Regulation – current approach, how and why?

By Teresa Ko at the 2018 Capital Markets Forum for Listed Companies on 27 April 2018

Our market today

We have come a long way!

30 years ago, our exchange only had 276 listed companies and US$54 billion in market cap. This was less than 1 percent of the world’s total market capitalisation at that time.

Today, the Hong Kong Stock Exchange has 2,191 listed companies and in the last 20 years alone, market capitalisation has grown six times and trading has increased 11 times. Large cap and mid cap stocks have been the key driving force behind this phenomenal growth.

This looks like a lot of progress. But the world has also changed a lot!

These days, even stock exchanges feel the competition for IPO issuers and investors.

So let’s take a quick look at how other stock exchanges are doing. 

Set against the world’s other major international exchanges we look like this. 

Source: WFE

Comparing ourselves with Shanghai and Shenzhen stock exchanges, we look like this.

Source: WFE

This is before Shanghai lists any Red Chip or China Depository Receipts (CDRs) of innovative companies that have been the subject of a State Council announcement recently.

A key difference between our market 30 years ago and our market today is our investors. 30 years ago our market was described as being “characterised by a particularly vigorous retail element.” 

Today, international investors and large cap stocks account for a large share of total trading.  

In fact, the top 20 percent of our stocks account for 88 percent of our total market cap and 90 percent of our trading on the Hong Kong Stock Exchange – I mention this because we need to know where the liquidity of our market comes from.

Privileges

Before I go into the current approach, the how and the why, let’s start with some of the privileges enjoyed by our Hong Kong listed companies and their directors in our market.

You may ask what privileges? I can tell you there are plenty compared to what other listed companies have when listed on other international exchanges. 

To start, we have no class action procedure in Hong Kong. You can say neither does London. But London does not allow directors to issue up to 20 percent new shares every year, and with a maximum market price discount of up to 20 percent. This is extremely generous. 

In London, open offers and placings with price discounts of 10 percent or more must be specifically approved by shareholders and non-pre-emptive cash placings cannot be more than 5 percent of the issued share capital of a London-listed company, or 7.5 percent over a three-year rolling period.

Another privilege: voting in Hong Kong is by votes cast in person or by proxy. So if only 1 percent of your public shareholders turn up or give you a proxy and support your connected transaction, you can still get your measure through. Contrast this with the US, where you have to count all the shares entitled to vote whether they turn up or not, or whether they can be bothered to give you a proxy or not. This explains why there are so many proxy fights and directors think hard before putting anything before shareholders for a vote.

Another privilege, though we all know this is about to change is rights issues. Currently, practically the only requirement is a shareholder’s vote, at which the controlling shareholder or directors and chief executive and their associates have to abstain if the rights issued would increase the number of shares by 50% within a 12-month period.

Another privilege: GEM placings used to be quite relaxed and in July 2008 the Listing Committee delegated approval of GEM listings to the then listing division. Whether it will stay that way remains to be seen.

Some of you will know where I am going - yes over the years many of the privileges which had been enjoyed by our market got abused, got used for the private interest of certain shareholders, and often in total disregard of the fiduciary duties that all the directors of those companies are legally required to discharge. The consequence of this is that our listing rules got tightened up.

Our general mandate used to be refreshable without any limit. But abuses of this privilege with endless rounds of dilutive placings finally saw this privilege curtailed to curb this abusive conduct. Now you know why refreshment of general mandates within 12 months have to be approved by independent shareholders.

The market has also seen too many discounted and highly dilutive fund raising and almost blatant share price manipulation among some companies. So it is no surprise that there has been a review and consultation of changes to the Listing Rules on rights issues, open offers and specific mandate placings. We are waiting for the consultation conclusion to come out imminently and can expect a fair amount of the previous privileges enjoyed by the market to be taken away or subjected to more vigorous and prescriptive checks and balances.

Again, perhaps too many privileges turned into a bit of a nightmare for GEM listings, which became marked by extreme volatility. The average first-day price gain for all GEM stocks listed in 2015 was 743%. This fell in 2016, but the average first-day price gains still stood at 454%. Of course, these share prices did not stay high and half of the top ten first-day gainers in 2015 plunged by over 90% from their peak within a month. Those listed in 2016 fell by an average by 47% within a month of their peak.

Some of you may remember that this resulted in the SFC and the HKSE issuing a statement to remind new GEM applicants’, directors, sponsors and placing agents not only of their role in the GEM listing and placing, but also of their responsibility to ensure the integrity of the market and the standard of conduct that is expected of them.

You will expect me to mention backdoor listings. Interestingly, some saw backdoor listings as a privilege as well. Wrong! 

I was actually rather amused to see that there is a section in the 1988 Hay Davison report on “shell companies and acquisitions”. That was the report on the operation and regulation of the securities industry following the 1987 “Black Monday” stock market crash.

What the report recommended was that “listing of any company which ceases to trade should be cancelled, and if such a company is acquired by a purchaser and a major change of business is intended, full listing requirements should be imposed.”

Looking at this, the principle must be correct that backdoor listings should be the same as frontdoor listings in terms of the rigor of vetting, the level of information to be disclosed and the need to satisfy the basic listing criteria.

But people still try to sequence the asset injections, break them up into different pieces and perform all kinds of trickery to try to circumvent the rules relating to backdoor listings. Nobody should be surprised if we see another round of consultation with a view to tightening the rules in this area even further, to curb conduct which CLEARLY is unfair to the rest of our market. Even the briefest of histories of the evolution of listing regulation clearly shows how so many of our rules were made more strict to deal with problem behavior seen in the market.

Current approach

It should now be very clear to the market as to who does what between the HKSE and the SFC.

HKSE continues to be the front-line regulator whilst the SFC has the statutory duty to regulate our entire securities market through the powers conferred by the Securities and Futures Ordinance. Incidentally, the Ordinance is 15 years old this month. How sad that no one is celebrating this!!

Many of you will know that, in the face of all the abuses that we have seen in the market, con stocks, price volatility in GEM stocks, highly dilutive fund raisings, backdoor listings, price manipulation, corporate fraud and misfeasance, the SFC has pursued a different approach to regulate listed companies in Hong Kong.

They looked at the regulatory tools available to them and they now use a “front loaded and real time” regulatory approach to directly intervene at an early stage.

The SFC has organised itself to become more specialised, collaborative and multi-disciplinary. Basically, instead of working in siloes within their own divisions and not talking to each other or sharing information, Intermediaries, Corporate Finance and Enforcement (being three of the five divisions within the SFC) now pool their resources and work very closely together to implement a concerted strategy to tackle listed companies issues. An example of this new initiative was Operation ICE (using the first letter of the three divisions), which tackled the unusual price volatility in many GEM stock listings in July 2016.

The regulator has also found powers in a little-known piece of secondary legislation called the Securities and Futures Stock Market Listing Rules (SMLR) which allows it to require information, to object to the new issuance of shares and to block new listings, all of which it has done recently.

So the SFC is increasingly no longer behind-the-scenes and is more prepared to use its formal statutory powers to intervene and interact directly with the market. 

You should also know that the SFC does not work alone and collaborates with various local, mainland and overseas organisations and agencies. A very recent example is the first joint investigation with the Independent Commission Against Corruption (ICAC) to raid offices and premises of Convoy Global Holdings and Lerado Financial Group. This approach also allows the SFC to pass on any findings or evidence of corruption to the ICAC for them to investigate further.

Source: SFC

Last December, there were also in-depth discussions on cross-border enforcement and this has been increasing since the launch of the Shanghai and Shenzhen Connect given activities in one Exchange will impact the other Exchange or Exchanges. 

Yes the SFC and the CSRC do talk to each other and they meet regularly to strengthen regulatory and enforcement co-operation.

Tom Atkinson, our Head of Enforcement at the SFC, has described the SFC and the CSRC as having become “strong and trusted partners”. 

So what exactly is the SFC up to these days?

The SFC is focusing on:

? Corporate fraud

? Corporate misfeasance

? Insider dealing

? Market manipulation

? Intermediaries misconduct

False or misleading financial statements identified post listing come under Corporate Fraud as well as fraud at the time of an IPO. Serious conflicts of interest come under Misfeasance, as would failure to discharge fiduciary duties.

What about the HKSE?

The HKSE has taken a themed approach to enforcement activities since 2014 and the Listing Committee has modified the focus for investigation and enforcement action around the following seven themes: 

? Directors’ performance of fiduciary duties

? Failure of issuers and directors to co-operate with the HKSE’s investigation

? Inaccurate, incomplete and/or misleading disclosure in corporate communication

? Failure to comply with procedural requirements in respect of notifiable/connected transactions

? Repeated breaches of the Listing Rules

? Delayed trading resumption

? Financial reporting – delays or internal controls and corporate governance issues

It is interesting that the second item is failure to co-operate – all directors should know that by signing your form B or H, you have undertaken to “co-operate with any investigation conducted by the Listing Department and/or Listing Committee, including answering promptly and openly any questions, promptly producing originals or copies of relevant documents and attending meeting or hearing requested.” 

So if you refuse to co-operate, you can’t argue as you will be in breach of the undertaking you have signed.

Why

Now on to the “why” regulate – let’s see what the mother or father of all securities regulators round the world (i.e. International Organisation of Securities Commissions (IOSCO) has to say. 

Their answer is very simple – securities regulation is based on just three objectives, namely:

1. to protect investors;

2. to ensure markets are fair, efficient and transparent; and 

3. to reduce systemic risk. 

I don’t think anyone would disagree with that.

We regulate as we need to protect investors and often we say the minority investors as they don’t have anyone looking after them. Correct, but a wider reason is because we want to continue to attract institutional investors to our market. They are playing an increasingly significant role in the development of sustainable securities markets all over the world.

When we say institutional investors we are not just talking about mutual funds, we are talking about pension funds, insurance companies, securities companies, private equity funds, sovereign wealth funds, and endowment funds. The amount of assets under management for institutional investors in OECD countries alone is nearly US$100 trillion according to the World Bank in 2013, - that is around 23 times the market capitalisation of the entire Main Board.

A subcommittee of IOSCO on the Development of Institutional Investors in the Emerging Markets in June 2012 (which by the way, was chaired by CSRC), reported that, based on a survey amongst 24 emerging jurisdictions, lack of market depth and liquidity is one of the major obstacles for institutional investors.

Thankfully, the liquidity in our market has improved over the last year. Average daily securities market turnover last month was about HK$135 billion, but exchanges are all competing for business. You will have heard recently that the London Stock Exchange is also implementing its own version of Connect with the Shanghai Stock Exchange.

Speaking of Connect, the Southbound Connect, which now accounts for around 7 percent of our trading with a daily quota increasing from May 1 from RMB10.5 billion to RMB42 billion, only covers Hong Kong-listed A- and H-shares, all the constituent stocks of the Hang Sang composite large caps, Hang Sang mid caps and only those on the Hang Sang composite small cap index which have a market cap of HK$5 billion or more. Even China is trying to protect its investors from the smaller end of our market!

In terms of quantity of stock, market cap and trading volume, what does Southbound Connect mean? 

Southbound Connect covers 89 percent of our market cap but 95 percent of our trading but only 460 stocks, which is one quarter of our listed companies in Hong Kong. And what happens to the other three quarters of our listed companies that do not get included in the Southbound Connect? There are over 1731 of them! Is it conceivable that one day, all or most of these stocks will be covered by the Southbound Connect and if not, why not? 

Coming back to the “why” - you can argue a bit of bad behaviour in a small segment of the bottom end of the market is to be expected – what’s the fuss? Lots of people are making a lot of money! Apart from obviously hurting unsuspecting investors – many of them retail investors – these activities also hurt everything that we want our market to represent, such as integrity, market quality, fairness and transparency. It’s really not good enough to say it is just a small segment of our market which is not behaving, so we should just let it be.

Another reason to regulate is that it creates an uneven playing field if people are allowed to get away with their abusive conduct. There are so many law-abiding listed companies which pay a huge amount of attention to doing the right thing and have a fantastic culture of compliance. They will be disadvantaged if those who don’t play by the rules are not restrained.

But what is really bad (and this does upset me) is that all this bad and abusive conduct hurts Hong Kong’s reputation as an international financial centre. Some will say these abusive activities happen everywhere. Do they? Yes, market failure happens everywhere, but not abusive activities of the intensity that we have seen, many of which have demonstrated total disregard for our legal and regulatory regime.

This is what we read in our local papers and some of it even gets into the international press. I am sure that if no regulatory action was taken, this would soon affect the confidence that international investors have in our market as a whole.

Privileges come with responsibility and responsibility comes with accountability. We can do so much better together to enhance the reputation of the only stock exchange we have in Hong Kong.

I can tell you that I wish the staff at the SFC and the Stock Exchange didn’t have to work so hard to try and curb abusive conduct.

I can tell you that I wish we didn’t have to continue to tighten up our rules and regulations and explain to clients how they may be affected, and sometimes quite unfairly, by the changes.  

I can tell you that I wish more time could be spent in developing our markets, seizing more opportunities and fending off competition in a more proactive, timely and sustainable way.

We all have a part to play in this by:

? Promoting a culture of compliance

? Showing respect for our rules and regulations

? Being responsible for our actions

? Being accountable

? Maintaining high standards

? Helping to enhance the reputation of our exchange

At the end of the day, some will say that we get the market we deserve. But permit me to propose an alternative: we should be proactive in building the high quality, hugely liquid and fair and transparent market that we want. It is the responsibility of all listed companies, their controlling shareholders, directors, and all intermediaries to work towards this goal and not to allow a few to pull the rest of us down.

If you are one of the “few”, the message from the SFC is clear: they will come knocking!

The views and opinions expressed in this article are those of the author.