Hong Kong's bid to tidy up corporate governance while preserving its free market ethos hasn't persuaded skeptics.
By Kevin Hamlin
October 2002
Institutional Investor Magazine
Enron, WorldCom, Tyco International and all the other U.S. business scandals have prompted worldwide concern about lax corporate governance. The New York Stock Exchange set the tone for stricter vigilance by bourses this summer when it adopted stricter rules to guarantee the independence of boards of directors. Other major exchanges -- Frankfurt, London, Paris -- are getting tougher on errant companies and CEOs. In every case, investors have applauded them for it.
But when Hong Kong Exchanges and Clearing, or HKEx, merely floated a proposal in July to stiffen its corporate governance standards by tightening listing criteria for penny stocks, investors were so unnerved that they sparked a sell-off, erasing more than $1 billion, or about 10 percent, from the penny stocks' market capitalization in a single day.
The real loser, however, was Hong Kong itself. By reputation home to one of the better-run financial markets in Asia, it is in an alley fight to maintain its edge over up-and-coming regional stock market centers like Kuala Lumpur and Shanghai in attracting and retaining the confidence of global investors. Even as the former crown colony strives to preserve its famously freewheeling market culture, it is trying to clean up perceived shortcomings in financial reporting and board oversight that threaten to put it at a disadvantage. Hong Kong can ill afford blunders -- like the penny stock fiasco -- that make it appear weak or indifferent on crucial matters of integrity and investor protection. Hong Kong's regulatory regime makes conflicts and miscues all but inevitable:
HKEx is a publicly listed company that not only runs the stock market (for a profit) but also helps to regulate it. However sound HKEx's penny stock proposal was in principle -- it would have delisted companies trading at less than HK$0.50 (6.5 cents) per share for longer than 30 days -- investors had every right to panic: 370 of the 761 listed stocks would have been booted off to an uncertain future.
As the market reeled, the government had to intervene quickly. It forced HKEx to withdraw the so-called consultation paper and authorized an official inquiry that ended in mid-September. The conclusions, and the way they were arrived at, were almost as alarming to many investors as the consultation paper itself -- and pointed up the fundamental deficiencies in Hong Kong's approach to regulation.
For a start, Hong Kong Financial Secretary Antony Leung's decision to appoint a panel, consisting of barrister Robert Kotewall and accountant Gordon Kwong, to investigate the incident upset politicians and other observers: They felt that as the person ultimately responsible for Hong Kong's financial markets, Leung should have conducted the inquiry himself.
Under Hong Kong's complex three-tier regulatory regime, the government (the chief executive and financial secretary), the Securities and Futures Commission and the stock exchange each have a say in setting and enforcing rules. The stock exchange supervises companies under the terms of its standard listing agreements with issuers, but it has no power of investigation. The SFC, meanwhile, is the exchange's statutory regulator but can act only when listed companies breach Hong Kong's Code on Takeovers and Mergers. The government is responsible for the overall integrity of the capital markets but intervenes only as a last resort.
Many saw Kotewell and Kwong's 280-page report as a whitewash. "The daily reports of majority abuse [of minority investors], especially in some of the smaller listed companies, leave an unfortunate image on the Hong Kong market," they acknowledged. But after declaring that there was no "serious cancer" in the regulatory system, the pair concluded that the penny stock crash was caused by "instances of errors of judgment, some perhaps even understandable in the circumstances, a few mishaps, examples of miscommunication and some systemic wrinkles here and there."
The panel gingerly summed up its conclusions this way: "There was a perception that the roles of the government, the SFC and the Hong Kong Exchange within the three-tiered regulatory structure suffered from a lack of clarity over, in particular, the delineation and division of responsibilities amongst the three parties."
Shareholder activist and private investor David Webb, a former BZW Asia investment banker, describes the penny stock episode and ensuing inquiry as just the latest evidence of Hong Kong regulators' failure to protect minority shareholders and set high standards for corporate governance.
"One of the stated goals for delisting stocks was that it would improve corporate governance," says Webb, who now runs the eponymous Webb-site.com, which he says reached some 6,000 people last year. "But if you have compulsory delisting, then you remove the marketplace for investors and thus the protection of the listing rules -- inadequate as they are. So it increases the license to rip off minorities."
While Hong Kong dithers, its rivals are starting to outdo it in championing good governance. Mainland China has moved ahead of Hong Kong in two areas: requiring quarterly corporate reports and, starting next June, mandating that independent directors hold at least one third of company board seats. Though short of the majority called for by NYSE and Nasdaq Stock Market guidelines, this is a significant step for China.
Such measures are only now being considered by Hong Kong, and they are coming under heavy fire from the business establishment. Hongkong and Shanghai Banking Corp. chief executive David Eldon, for instance, argues that quarterly reporting puts too much emphasis on short-term performance (although HSBC's British parent, HSBC Holdings, reports quarterly in the U.S.).
Quarterly reporting is "asking for trouble," contends Anthony Rogers, the Court of Appeal justice who chairs Hong Kong's Standing Committee on Company Law Reform, which is reviewing corporate governance provisions and is scheduled to deliver its report to Financial Secretary Leung this month. Indeed, Rogers attributes much of the "fraud and crookery" at Enron and elsewhere to the pressure on managers to meet Wall Street's expectations quarter to quarter.
"It's not transparency; you're not going to find out things earlier with quarterly reporting," Rogers asserts. "If the accounts are wrong, the accounts are wrong. If the accountants are not doing their jobs properly, investors are not going to find anything earlier." Nevertheless, Rogers is resigned to Hong Kong's embracing quarterly reporting to bring it into line with the U.S. and other major markets. "If the accepted international accounting standard is quarterly reporting," he says, "then we've got to jump over the cliff like all the other lemmings."
But Hong Kong may be able to delay that leap for already-listed companies: A HKEx proposal now under discussion would phase in quarterly reporting over four years; newly listed companies would be required to file quarterly results from the start.
In this same recalcitrant spirit, the stock exchange may be watering down proposals on the table to enhance director independence. In July HKEx chief executive Kwong Ki-chi confided to Institutional Investor that because of a shortage of independent director candidates, "it may be necessary for us to consider allowing a suitable transition period, if the proposal is to be implemented properly." Later Kwong told II that it wouldn't be appropriate for Hong Kong companies to adhere to the new U.S. standard requiring that a majority of directors be outsiders, because Hong Kong companies, unlike U.S. companies, usually have a dominant controlling shareholder. "If the board can't agree, you can't get business done," reasons Kwong.
Nor does the HKEx seem inclined to compel companies to disclose directors' remuneration. Kwong says feedback from the market on this proposal has been overwhelmingly negative.
Foot-dragging by HKEx prompts critics to accuse it of pandering to corporations and their controlling shareholders, who wield enormous power in Hong Kong. Of the 33 companies that constitute the bellwether Hang Seng index, 32 have controlling shareholders; the exception is HSBC Holdings. Almost 90 percent of listed companies have an owner who alone or in conjunction with family members controls 25 percent or more of the share capital, estimates the Hong Kong Society of Accountants. Companies can list on the exchange by floating as little as 25 percent of their shares. This low listing minimum, noted rating agency Standard & Poor's in a January report, "can inhibit the ability of minority shareholders to exercise their voices."
Increasingly, shareholders are raising their voices in frustration. Investors in Hong Konglisted holding company Beauforte Investors Corp. placed ads in local newspapers this May calling on SFC chairman Andrew Sheng to take action against Beauforte's controlling shareholders for supposedly ignoring minority shareholders' interests (see box).
The company had announced its intention to buy from Continental Mariner Investment Co. a 29.5 percent stake in chemical fibers maker Poly Investments Holdings. The HK$255 million deal worked out to a roughly 85 percent premium to Poly's closing price on April 26. In turn, Continental Mariner, a property company, had proposed to simultaneously sell its remaining 17 percent stake in Poly to "independent investors" -- at a 20 percent discount to its closing price.
As Beauforte's angry minority investors saw it, they were having to pay a huge premium for a stock that was being off-loaded elsewhere by the seller at a steep discount. Some suspected that the controlling shareholders were acting in concert with the so-called independent investors -- who did not have to reveal themselves under Hong Kong securities law -- to gain control of Poly without having to make a general offer for the company. But Hong Kong's Code on Takeovers and Mergers would require such an offer if Beauforte and the independent investors could be shown to be working in concert and had together acquired more than 35 percent of Poly's shares. Beauforte officials did not return calls seeking comment.
The SFC's Sheng indirectly but firmly rebuffed the Beauforte investors. In an open letter that was published in local newspapers -- and never mentioned Beauforte or Poly -- Sheng stated that when no rules and regulations have been broken, "the ultimate practical remedy for investors may be to sell." He concluded his missive with brusque advice for investors: "Get the facts before you invest."
Sheng now contends that he was "just pointing out the facts" -- that "rules are rules" and that the SFC cannot intervene in transactions just because they may be "perceived by investors to be unfair under the rules." Although conceding his message was "a little blunt," Sheng insists that "everybody must invest with their eyes open."
The letter caused "a bit of a shock wave," according to Low Chee Keong, head of the Chinese University of Hong Kong's Center for Accounting Disclosure & Corporate Governance and author of Corporate Governance: An Asia-Pacific Critique. "I don't remember a top Hong Kong regulator ever before telling investors that basically they are on their own," says Low.
Adds activist Webb: "The biggest mistake Sheng made was to say that if the company has complied with all the rules, the remedy may be to sell. If a company has managed to rip off all its shareholders and still has complied with the rules, then the remedy is to tighten the rules and look at the deficiencies in the regulatory system."
Mark Mobius, Singapore-based manager of Franklin Templeton's emerging-markets funds, also took Sheng to task: "The small investor doesn't have a voice. The SFC should act as their voice. It is not a matter of the letter of the law but a matter of the spirit of the law. It depends on how much Sheng is interested in protecting small investors."
In June Sheng sent Beauforte a letter, saying that the SFC was not "fully satisfied with the independence" of certain parties to the Continental Mariner deal. That was enough to derail it. Still, critics of the SFC point out that the commission has neglected to act in similar cases and that the Beauforte response -- made in the context of a shareholder revolt -- shouldn't be seen as a precedent.
Another reason for investors' lack of faith in Hong Kong authorities may be seen in the Pacific Challenge Holdings affair. Kistefos Investment, a Norwegian private equity firm, is taking Hong Konglisted Pacific Challenge to court -- in Bermuda, where the financial services company is headquartered. Kistefos charges that Pacific Challenge's then controlling shareholder, Lily Chiang, took advantage of Hong Kong's relaxed listing rules to dilute the Norwegian firm's stake from about 26 percent to 22 percent, while increasing her own position from roughly 25 percent to 34 percent, primarily through a share placement -- equivalent to 20 percent of Pacific Challenge's outstanding shares -- that was not made available to all shareholders. Such large "general mandate" issues are perfectly legal in Hong Kong, provided a majority of voting shareholders agree to them -- not a huge hurdle when most listed companies have dominant majority holders.
Pacific Challenge's managers also allegedly attempted to siphon HK$170 million out of the company in early 2000 by purchasing 62 percent of a nearly worthless dot-com from Chiang. She has never commented publicly on the incident and in July sold her stake in Pacific Challenge.
In October of last year, Judge Philip Starr of Bermuda's Supreme Court dismissed Kistefos' request to have Pacific Challenge wound up and its assets sold but ordered a trial to determine whether the company should be forced to buy out Kistefos' stake at a court-determined price. The judge observed that the decisions of Pacific Challenge's management "could support a conclusion that a series of transactions were being carried out . . . to cause unfair prejudice to a minority, namely Kistefos." Pacific Challenge has maintained that all its actions were based on legitimate commercial considerations. (No trial date has been set.)
Kistefos CEO Erling Thiis calls his Hong Kong investing experience "traumatic." Attempts to get Hong Kong's regulators involved in the Pacific Challenge case "have been futile," he says. If Hong Kong wants to improve investor confidence, Thiis suggests, regulators should look into the affair and announce their findings to the public.
Thiis also recommends that the exchange tighten rules that he says allow controlling shareholders to dilute the holdings of minority shareholders at will. Listing rules are a critical line of defense, since roughly 75 percent of listed companies are domiciled elsewhere and thus are subject only to listing laws, not to Hong Kong's corporate code.
Yet in a consultation paper published in January, HKEx argued that the type of dilutive fundraising used by Pacific Challenge is essential because "many issuers . . . are relatively small in size and rely on external funds to develop their operations." HKEx views this tactic for fundraising as quick and cost-effective and dismisses calls to adopt U.K.-style preemption guidelines that limit such issues to 5 percent of outstanding shares in any one year.
In an article for the South China Morning Post in March, Thiis likened Hong Kong's securities regulation to that of "a banana republic." Asked if he stands by that comment, he says, "I'd be very happy to be proven wrong."
Hong Kong's regulatory lapses grow ineluctably out of its administrative structure, many critics contend. For a start, HKEx has an inherent conflict between its regulatory and its commercial dictates. Alex Pang, a former SFC official who's now head of strategy and development at the China Securities Regulatory Commission in Beijing, advocates handing all market supervision over to the SFC. In a June letter to Financial Secretary Leung, Pang warned that the quality of listed companies in Hong Kong was deteriorating, and he blamed HKEx. As a listed company with a profit motive, Pang said, the exchange should not be entrusted with regulating the companies that provide its revenue stream.
The SFC's Sheng says he has moved to help resolve HKEx's entrepreneur-regulator conflict by ensuring that all listing documents and corporate announcements are filed simultaneously with the exchange and his commission, which has enforcement powers. Company officials who provide false or misleading information now face up to two years in jail and a fine of HK$1 million.
An impartial judiciary and a tradition of free enterprise make Hong Kong the superior stock-trading venue in Asia ex-Japan, its officials maintain. Although they don't dismiss competition from China or Malaysia, they note that Hong Kongbased investment bank CLSA Emerging Markets and Standard & Poor's have both ranked Hong Kong second only to Singapore for corporate governance in Asia.
"You can cite instances such as Beauforte and Pacific Challenge and get pretty worked up about the state of corporate governance here," says Calvin Wong, head of governance at S&P in Hong Kong. "But Hong Kong has a good legal-regulatory framework, and at the government level, there has been an awful lot of initiative."
Few believe that Hong Kong is in imminent danger of falling behind its regional rivals. Mainland China economist Wu Jinglian, a senior fellow at the Development Research Centre of the State Council, recently said that China's stock markets are "worse than casinos." Malaysia's market is only now recovering from virtual pariah status following Prime Minister Mahathir Mohamad's 1997 decision to impose capital controls amid the Asian financial crisis.
Still, just for insurance, Hong Kong officials are forging ahead with corporate governance initiatives, despite the exchange's foot-dragging. In early 2000 thenfinancial secretary Donald Tsang ordered a comprehensive review of governance standards by the Standing Committee on Company Law Reform. In July 2001 the committee published a 99-page document with tentative proposals for improvements. Its final report is due to be delivered to the government this month. Among the first batch of proposals:
* Give shareholders and directors, past and present, the statutory right to bring so-called derivative lawsuits on behalf of a listed company for a wrong done to it (and thus, indirectly, to its shareholders). The grounds would include fraud, negligence, default on complying with laws and rules and breach of fiduciary or statutory duty.
* Allow the SFC, without having first to gain court approval, to bring derivative lawsuits on behalf of a company, including overseas companies listed on the exchange.
* Establish a body to investigate financial statements and correct them when necessary.
* Give courts clear powers to award damages and interest on those damages to shareholders who bring successful suits against companies.
* Give shareholders the right to obtain access to company books, subject to court approval and other safeguards.
Under a new Securities and Futures Ordinance, which is expected to take effect early next year, the SFC will gain enhanced powers to investigate banks, auditors and anyone deemed relevant to a probe of corporate misdeeds. The law also provides for a Market Misconduct Tribunal, chaired by a High Court judge, that is intended to deal expeditiously with cases of insider trading, market manipulation and misinformation. The court will have the power to make malefactors disgorge profits, to disqualify directors, to deny individuals access to the market for up to five years and to issue cease-and-desist orders.
HKEx's parallel reform proposals -- besides the ill-fated penny stock initiative -- include quarterly financial reporting, an increase in the minimum number of outside corporate directors from just two to one third of the board and disclosure of directors' compensation. The exchange also would like companies to discuss their corporate governance practices in their annual reports, disclosing deviations from the minimum standards laid down in HKEx's code of best practices.
Even critics acknowledge that Hong Kong is moving in the right direction. But they see minority shareholders in Hong Konglisted companies as far less empowered than their counterparts in the U.S., the U.K. or even Singapore. The standing committee has noted that minority shareholders who feel ill-used by controlling shareholders have no effective legal redress in Hong Kong. The common-law legal system, based on the U.K.'s, doesn't permit class-action lawsuits, and an individual plaintiff, though liable for potentially huge legal costs, has no right to damages. (Only companies can collect damages.)
The standing committee proposes giving individuals and the SFC the statutory right to bring suits against wrongdoers without first having to win a judge's permission -- conduct a trial before the trial, in effect -- and to collect damages.
The catch is Hong Kong's prohibitive legal costs, which are apt to deter most suits from individuals and even from the SFC. Although the commission has had the power to initiate court actions all along, it has rarely done so. One case stemmed from a 2000 order that Mandarin Resources Corp.'s former controlling shareholder, Chim Pui-chung, a convicted forger, buy out minority investors and sell the company to an independent third party. The cost to SFC: $30 million.
Webb, for one, is skeptical that the SFC will adopt a tougher stance. "If Sheng thinks he shouldn't be intervening [in cases like Pacific Challenge and Beauforte], if he isn't using his existing powers, then will he use the stronger powers that are being proposed?" he wonders.
Raising standards 'step by step'
In his spare time Securities and Futures Commission chairman Andrew Sheng visits remote parts of Borneo, where he was raised, in search of tribal textiles. He's a fan of ikat weavings made by the Iban tribe of Sarawak. "What is thought to be made by primitive man is actually so intricate and complex that modern designers gasp in admiration," he says.
In May Sheng came face-to-face with a tribe of a different sort, though he did not seek them out: Hong Kong minority shareholders. After they appealed to him for help in newspaper advertisements in May, Sheng's controversial response stirred a heated debate over the state of corporate governance in Hong Kong (story).
A Malaysian who rose to become assistant governor of that country's central bank in the late 1980s, Sheng, 56, moved to Hong Kong in 1993 to become deputy chief executive of the Hong Kong Monetary Authority, the city's de facto central bank. He became SFC chairman in October 1998. He holds a first-class honors degree in economics from the University of Bristol in England and is a chartered accountant.
A great believer in his adopted home's free-market philosophy, he defends its regulatory record with some passion. "We have one of the best enforcement records in the region," he says. "We are one of the leading jurisdictions when it comes to taking tough action on insider dealing, with clear-cut cases of successful prosecutions. And we have cut short our investigation-to-prosecution time."
Though some critics talk about countries like China and Malaysia closing in on Hong Kong, Sheng dismisses that, saying investors need to look at what is really happening. "We're walking the talk, not just talking about this issue," he says. He recently spoke with Hong Kong Bureau Chief Kevin Hamlin.
In your open letter to minority shareholders in May, you dismissed their grievances by saying that perhaps they should just sell their shares. Shouldn't you have shown more concern with rules giving controlling shareholders so much power?
I did say in the letter that we continually review the rules and that we will change the rules when they are not appropriate. But I cannot confirm that these rules will be changed, because there is a consultation process. If people in these companies break the law and flout the rules, we will pursue them. But there is also a due process in doing so. We don't change rules arbitrarily.
Isn't it legitimate for investors to ask the SFC to provide better rules and laws?
One of our functions is to change rules when they are no longer appropriate. But rules are rules. The existing rules must apply. If people feel that the rules don't apply, then there will be a lot of requests and we can change the rules.
You could have seized on minority investors' pleas for help as an opportunity to push for more rapid reform. Instead, you chose to scold investors. Why?
I wasn't scolding investors. I was just pointing out the facts. If you are an investor, what are you buying in a company? You are buying two things: the quality of its assets and the quality of its management. If you have doubts over the quality of the management from a self-protection point of view, why are you still holding on to the shares? I just pointed out that it was the prerogative of the investor to make the ultimate decision.
Critics say the proposals made by Hong Kong's stock exchange to tighten its listing rules won't put Hong Kong on a par with the world's best markets. Do you agree?
We have made huge strides in Hong Kong. We have totally updated the Securities and Futures Ordinance to make it as modern as such rules come. If you consider how many laws we have changed and the rules that have been changed over the past three years, I think we are clearly moving in the right direction. The level of protection for minority shareholders has substantially increased in our new legislation. Our job in a very global market is to raise standards step by step. We have to win the community's consent that this is the right way forward. Some people would want a faster pace; some people would prefer not to move at all. We are definitely moving in the right direction.
