THE TWILIGHT REGULATOR
A delisting fiasco left Hong Kong's stock exchange accused and badly bruised. Now it may be getting out of the regulations business altogether. It's about time.
By Jasper Moiseiwitsch

When Hong Kong's stock exchange released a consultation document on rules changes for "penny" stocks last July, the sky fell. The exchange asked the public for suggestions on dealing with companies with a share price below HK$1.00. A sensible move but there was a detonator nestled in the document in the shape of an idea to delist companies that fell below HK$0.50. About a third of Hong Kong's listed firms fall into that category.

Investors saw that delisting penny stocks would make the shares almost worthless. With no market to trade them, there would be no one to buy them. Brokers screamed sell, and about HK$10.9 billion in investor wealth was erased in one hour's trade.

The event was traumatic enough to spark two government inquiries: First came the Report of the Panel of Inquiry on the Penny Stocks Incident [PIPSI]), a 181-page document that described how it all happened. This report begat a government-appointed expert group to review Hong Kong's system for regulating financial markets and listed companies.

While PIPSI wanly affirmed Hong Kong's three-tier regulatory structure (in which the exchange [HKEx] regulates companies, the Securities and Futures Commission [SFC] regulates market users, and the government oversees both bodies), the report noted flaws. It revealed that the three tiers don't always get along, they don't have perfect communication and they are sometimes confused as to which role belongs to whom. The expert group will go back over these issues and it is widely expected to rethink the exchange's role as Hong Kong's regulator of listed companies.

"Rabbits in charge"

The exchange's critics say it should have been relieved of these duties long ago. As one of the few stock exchanges to hold its place as frontline regulator of listed companies, the exchange has a duty to rigorously hold companies to the highest standards of corporate governance.

But the exchange is also a listed company with its own governance standards to comply with, such as a commitment to maximize invested capital. Given that the HKEx generates most of its income from the transaction fees and listing fees spun from its listed companies, it has a commercial interest in floating as many firms as possible. By that thinking, the exchange could benefit from relaxed listing rules that encourage companies to come to that market.

It is a clear conflict of interest. As Anthony Rogers, an Appeal Court judge and the chairman of Hong Kong's Standing Committee on Company Law Reform (SCCLR), famously said, putting the exchange in charge of company regulation is like "putting the rabbits in charge of the lettuce".
For the exchange's critics, this conflict of interest was fully apparent in its mid-January revision to its listing rules. It was the exchange's first overhaul of its corporate governance codes in years and, potentially, could have been a major step forward for reform. Instead it offered little to excite most governance advocates.

The exchange did offer some amendments: it raised the number of required non-executive directors from two to three, and it now requires voting by poll for approvals on connected transactions. But the exchange also rejected many reforms that are standard in the region. These included proposals for quarterly earnings reports, expanding the rules on associated-party transactions and making companies appoint a remuneration committee.

Richard Williams, the senior vice president of the exchange's listing division, was asked if the exchange's modest rules changes opened it up to criticism that it acted on behalf of issuers - its main source of funds - and not investors. "I think it is inevitable that there will be criticism," he answered.

His answer to the next question - is such criticism fair? - is more interesting. "No comment," said Williams.

Even more controversial was the way the report was put together. The exchange had a public consultation. But in its profile of respondents, it reported that listed issuers comprised 110 of the 167 total responses (66 percent). It added that it only received five responses from investors.

Where there was investor feedback to the study, it seemed discounted. David Webb, an investor and Hong Kong-based corporate governance advocate, collected 337 investor responses through his website (webb-site.com). These were forwarded to the exchange, which counted the hundreds of submissions as a single response. It all made for an "outrageous disregard of investor interests", says Webb.

No Power

Even if the exchange addressed investor concerns thoroughly and created the most fanatically tough corporate governance regulation, it would still be limited in its role as frontline regulator. As a for-profit enterprise, the HKEx (the parent company of the exchange) cannot wield statutory powers. In other words it can't use the law to investigate or punish a firm or company director. It can only threaten to censure companies for violations of the listing rules or, in the most drastic case, delist firms.

Hong Kong's minority shareholders complain that these are scarcely sufficient powers to punish corrupt companies. Their main worries are about associated-party transactions and the infinite ways that controlling shareholders can abuse these.

The Hong Kong Society of Accountants says that about 88 percent of Hong Kong-listed companies have one shareholder or shareholder faction that owns 25 percent or more of issued capital. This huge base of controlling shareholders can - with a speck of creativity or with the help of an obliging intermediary - engineer cash transfers away from or liability transfers to the listed company.

Rogers, chairman of the SCCLR, says controlling shareholders create most of the high-profile corporate governance abuses. The temptation can be overwhelming: "The difficulty comes when… you have a family or individual who gets into financial difficulty. There is a temptation to strip it out [the wealth of the listed company]," says Rogers.

And the deterrence can be minimal, or so notes SFC executive director Ashley Alder. "The usual penalty for serious listing-rule breaches is a public censure...The balance of incentives is not right," he says.

Hong Kong has plenty of examples of controlling shareholders channeling public company funds to private entities. Consider the case of the HKEx-listed Dickson Concepts, which entered into a HK$130 million consulting agreement with a private company owned by the chairman. Or consider Northeast Electrical Transmission, which lent HK$11.4 million to its controlling shareholder, without independent shareholder approval.

Or consider the case of Boto International Holdings, which sold its core operations to a private company part owned by the Boto chairman. Minority shareholders narrowly approved the deal. However, Webb - a Boto investor who campaigned against the transaction - says that management and family related to the Boto chairman were allowed to vote on the deal.

Hong Kong's perennial corporate governance question has been, does the exchange have the will and the wherewithal to deal with this kind of activity? In the exchange's January review of its corporate governance rules, it decided against expanding the rules on associated-party transactions. Possibly as a nod to the Boto affair, it did however note "diverse" views on the matter.

Mother Regulator

The exchange takes a modest regulatory approach partly as a matter of principle: it follows a disclosures-based approach to regulation. All three tiers buy into this thinking, which says companies must disclose as much market sensitive information as possible within reason.

"The principal regulatory mechanism in Hong Kong has gradually moved towards a disclosure-based system. Under this regime, investors' interests are protected through the public availability of timely, fair and detailed information," said HKEx chairman Charles Lee in an October 2001 speech on corporate governance.

The disclosures-based system puts the burden of regulation back to investors. With their power to bestow or withhold capital they act as the final and truest judge of a company's governance. The exchange's main obligation here is to make sure investors have the right information to make those decisions.

David Stannard, a former SFC executive director, puts it more pithily: "The corporate governance regime isn't a substitution…of the obligation of the shareholder to look after himself," he says. "The regulators don't act like mother...I don't think regulators should be substituting an opinion for the shareholders."

Most mature markets have adopted a disclosures-based regulatory system, and this includes regional markets such as Singapore and Malaysia. Less mature markets tend to favor a merit-based system, where authorities review the worthiness of securities offerings on a case-by-case basis.

Lack of Support

The question is not whether Hong Kong's markets are sufficiently mature to take on a disclosures-based system (they are). It's whether authorities have supplied enough supporting legislation and institutions to make this system work. A report (Regional Monitor, June 2000) published by HKEx explains the main points of the model disclosures-based system in the US.

The report notes that US investors act as the main driver of securities rules compliance, and that investors can press claims against poorly governed companies through class action lawsuits. It also notes that the Securities and Exchange Commission (SEC) acts as the US' main markets regulator, and that the SEC enforces rules compliance via robust statutory powers. Further, the report says there are strong supporting institutions in the US - such as an investor association - and strong supporting legislation - such as a freedom of information act - which impose a high degree of government transparency and accountability.

But none of these conditions apply in Hong Kong. There is no contingency fee system in Hong Kong, so there are no investor class action suits. Investors in Hong Kong are quiet, meek and completely lacking in a sense of advocacy, and are certainly not the main driver for securities rules compliance.

When David Webb submitted a proposal to government for a minority shareholders association, it was rejected. Webb asked for automatic funding via a slim markets fee, but the government turned the proposal down on accountability issues.

Furthermore, Hong Kong's SEC counterpart, the SFC, is not the main markets regulator. It shares the role with the exchange, which has no statutory powers. Neither the exchange nor the SFC has jurisdiction in mainland China, where many of Hong Kong's most poorly governed companies come from. If directors abscond to the PRC with public company loot, Hong Kong authorities do not have the power to issue arrest warrants or subpoenas in China. Hong Kong, a sovereign part of mainland territory, does not even have an extradition treaty with China.

Finally, there is no freedom of information act in Hong Kong - although there is a much weaker Access to Information Code - and, as an undemocratic state, there are few mechanisms guaranteeing government accountability generally.

Furthermore, when the exchange has looked at ways to increase company disclosure, it has at key times stepped back. It said it would delay main board quarterly reporting until 2005, at the earliest. For investors, that announcement constituted their biggest disappointment in the latest governance rules changes.

"We [investors] would rather have greater disclosure on items in the profit and loss accounts, on balance sheets and cash flows. We'd rather have quarterly reporting and breakdown of the business by business units," says Robert Conlon, chief investment officer of Investec Asset Management Asia, of investing in Hong Kong.

Furthermore, Conlon says the exchange has tended to extend disclosure waivers to its largest mainland listed companies, such as China National Offshore Oil Corporation and PetroChina. These companies are the privatized portions of large PRC government-owned companies. They have extensive dealings with their parent companies and, as such, have detailed daily disclosure requirements regarding connected transactions. These companies are the cream of the most recent main board listings. And when they ask for disclosure waivers, the exchange seems inclined to grant them.

Shed a Tear

This month, the expert group will release its review of Hong Kong's three-tier regulatory system. Favored theories on the report's findings suggest that the exchange might be getting out of the regulation business, possibly by adopting the Australian model for separating regulatory roles.
These theorists note that Alan Cameron, chairman of the expert group, is a former chairman of the Australian Securities Commission. They add that the Australian Stock Exchange (ASX) has an independent supervisory system that could easily be adopted in Hong Kong.

Specifically, the ASX spun off its market oversight committee into a separate company. The ASX owns the company, but its board is composed of a majority of independent non-executive directors with no connection or attachment to the ASX.

It is a similar set-up seen at the HKEx but with a clearer division of powers. If adopted, it could be the beginning of a more rigorous and independent listing division (although one still lacking in statutory powers).

If new arrangements eventually lead to better corporate governance, CFOs will be better off, broadly speaking. Hong Kong's stock market is dogged by investor skepticism about the quality of listed companies. Better rules would boost Hong Kong's reputation, raise listing PEs and create better funding opportunities for everyone.

Jasper Moiseiwitsch is a senior writer, Hong Kong, for CFO Asia.