus reserves refer to the accumulation of earnings which are extracted from the after-tax profit and kept in companies for specific purposes. According to Chinese Company Law, listed companies shall draw statutory surplus reserve funds from their net profits (after making up for losses in previous years) at a rate of 10%. The capitalisation of surplus reserves means that a listed company converts all or part of its surplus reserves into equity. It will reduce the retained profits while increasing the size of the share capital, but will not change the total amount of shareholders' equity. Therefore, capitalisation of surplus reserves essentially achieves a similar result with bonus shares. Neither bonus shares nor capitalisation of surplus reserves will result in any cash outflow, nor will they lead to a decrease in a company's property. They only change the structure of owners' equity, which is increasing the total capital stock by reducing the after-tax profit and surplus reserves.
At present, there is no specific definition and scope of bonus shares in China, but in the relevant documents of the CSRC and stock exchanges (table 1), bonus shares always appear in parallel with cash dividends, which both belong to the profit distribution forms of listed companies. Hence, under the acquiescence of the regulatory authorities, issuing bonus shares, as a profit distribution method, has become one of the typical ways for many companies to substitute cash dividends when distributing profits. With the issuance of stocks on the Main Board and GEM and the continuous development of trading markets in China, a large number of bonus shares are issued in China's listed companies.
Table 1
Documents Provisions Meaning
2008 [CSRC Decree No. 57] Notice on Amendment in Regulations for
“A listed company shall disclose the scheme of profit distribution or
The capitalisation of capital reserves does not belong to profit
Listed Companies’ Cash Dividend31
that of capitalisation from the capital public reserve.”
distribution. Bonus shares (including capitalisation of surplus reserves) are profit distribution. 2013 No.3 Guideline for the
Supervision of Listed Companies - Cash Dividend Distribution of Listed Companies32
“Listed companies shall specify the priority of cash dividend
distribution relative to the stock dividend in the profit distribution methods.”
Both cash dividends and bonus shares are profit distribution forms. But no definition of bonus shares. 2016 Formats of Information Disclosure Announcement of Listed Companies: No. 38, No. 43, No. 42 (Shenzhen Stock Exchange, on February 2016)33
The format of profit distribution plan announcement of listed companies contains three forms of profit distribution,
respectively for bonus shares, cash dividends, and capitalisation of reserves.
Bonus shares and capitalisation of
reserves are both profit distribution. But there is no distinction between capitalisation of surplus reserves and capitalisation of capital reserves, both of which are generally included in the profit distribution plan.
It is worth noting that many listed companies and investors in China confuse the capitalisation of capital reserves with the capitalisation of surplus reserves, and also regard the former as a dividend distribution method. In fact, issuing bonus shares and capitalising surplus reserves are both from the after-tax profit of a company, and can only be implemented if the company has a surplus. However, capital reserves are shareholders' equity generated from capital, assets and other reasons, which are outside of a company's production and operation. Thus, capitalising of capital reserves is not limited to the company's distributable profits in the current year. Therefore, strictly
31 Notice on Amendment in Regulations for Listed Companies’ Cash Dividend [CSRC Decree No.57]. 32 No.3 Guideline for the Supervision of Listed Companies - Cash Dividend Distribution of Listed
Companies.
speaking, capitalising of capital reserves is not a profit distribution method.34 In the
early years, regulatory authorities did allow only listed companies to distribute dividends by issuing bonus shares and capitalising surplus reserves (the first document in table 1).
But in recent years, based on the latter two documents listed in table 1, it can be found that the regulatory authorities have gradually blurred the distinction between capitalisation of surplus reserves and capitalisation of capital reserves. By 2016, regulators no longer distinguished between the two; they disclosed them in a general term in profit distribution plans. At present, regulators still maintain the regulatory attitude. Shanghai Stock Exchange only requires listed companies to disclose one item named issues of bonus shares in their profit distribution plan, and Shenzhen Stock Exchange requires to separately disclose issues of bonus shares and capitalisation of reserves which simultaneously contains surplus reserves and capital reserves. This phenomenon shows that from the perspective of the government, the issues related to the specific definition and scope of bonus shares are less urgent and the main focus of current supervision is on other issues that are more urgent and have a greater impact on the healthy development of China's capital market. The most important concern of regulators at present on the bonus shares is a series of consequences caused by high-ratio issues of bonus shares that are detrimental to the stability of the financial market, which will be discussed in section 4.3.
34 Wang Junhui and Li Meihua, ‘Comparison between Bonus Shares and Capitalising of Capital
Reserves’ [2007] Chinese Township Enterprise Accounting 8
<https://kns.cnki.net/KCMS/detail/detail.aspx?dbcode=CJFD&dbname=CJFD2007&filename=XQKJ2 00707003&v=MjAxOTMzcVRyV00xRnJDVVI3cWZZT2RvRnluZ1Y3ektQVHpBWkxHNEh0Yk1x STlGWjRSOGVYMUx1eFlTN0RoMVQ=&UID=WEEvREcwSlJHSldTTEYzWEpEZktmaVJGS25C ajRvMTMxRnJLNWJUMm43MD0%3D%249A4hF_YAuvQ5obgVAqNKPCYcEjKensW4IQMovwH twkF4VYPoHbKxJw!!&autoLogin=0> accessed 16 July 2020.
4. Problems Existing in bonus shares
Bonus shares, as a stock dividend policy in China’s capital market, certainly have the benefits listed in section 2.2, but there are still some flaws in this system, which are the focus of this thesis.
4.1 No substantial return for shareholders
As mentioned above, bonus shares, as a dividend policy that distributes after-tax profit of a company to shareholders, can only be issued if a company has a surplus. In relevant documents of the CSRC and stock exchanges, bonus shares are also regarded as an alternative to cash dividends, which implies the nature of profit distribution. However, whether issuing bonus shares essentially distributes companies’ profits to shareholders is still questionable.
Under the current accounting theory, shareholders should not recognize the bonus shares issued by listed companies as the income from an investment. In other words, bonus shares should not be considered as a method of profit distribution. This is the view generally held in the accounting field.35 The differences between bonus shares
and cash dividends are visible from the specific accounting treatments. Cash dividends will lead to a decrease in companies’ monetary assets, but it will not cause the share capital to expand, and shareholders will receive substantial income in the process. The issuance of bonus shares, however, does not impact companies' assets. Only when adjusting the internal structure of the owner ’s equity, the undistributed profits will be transferred to the equity account, thereby expanding equity. In this process, shareholders cannot obtain the actual income from the undistributed profits of the companies, nor can they control the companies’ undistributed profits. That is to say, bonus shares do not make companies' undistributed profits translate into earnings that shareholders can control on their own. There is no substantial return for shareholders.
4.2 Free cash flow: agency problems between managers and shareholders
Jensen and Meckling define the agency relationship as a contract in which the principal entrusts the agent to perform affairs on his behalf and delegates some decision-making rights to them.36 However, because the interests and objectives of the agent and the
principal are not completely consistent, the agent does not always act in the best interests of the principal. When the agent deals with a matter on the principal's behalf, if there is no effective monitoring mechanism to supervise the agent ’s behaviour, the agent will make some decisions for their benefit. These decisions may be different from those that can maximise the interests of the principal, and, hence, the interests of the principal will be harmed.
On corporate governance, the typical agency problem involves the agency relationship between shareholders and management.37 Shareholders, as the owners of a company,
choose not to directly participate in the corporate governance due to lack of professional knowledge and experience in corporate governance or because the company's equity is too dispersed. Instead, they employ professional managers to govern the company. This results in the company’s separation of ownership and control. Although managers, in theory, should take the maximisation of shareholders’ interests as the principle of action, in practice, they may make decisions that do not reflect the best interests of shareholders, either intentionally or unintentionally, because their interests and goals are often inconsistent with shareholders. For example, shareholders often pursue the long-term development of the company, but managers tend to pursue the company's short-term interests for their performance.
Free cash flow (hereinafter referred to as FCF) is one of the sources of agency problems between managers and shareholders. Jensen defines FCF as "cash flow in excess of that
36 Michael C Jensen and William H Meckling, ‘Theory of the Firm: Managerial Behavior, Agency
Costs and Ownership Structure’ (1976) 3 Journal of Financial Economics 305.
37 John Armour, Henry Hansmann and Reinier Kraakman, ‘Agency Problems, Legal Strategies and
required to fund all projects that have positive net present values when discounted at the relevant cost of capital".38 According to his agency costs of free cash flow
hypothesis, when a company has a large amount of FCF, it is easy to cause conflicts between management and shareholders and bring agency costs. Because in a company with a lot of FCF, management will tend to invest in projects with a negative net present value (NPV), resulting in a reduction in the value of the company.39 On the contrary,
if a listed company pays FCF to shareholders in the form of cash dividends, it can restrict the control of the agent by reducing the CFC, thereby reducing agency costs and avoiding agency problems.
Moreover, Bao conducts a direct measurement and regression analysis on the over-investment and FCF of China's listed companies and finds that there is a strong positive correlation between the two factors, which matches with the agency costs of FCF hypothesis proposed by Jensen.40 Bao’s finding suggests that the agency costs of FCF
hypothesis also applies to China's capital market.
Therefore, when a listed company keeps a large amount of FCF in the company through issuing bonus shares, agency conflicts between shareholders and management aggregates. FCF increases the control right of management, who are likely to make decisions for their benefit and use FCF to engage in behaviours that are detrimental to the interests of shareholders. Besides, compared with other systems that can keep cash in a company as much as possible, bonus shares may pose a supervision problem. Considering agency problems that FCF may bring, shareholders tend to let the company distribute more cash dividends to reduce its FCF, thereby restricting the power of agents.41 At the same time, to alleviate agency problems and reduce agency costs,
38 Michael C Jensen, ‘Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers’ (1986) 76
The American Economic Review 323 <https://about.jstor.org/terms> accessed 9 June 2020.
39 Richard Fairchild states another argument that “a firm may need to cut dividends in order to invest
in a new value‐creating project, but the firm will be punished by the market since investors are behaviorally conditioned to believe that dividend cuts are bad news. This may result in firms refusing to cut dividends, hence passing up good projects.”
40 Suyu Bao, ‘Free Cash Flow, Over-Investment in Listed Companies and Debt Governance’ (Xiamen
University 2007).
41 Larry HP Lang and Robert H Litzenberger, ‘Dividend Announcements. Cash Flow Signalling vs.
shareholders will also actively monitor and restrict the agent's other behaviours. However, when the dividend distribution needs are met by the issuance of bonus shares, some shareholders' willingness to supervise the management will be weakened and agency costs will be even higher.
4.3 Insider trading: agency problems between controlling shareholders and minority shareholders
During the process of issuing bonus shares, when the ratio of issuances that are granted to the original shareholders are higher than the general standard, a risky phenomenon called high-ratio42 issues of bonus shares emerges. Due to the high-ratio issuance,
sometimes the newly issued shares are even more than the original shareholding amount of shareholders. High-ratio issues of bonus shares are likely to become a tunnel for controlling shareholders or management to damage the interests of minority shareholders; this may cause an array of illegal profit-making activities such as pushing up the stock price, reducing shareholding to cash out, tunnelling and insider trading. On the one hand, these behaviours disturb the order of the capital market and affect the financial stability; on the other hand, these behaviours are often not conducive to the interests of minority shareholders and aggravate the agency conflict between the controlling shareholders and minority shareholders. Therefore, the agency conflicts between controlling shareholders and minority shareholders of listed companies caused by high-ratio issues of bonus shares are the most worrying issue for regulators in China's capital market. That is, the controlling shareholders use their dominant position to expropriate the interests of the minority shareholder.
This thesis selects a typical case to elaborate on this issue.
42 The Memorandum for Listed Companies’ 2011 Annual Report No. 4 2012 notes as follows: "If the
issue of bonus shares reaches the ratio of 50% (i.e. the proportion of newly issued shares to the shares before issuance), it can be deemed a high ratio.”
4.3.a Case study: insider trading by issuing high-ratio bonus shares
On January 23, 2015, the Hareon Solar Technology Co., Ltd. (hereinafter referred to as "HST", stock code 600401) released the "Pre-disclosure Announcement of the 2014 Profit Distribution Plan". The announcement showed that under the proposal of the top three shareholders, Huaijin Yang, Jiurun Pipe Industry Co., Ltd. and Zijin Electronics Group Co., Ltd., the company formed the 2014 annual plan profit distribution and capitalisation of capital reserves: issuing bonus shares to all shareholders at the ratio of 200% (i.e., newly issuing 20 shares for per 10 shares held by original shareholders). In fact, from the beginning of January, the stock price of HST had continued to rise, and the company's actual controllers had begun to reduce their shareholdings. After releasing the announcement, a lot of individual investors bought stocks of HST and massive money poured in the capital market, which made its stock price climb on the daily limit and continued to rise in the following days. However, one of its major shareholders, Jiurun Pipe Industry Co., Ltd., sold its shares through the secondary market on 27th and 28th, accounting for 4.98% of the total share capital of the company. In the end, the three major shareholders collectively reduced their holdings of more than 1.5 billion yuan.
After the collective reduction, on January 30, HST released the Notice of Pre-loss of 2014 Annual Performance, and warned a risk: according to the Stock Listing Rules in Shanghai Stock Exchange, if the company's audited net profit in 2014 is lost, the company will lose for two consecutive years, and its stock will be subject to delisting risk warning after the disclosure of the 2014 annual report. The company's stock price had since fallen sharply.
The above behaviours arouse suspicion of regulators: possibly, before the disclosure of the 2014 annual report, the three major shareholders had insider information about the company's loss, but they still proposed to issue bonus shares at a high ratio regardless of the actual situation of the company. By taking advantage of the hype and irrational pursuit of high-ratio bonus shares in China's capital market, they achieved a rapid rise
in the stock price in this way. At the same time, they were significantly active in the market. They frantically reduced their shares through bulk trading many times, and finally withdrew their money from the company at the peak of the stock price. However, the ordinary investors (i.e. uninformed investors) in the market bought stocks when seeing the good news of issuing high-ratio bonus shares, and then immediately received significant bearish news about the delisting warning. Buying at a high price and selling at a low price made these minority shareholders suffer significant losses. In contrast, the actual controllers of the company gained considerable benefits by expropriating minority investors, which was a typical insider trading and benefit transfer through high-ratio issues of bonus shares. Eventually, the three major shareholders were punished by the Shanghai Stock Exchange through a public censure announcement for violating regulations on information disclosure and directors were circulated a notice of criticism for violating their duty of loyalty and diligence.43
4.3.b Regulatory measures of the CSRC and their effects
Since 1993, the CSRC has issued several regulatory policies to regulate the “high-ratio of bonus issues of shares”. At first, the CSRC only focused on the regulation of bonus shares, mainly coordinating the relationship between bonus shares (i.e. stock dividends) and cash dividends. The regulatory purpose was to cultivate the long-term investment concept of investors in the capital market and enhance the attractiveness and vitality of the capital market. As of 2012, the CSRC started to pay attention to high-ratio issues of bonus shares. The aims of the regulation are now preventing high-ratio issues of bonus shares from encouraging speculation in stock prices and protecting minority investors.
Among them, 2017 is the most important year because the CSRC has gradually shown a negative attitude towards high-ratio issues of bonus shares. On March 24, 2017, the CSRC spokesman said that the CSRC would strictly regulate the high-ratio issues of bonus shares of listed companies. On April 8, the chairman of CSRC stated that the
issuance of bonus shares at the ratio of 300%, as a typical act of speculation, must be included in key supervision. In December of the same year, the CSRC again responded to the problems brought by high-ratio issues of bonus shares, stressing that the CSRC would continue to maintain high-handed supervision of the high-ratio issues of bonus shares of listed companies.
Consistent with its attitude, the CSRC has carried out a series of regulatory measures on the high-ratio issues of bonus shares since 2017. First, it carried out risk investigation on the listed companies that issued high-ratio bonus shares. Second, it severely investigated and punished the insider trading happened in the issuance of high-ratio bonus shares. Thirdly, it has been improving the supporting regulatory system of information disclosure.
The series of measures has acted as a deterrent to irregularities in the capital market, and to some extent curbed the excessive hype about high-ratio issues of bonus shares. The market's response to high-ratio issues of bonus shares is more rational now. On the one hand, listed companies are more cautious to implement this scheme. As shown in table 2, since 2017, the number of listed companies issuing bonus shares at high ratios has decreased significantly, and its proportion in all listed companies which issue bonus shares has also decreased. According to table 3, among all listed companies that implemented this scheme, the ratio at which bonus shares are issued has also declined as a whole: bonus shares at more than 100% have rapidly reduced, while issuance at more than 150%, which are more likely to be identified as speculation, has almost disappeared. By 2018, more than 90% of high-ratio issues of bonus shares have been mainly concentrated in the ratio range of 50%-100%. On the other hand, investors' enthusiasm for high-ratio issues of bonus shares has cooled somewhat. They no longer blindly follow the surge of investment aroused after the announcement of issuing bonus shares at high ratios of listed companies; they can rather, more rationally, look at the signals released by the announcements. As a result of the addressed developments, the influence of high-ratio issues of bonus shares on the stability of the capital market has been gradually reduced. It has also greatly reduced the feasibility of listed companies
to take advantage of high-ratio issues of bonus shares to conduct illegal operations and grab profits from minority investors.
However, the issues are not entirely solved. Although there is a negative tendency of the market's attitude, high-ratio issues of bonus shares, which are rare in other countries' capital markets, still exist in China's capital market — in 2018, more than 25% of listed companies that issued bonus shares still adopted high-ratio schemes. There are still some listed companies trying to use high-ratio issues of bonus shares to inflate their stock prices and engage in illegal behaviours, and the interests of minority investors are still at risk of being expropriated. The existence of high-ratio issues of bonus shares has always been a hidden danger for the stable development of China's capital market.
Table 244
Year High-ratio issues of bonus shares Issues of bonus shares Listed companies Proportion A45 2016 435 601 3084 72.4% 2017 349 723 3521 48.3% 2018 173 686 3622 25.2% Table 3
44 Data Sources for table 2 and table 3: Shanghai Stock Exchange, ‘The Issue of Bonus Shares by
Listed Companies’ (Shanghai Stock Exchange)
<http://www.sse.com.cn/market/stockdata/dividends/bonus/> accessed 9 June 2020. CEIC Data, ‘China CN: No of Listed Company: Shanghai Stock Exchange: Annual’ (CEIC Data)
<https://www.ceicdata.com/en/china/shanghai-stock-exchange-no-of-listed-companies-and-securities/cn-no-of-listed-company-shanghai-stock-exchange-annual> accessed 9 June 2020. Shenzhen Stock Exchange, ‘Thematic Statistics’ (Shenzhen Securities Information Co., Ltd. (SSIC))
<http://webapi.cninfo.com.cn/#/thematicStatistics> accessed 9 June 2020. Shenzhen Stock Exchange, ‘Securities Summary’ (Shenzhen Stock Exchange)
<http://www.szse.cn/English/siteMarketData/marketStatistics/securities/index.html> accessed 9 June 2020.
45 Proportion A refers to the proportion of the number of listed companies that issued bonus shares at a
high ratio (i.e., the proportion of newly issued shares to the shares before issuance is more than 50%) in the total number of listed companies that issued bonus shares in the year.
42%
40% 11%
7%
Listed Companies That Issued Bonus Shares at a High Ratio in 2016
50%-100% 100%-150% 150%-200% 200%-300%
77% 17%
4% 2%
Listed Companies That Issued Bonus Shares at a High Ratio in 2017
50-100% 100%-150% 150%-200% 200%-300%
93% 6% 0.5% 0.5%
Listed Companies That Issued Bonus Shares at a High Ratio in 2018
5. Foreign Systems: Dividend Reinvestment Plans (DRPs)
On the 27th of December 2013, the state council of China issued a document advocating
the establishment of scrip dividend schemes, a type of dividend reinvestment plans to enrich the way of dividend distribution.46 However, this proposal does not seem to
have been widely discussed in academic and practical circles. After several years, the relevant implementation rules have not yet been issued, and there is no case of putting into practice in A-share listed companies. Scrip dividend schemes and other kinds of DRPs may provide ideas for the reform of the existing stock dividend policy in China's capital market. This section will introduce the application of scrip dividend schemes and other kinds of DRPs in foreign countries, and compare the similarities and differences between them and bonus shares in China. The purpose is to discuss whether the foreign systems can provide helpful solutions to solve the main problems that China's bonus shares are facing mentioned in section 4 while giving full play to the advantages of stock dividends mentioned in section 2.2.
5.1 DRPs in the European Union and the United States
In many countries, such as the United Kingdom and the United States, there are no bonus shares like in China. Listed companies only pay out cash dividends, and shareholders have the option to accept the cash dividends by a check or a direct deposit into their bank account or use all or part of the cash dividends through DRPs to automatically buy more shares of the company.
DRPs, pronounced “drips” and therefore often represented as “DRIPs”,47 are a kind of
alternative to cash dividends, allowing shareholders to have all or a portion of their cash
46 Opinions of the General Office of the State Council on Further Strengthening the Work of
Protection of the Legitimate Rights and Interests of Minority Investors in the Capital Markets No. 110 2013.
dividends from a listed company reinvested in additional shares issued by the firm.48
There are two types of DRPs, depending on the different sources of shares used for reinvestment: in new-issue DRPs, listed companies issue new shares and distribute them to original shareholders who choose to join the DRPs, which are commonly used and referred to as scrip dividend schemes in British and the European Union;49 in
countries adopting open-market DRPs, such as in the United States, companies meet the need for additional shares by purchasing them in the open market instead of issuing them.
5.1.a The new-issue DRPs (i.e. scrip dividend schemes)
The European capital market has relatively mature experience in the application of scrip dividend schemes.50 Although no specific provisions have been found for the definition
of scrip dividend schemes, ‘dividends paid out in the form of shares of the same class as the shares in respect of which such dividends are paid’ in Article 1 in the Regulation on Prospectus to Be Published51 indirectly testifies to the application of scrip dividend
schemes in the European Union.52
In scrip dividend schemes, if shareholders make no choice, they will automatically receive cash dividends; shareholders can participate in the reinvestment program only if they choose to join in the DRPs. Furthermore, unless shareholders actively modify their previous choice (i.e., exit the DRPs), the choice will be automatically renewed and the subsequent cash dividend will automatically be used to buy the company's
48 Mathew Abraham, Alastair Marsden and Russell Poskitt, ‘Determinants of a Firm’s Decision to
Utilize a Dividend Reinvestment Plan and Shareholder Participation Rates: Australian Evidence’ (2015) 31 Pacific Basin Finance Journal 57.
49 Isabel Feito-Ruiz, Luc Renneboog and Cara Vansteenkiste, ‘Elective Stock and Scrip Dividends’
(2020) 64 Journal of Corporate Finance <http://ssrn.com/abstract_id=3245088www.ecgi.org/wp> accessed 16 July 2020.
50 Scrip dividend schemes are applied in Europe in two different contexts. On one hand, it is used to
pay managers’ salary, which is beyond the scope of this article. On the other hand, it is used as a way to pay shareholder dividends.
51 Regulation (EU) 2017/1129 of the European Parliament and of the Council of 14 June 2017 on the
prospectus to be published when securities are offered to the public or admitted to trading on a regulated market, and repealing Directive 2003/71/EC Text with EEA relevance [2017] OJ L168/12, art 1.
52 There are more detailed information can be found from the scrip dividend programmes published by
newly issued shares. The process of scrip dividend schemes can be divided into two steps. In the first step, shareholders receive the distribution of profits in the form of cash dividends. Second, shareholders waive the company's obligation to pay cash, but ask for equivalent new-issued shares of the company. As a result, shareholders essentially receive their dividend earnings and reinvest them back into the company by buying new shares.
The number of new shares received by shareholders who choose to participate in scrip dividend schemes is calculated by the following formula:
!chosen to join a scrip dividend scheme × cash dividends per share7the number of shares held at the dividend record date and ÷ reference price of new shares
The reference price of new shares is the average mid-market quotation for five consecutive dealing days starting from the ex-dividend date or other approximate time.53 Some companies offer discounts on this basis.54 In addition, in scrip dividend
schemes, shareholders often do not need to pay commissions55 or only pay a nominal
fee, which makes the reinvestment in the new shares almost no frictional costs. Therefore, due to the commission-free and discounted prices, the cost of shareholders investing in new shares is significantly lower than the cost of directly buying shares in the open market. However, as a kind of reinvestment, shareholders have to pay tax on the dividends as normal. The taxable income is the amount of distribution profit.
53 For example, in National Grid, ‘Dividends Ordinary Shares’, the reference stock price is “calculated
as the average closing mid-market price of an ordinary share for the five dealing days commencing with, and including, the ex-dividend date”. In Royal Dutch Shell Plc, ‘Royal Dutch Shell Plc Scrip Dividend Programme Terms and Conditions’, the reference stock price is “the US dollar equivalent of the average of the closing price for the Company’s A Shares listed on Euronext Amsterdam for the five dealing days commencing on (and including) the date on which the Shares are first quoted ex-dividend in respect of the relevant dividend”.
54 The discount is usually 2%-5% of the market price.
55 For example, the National Grid Scrip Dividend Programme is with no stamp duty or commission to
5.1.b The open-market DRPs
Compared with the popularity of new-issue DRPs in the EU capital market, open-market DRPs are widely used in the United States. These two systems share the following characteristics.
First, shareholders have options. All DRPs provide shareholders with options. Shareholders can choose whether they want to participate in reinvestment. They can also choose how much of cash dividends will be reinvested.
Second, they are identified as reinvestment. All DRPs are premised on the actual distribution of dividends. Shareholders exercise their options to join the reinvestment plan, in which they reinvest the cash dividends they should have received in the company's additional shares and directly receive the shares instead of cash.
Third, the market price is used as the reference price when calculating the number of new shares. All DRPs use the market price of the company’s share as the reference price when calculating the number of new shares that shareholders can obtain after reinvesting the cash dividend. Only the benchmark for market quotes may be different. Fourth, the cost of reinvestment is low. Most DRPs provide investors with a way to purchase shares free of commissions and fees, and the new shares are often bought at a discount to the current market price. As a result, the overall investment cost is significantly lower than the cost in the current market.
Fifth, minority shareholders can accumulate shares and earn compound interest by DRPs. Through DRPs, investors can continuously reinvest their cash dividends into the stock market, and the longer they participate in DRPs, the more shares they accumulate. Through long-term investment, the total number of their shares gradually increases, which means they have more cash dividends that can be reinvested, ultimately resulting in an amazing compound effect and reaping a large amount of compound interest. Sixth, listed companies keep more cash by DRPs. Through DRPs, listed companies can prevent all cash flows of cash dividends from flowing out, and the retained cash will
continue to be used as capital for operations and investments. This is a low-cost internal financing method. Companies bypass investment banks and deal directly with investors, saving a lot of financing costs.
Despite the above identical characteristics, some differences between the two DRPs cannot be ignored.
First, the sources of new shares are different. The new-issue DRPs require listed companies to issue new shares, which are issued without paying any brokerage or stamp duty. However, in the United States that adopts open-market DRPs, listed companies cannot meet the reinvestment needs of shareholders by issuing new shares like new-issue DRPs, and can only buy shares directly from the secondary market. Earnings per share (EPS) will not be diluted, and stamp duty is payable.
Second, the treatments of fractional shares are different. When calculating the number of new shares according to the formula mentioned above, the results are not always integers. In other words, when shareholders reinvest in companies' shares through DRPs, it is possible to generate fractional shares which are less than one share. For the fractional shares, European companies that mostly use new-issue DRPs generally have the following different arrangements. First, they may pay the corresponding cash directly to shareholders. Second, the fractional shares may be automatically carried forward to the next dividend. Third, they may sell all the fractional shares together and the proceeds are owned by the companies or donated to charity.
But things are different in the United States. Generally speaking, U.S. shares are sold with one share as the smallest unit, and there will be no fractional shares. But the open-market DRPs exceptionally allow investors to buy fractional stocks (i.e. non-integer stocks) in the market and also allow these fractional stocks to be sold directly so that every dollar of dividends that investors plan to use for reinvestment can actually be reinvested in companies' shares.
This is especially significant for minority shareholders. Due to the low shareholdings, the cash dividends that can be received by minority shareholders are low. It is likely
that all of their cash dividends in the current period may not be enough to buy one share. In this case, they cannot immediately reinvest their cash dividends through new-issue DRPs. However, by allowing the purchase of fractional shares, the open-market DRPs offer a way for these minority shareholders to reinvest their cash dividends and accumulate more shares.
5.2 The comparison between DRPs and bonus shares 5.1.a Advantages of DRPs over bonus shares
DRPs, as alternatives to cash dividends, have some functions that are similar to those of bonus shares mentioned in section 2.
First, DRPs enable companies to reserve cash for their subsequent operations and investments. DRPs fully respect the shareholders' right to choose and it is theoretically possible that all shareholders may choose to receive cash dividends. However, de facto, there is always a certain percentage of shareholders who choose to reinvest their cash dividends in the companies' shares; hence, there is always a portion of cash flow left in companies. As with bonus shares, cash dividends retained by shareholders can be used in day-to-day operations of companies as well as be used as investment capital.
Second, DRPs, like bonus shares, are able to release signals to the market and investors about the current state and prospects of the company, enabling investors to obtain more information and alleviate information asymmetry. However, the signals transmitted by DRPs may be more credible than the signals from bonus shares. Bonus shares only provide newly issued shares, not cash dividends. In contrast, DRPs also provide cash dividends while reinvestment opportunities are available, which can better reflect that the company has sufficient cash flow and good financial condition at present, and has a good expectation of future operation. These signals can give investors more confidence in the companies.
Beyond the above, the advantages of the DRPs over the bonus shares are more obviously revealed in the differences between them.
First, the accounting treatment methods are different. The stock price of new shares distributed by bonus shares is the par value of the stock (which is legally set at 1 yuan in China's stock market). The increase of the share capital is achieved directly by defining the ratio of issuance in advance, which has nothing to do with the market value of the shares. After the issuance, the company's undistributed profits shall be transferred into the share capital at the par value of the shares. As a result of an increase in the total number of share capital, the earnings per share and stock price shall be diluted accordingly. In the end, there is no change in companies' assets, and only the internal structure of the owner ’s equity is adjusted, which means shareholders do not get any substantial benefit. Unlike bonus shares, the reference price for new shares distributed by DRPs is the market value of the shares. After the implementation of DRPs, the undistributed profits of the companies shall be reduced: a part of the undistributed profits is used to pay cash dividends, and the other parts are converted into equity and capital reserves according to the market value of the shares. Since the market value is more able to reflect the fair value of each share, after the implementation of DRPs, the fluctuation of the company's stock price will be less than that after the issuance of dividend shares, which is conducive to maintain the stability of the company's stock price. In addition, since DRPs are a way of reinvesting dividends, the companies' stock price does not need to go ex-rights.56
Second, there are differences in functions. As a system that provides shareholders with a variety of dividend distribution methods, DRPs have the advantages that bonus shares, which only offer a single dividend distribution method, do not have. DRPs give shareholders the right to choose the form of dividends received from listed companies, rather than being completely determined by the listed companies themselves. In this way, different interests and preferences of different investors can be taken into account,
56 When cash dividends are distributed by a listed company, the stock price shall be reduced by the
corresponding market value, which is to go ex-dividend. For each $1 cash dividend paid, the stock price decreases by $1. When bonus shares are issued, the stock price shall also be reduced by the corresponding market value, which is to go ex-right. If the share capital is doubled, the stock price shall be halved.
