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Measuring a firm’s goodwill value

June 25, 2012

A company’s goodwill is intangible even if someone claims it to be an asset.

The valuation of goodwill being an intangible asset requires difficult and sophisticated methods, and has a likelihood of being misused by companies to issue shares without adequate consideration. It is therefore the job of the corporate and securities regulator to ensure that the securities being offered to the public are correctly valued.

It is on this premise that Capital Issue Rules 1996 prohibited issuance of shares against goodwill. These rules were amended last year when a company seeking listing of its shares hit snags for raising over Rs1.3 billion against real assets of Rs580 million.

The Islamabad Police almost the same time started warning the general public about failure of the tracker system to control car theft.

Trakker (Pvt) Limited (TPL) was a private limited company at the time owned jointly by Ali Bhai Group, Ali Jameel Group and Digicore International with authorised share capital of Rs50 million. The company created a new company with similar name – TPL Trakker (Pvt) Limited (TTPL) with authorised share capital of Rs50 million and wanted to become a public limited company.

To become public limited, the company applied before the Sindh High Court under Section 284 of the Companies’ Ordinance to transfer 70 per cent assets and liabilities of the TPL into TTPL. The court required the Securities and Exchange Commission of Pakistan to file its comments in view of conversion of a private limited into public limited to explain if assets valuation and swap ratio were reasonable.

The SECP challenged the valuation of the assets but did not comment on the goodwill valuation. The SECP, however, did not inform the court that shares against goodwill could not be allowed under capital issue rules of 1996. As a result, the high court cleared share transfer from TPL to TTPL.

Subsequently, the TTPL approached the SECP for approval of its prospectus for public listing of its shares worth Rs1.8 billion including Rs1.3 billion against its goodwill. The SECP declined to approve the prospectus on grounds that rules did not allow issuance of public shares against goodwill. The TTPL questioned the SECP ruling saying how it could disallow public listing when the high court had approved share transfer.

The SECP’s securities market division, sought legal opinion of its law division that upheld the earlier decision of disallowing public listing of shares against goodwill and wrote that since the court was kept in the dark about the capital issue rules, the court allowed merger of shares. Now that the issue was of listing involving public interest, the public could not be exposed to a company whose assets may not worth the issue on the basis of a past mistake.

Therefore, the Securities Market Division declined the public listing for the second time. The review was disallowed for the third time even though one review is allowed under the law. As a result, the SECP decided to change the rules to enable TTPL for public listing.

The amendments to said rules were made and published in September 2010 by the SECP for eliciting public opinion when the previous SECP chairman was still in office but these could not be notified. Interestingly, after passage of one year the same rules were again published last year and then notified doing away with a prohibition on issuance of shares by companies against goodwill.

After getting the shares issued, the company applied for the SECP approval to offer these shares to the public last month through public subscription and raised public money. Simply put, the company may or may not be worth what it claims to be.

The Islamabad police have questioned the very credibility of the tracker system and publicly asked car owners to adopt alternate security arrangements.

A public disclosure has, however, been made on behalf of the SECP that even though it approved prospectus and allowed public listing it disclaimed any responsibility. It said “It must be distinctly understood that in giving this approval, the SECP does not take any responsibility for the financial soundness of the company and any of its schemes stated herein or for the correctness of any of the statements made or opinions expressed with regard to them by the company in this prospectus.”

“The SECP has not evaluated quality of the issue and its approval for issue, circulation/publication of the prospectus should not be construed as any commitment of the same. The public/investors should conduct their own independent due diligence and analysis regarding the quality of the issue before bidding/subscribing.”

The Karachi Stock Exchange as regulator has also disowned its responsibility. The prospectus said “It is clarified that information in this prospectus should not be construed as advice on any particular matter by the Karachi Stock Exchange and must not be treated as a substitute for specific advice. The Karachi Stock Exchange disclaims any liability whatsoever for any loss howsoever arising from or in reliance upon this document to any one, arising from any reason, including, but not limited to, inaccuracies, incompleteness and/or mistakes, for decisions and/or actions taken, based on this document. The Karachi Stock Exchange neither takes responsibility for the correctness of contents of this document nor the ability of the company to fulfill its obligations there-under.”

The auditors as a routine shed their responsibilities by stating that information disclosed in the prospectus and that whatever stated in the prospectus and the supporting documents is true and correct “to the best of our knowledge and belief and that nothing has been concealed”.

The company at least made substantial disclosure about the laws. It referred to auditor’s certificate of March 2012 and stated that “under Rule 8 of the Issue of Capital Rules 1996, it is required that goodwill and other intangible assets shall be excluded from consideration for Issuance of Shares otherwise than in cash. However, the shares were issued pursuant to the decision of High Court dated May 07, 2009.”

It is feared that a number of companies which currently are unable to recognise the value of the goodwill on their own books may head for similar schemes of mergers, de-mergers, transfer and sale of assets without any change in the beneficial ownership. To avoid this, the SECP has kept an element of discretion in the capital issue rules by saying that shares against goodwill could be issued subject to approval of the SECP.

Insiders say that in case of mergers between unrelated parties, there is at least some check, as both parties make sure that the valuations are done properly and swap ratios are calculated correctly. However, this may or may not happen where the mergers and de-mergers take place between companies within the same group or families. The only independent authority left to check the valuations and swap ratios is the regulator who can protect public interest.

The SECP unfortunately has no capacity or even the desire to conduct such valuations, especially in the cases of the powerful and mighty, and simply passes the buck and accepts the valuations of the auditors or the valuers appointed by the same companies.

And unsuspecting investors are carried away with attractive prospects issued by companies with the SECP’s approval.