We take a detailed look at the ongoing battle over the regulation of listed companies in Hong Kong, now in its third round of consultations after the PIPSI report and the Expert Group report, and take a look at the HKEx Chief Executive's recent statements on the subject, which has yet to be discussed by the board to which he reports, including Webb-site.com editor David Webb.

The Reason for Resistance
30 October 2003

On 3-Oct-03, the Government published a Consultation Paper on Proposals to Enhance the Regulation of Listing (PERL), which might have been better titled as the "Non-experts consultation on the Expert Group report". This followed the publication on 21-Mar-03 of the Expert Group Report, which was initially endorsed by the Financial Secretary, recommending that the regulatory functions of HKEx over listed companies be transplanted to the SFC and renamed the "Hong Kong Listing Authority". The report was also initially accepted by the then board of directors of Hong Kong Exchanges and Clearing Limited (HKEx, 0388), who in an announcement dated that day said:

"In light of the Government's intention to adopt the Expert Group's recommendations, HKEx will work closely with the Government and the SFC on their implementation"

However, it was only a few nano-seconds later that HKEx Chairman Charles Lee Yeh-kwong (Mr Lee) launched a political and media blitz against the report, and three weeks later on 10-Apr-03 succeeded in forcing short-dated Financial Secretary Antony "Lexus" Leung Kam-chung to slam his foot on the brakes, announcing that

"the general direction recommended by the Expert Group...is appropriate and will enhance the quality of our market... In view of the far-reaching implications and to ensure effective implementation, the Government will do more research and will consult the community further."

So it is only because of the earlier objections from the HKEx and their friends in high places that we are now going through a second round of consultation. For a more detailed recap of how this came about, see the lucid submission of 1-Jun-03 made by Peter Clarke, one of the three wise men of the Expert Group, to the Legislative Council.

Multiple Choice

Unfortunately, the new PERL paper devotes zero space to the "effective implementation" of the Expert Group recommendations. You will not find a single reference to the "Hong Kong Listing Authority" or the "Listing Panel" which were proposed in the Expert Group report. Instead, the Government has taken a giant leap backwards and acted rather like an examiner trying to contrive a 4-way multiple-choice question, when he knows that only one answer is correct and has to throw in three "trick" answers to confuse you. So the PERL paper asks readers to choose between options "A, B, C or D" - with "A" being the correct answer previously reached by the Expert Group, but this time faintly disguised as "Transferring listing functions to a new division set up under SFC". So here's your multiple-choice question. Should we:

(A) Transfer listing functions to a new division set up under the SFC

(B) Transfer listing functions to a new HKEx subsidiary

(C) Transfer listing functions to a new statutory authority

(D) Expand the "dual filing" system

As any schoolchild knows, if you don't know the right answer, then the easy way to answer multi-choice questions is by elimination. So here we go:

Option (B) is best described as "do nothing" - it is just a perpetuation of the existing system - HKEx already has a subsidiary, called The Stock Exchange of Hong Kong Limited, which administers the Listing Rules and puts proposals for rule changes and disciplinary hearings to the Listing Committee. Re-arranging deck chairs on the Titanic will not save the ship. However many committees and boards you create, there would be no escape from the fact that the subsidiary would remain part of a for-profit group and make its own rules, subject only to approval (but not direction) by the SFC.

Option (C) is best described as "set up a second SFC" or "set up a 4th tier". It is so obviously stupid that not even the HKEx management seems to support it, so we won't discuss it further. It was probably just thrown in by the examiner who thought that 3 choices was not enough.

Option (D) is an exercise in duplication and confusion, rather like setting having two air-traffic control bodies simultaneously running the same air space. When a plane goes down, each will point at the other and nobody will take responsibility. That's what you get with dual vetting and dual filing, and it's only a matter of time before we have major casualties. And option (D) implicitly includes keeping the listing function at HKEx, whether in the current subsidiary or a new one, it really makes no difference. Since (D) implies (B), and (B) is wrong, we know that (D) must be wrong.

And that leaves you with option (A).

Our position

Since Mar-99, when then Financial Secretary Donald Tsang announced the demutualization of the Stock Exchange and the creation of HKEx, Webb-site.com has advocated reform by removing the regulatory functions from HKEx, and we took the same position in our submission to the Expert Group on 25-Nov-02. Back on 3-Mar-99, we wrote:

"If the government proceeds with the [HKEx] flotation plan then the regulation of listed companies should be removed from the Exchange to the SFC, which will then operate along the lines of the US SEC. The SFC would regulate the merged exchange as well as the listed companies, and the listing division of the former SEHK would be transplanted to the SFC. This would at least remove the potential for disputes between the Exchange and the SFC over listing rules, that has existed until now. In addition, it would remove the risk that the Exchange would approve the listing of unsuitable companies simply to increase its own revenue."

OK, so we were a few years early, but at least we're consistent. And despite (or because of) this position, your editor David Webb was elected to the Board of HKEx by shareholders of the company at the first post-listing opportunity on 15-Apr-03. Clearly the shareholders recognise that the long-term success of HKEx depends on fostering a high quality market with a modern regulatory structure, in which investors can trust and trustworthy issuers can access affordable capital, not a race to the bottom by the waiving of listing rules or track record requirements or the molly-coddling of issuers who would rather not face a 1-share-1-vote democracy, quarterly reporting and disclosure of directors' pay.

HKEx's opinion?

Now since your editor joined HKEx board, the issue of Listing reform has remained in the background, and we are not giving away any secrets to tell you that the new board has yet to directly discuss it. Indeed, Chief Executive Paul Chow (Mr Chow) told The Standard on 9-Oct-03 that:

"the exchange...would respond by the end of the year after hearing directors' opinions at a board meeting in November".

Let's go back to Corporate Governance 101 here. A Chief Executive runs a business, and reports to the board. The board of directors directs the company. So if the board has yet to discuss this matter, then why is the Chief Executive running around giving interviews and writing letters to newspapers on this subject, expressing views of HKEx when these views have not been approved by the board? It puts unfair pressure on the board, at its meeting in November, to "tow the line" and agree with the public statements of the Chief Executive in order for him, and by association HKEx, not to lose face. If he is to express an opinion, then he should make it clear that this is his personal view and not necessarily the opinion of the board of HKEx.

To be sure, the previous pre-April board did approve a string of submissions to the Expert Group and a subsequent announcement agreeing to co-operate with implementation of the recommendations, and it did then approve a letter opposing those recommendations, but that is history. Of the 6 incumbent directors proposed for re-election by shareholders, 3 of them were rejected at the AGM, and one of those seats went to your editor, while another went to a fund manager. While your editor is always open to reasoned debate, given the change in board composition since April, it seems unlikely that the board will reach any unanimity on this subject when they eventually discuss it.

Letter to SCMP

In response to an SCMP editorial on 6-Oct-03 headed "Time is right for HKEx to end its conflict of interest", Mr Chow wrote (or at least, signed) a critical letter on behalf of HKEx, which the newspaper published on 24-Oct-03. Ironically, part of this held out the Board of Directors as "representative of all stakeholders in the market" with the implication that we have discussed this, which we have not.

As regards representation, let's deal with that first. The board can hardly be said to be "representative" when only 6 out of 13 directors can be elected by shareholders and 11 out of 13 come from non-investor constituencies. Your editor is a private investor and one of only two investor-based members of the Board, both of whom were elected by HKEx shareholders in April. Investors might have been willing to elect more of their own kind, but there were only 6 seats available, and the board sought to preserve its own imbalance by endorsing the candidacy for re-election of all 6 brokers who were elected before the listing of HKEx in 2000.

Of the 6 Government appointees, we have a Chairman who is a consultant to, and co-founded, one of the largest local corporate law firms in Hong Kong, Woo Kwan Lee and Lo, which has a long string of blue-chip clients. Mr Lee was once a director of  numerous listed companies including Cheung Kong (Holdings) Ltd, Hutchison Whampoa Ltd (where he was an Executive Director from 1979 to 1997), Cheung Kong Infrastructure Holdings Ltd and Hong Kong Electric Holdings Ltd, all of which are listed companies controlled by Mr Li Ka-shing. Mr Lee was also a non-executive director of Henderson Land Development Co Ltd from 1981 and Sun Hun Kai Properties Ltd from 1975. He only stood down from these directorships in 1997 in order to join Hong Kong Chief Executive Tung Chee-hwa's first Executive Council. He also served on the board of numerous smaller listed companies, such as the ill-fated Peregrine Investment Holdings Ltd and the always-entertaining Playmates Holdings Ltd.

Another government-appointed director is Mr Lo Ka-shui, the Managing Director of listed property firm and landlord to HKEx, Great Eagle Holdings Ltd. Another was Mr Liu Jinbao, the Chief Executive of listed BOC Hong Kong (Holdings) Ltd until he suddenly departed northwards to help authorities with their inquiries and later sent a back-dated resignation to HKEx. Bank of China, through another arm, is active in investment banking and of course lending to listed companies. Another, Mr Leong Ka Chai, runs a brokerage called Roctec Securities. Another, Tim Freshwater, is Chairman-Corporate Finance (Asia) of Goldman Sachs, which has investment banking business with large listed and to-be-listed companies and the government, and also gets consulting work from HKEx, and last but not least is Mr Fong Hup, the Senior Advisor of Deloitte Touche Tohmatsu, which of course audits numerous listed companies.

Let's be clear, we are not accusing any of our fellow directors of wrong-doing or impropriety. We are simply telling you which side their bread is buttered on. It is not the investor side and you cannot expect them to come out swinging against the vested interests of a small but powerful group of individuals who also happen to hold voting power over the Chief Executive of Hong Kong, and at the same time hope to win or retain business from them.

Market Savvy

One of the main themes of Mr Chow's letter to the SCMP was the old claim that HKEx has an "understanding of the way markets work" which by his implication is lacking in the SFC. Excuse us for asking, but if HKEx understands the market so well, then how does it account for its botched "Penny Stock" proposals of July 2002 which crashed the micro-cap market and (thankfully) has resulted in the Panel of Inquiry into the Penny Stocks Incident (PIPSI) and then the Expert Group report? Mr Chow also ignores the fact that the SFC's Corporate Finance Division is already a front-line regulator, administering the Takeover Code to listed companies. Hong Kong already has two front-line regulators, not one.

But let's give HKEx the benefit of the doubt, and assume that there is an element of "market savvy" in the SEHK in dealing with the Listing Rules. Then the Expert Group proposal to transplant all those staff to the new Listing Authority under the SFC would mean that the expertise gets transferred too - so that is not a valid reason for opposing the transfer.

And if Mr Chow is referring to the "market savvy" of the Listing Committee, then he can rest assured that the Expert Group's proposed Listing Panel, which would advise the SFC's Listing Authority, would also be made up of market practitioners, although hopefully it would include more investor representatives than the maximum 4 out of 25 on the current Listing Committee. Indeed, the SFC has already put in place the genesis of this panel, currently known as the Dual Filing Advisory Group (DFAG), which advises the SFC on cases under the dual filing regime, where the SFC can veto listing applications. Six out of the nine members of DFAG are also members of the Listing Committee, so if there is market savvy in the Listing Committee, then this must also exist in DFAG and there's no reason to believe such expertise would not continue with its intended successor, the Listing Panel of the SFC's Listing Authority.

Not only would the HKEx's Listing Division get transplanted to the SFC, but the door would open to harmonise the Listing Rules with the Takeover Code and give them both statutory backing. The Listing Division would be merged with the SFC's Corporate Finance Division, and harmonisation would remove the regulatory arbitrage of the type see in the Boto case in 2002.

In most respects, the Takeover Code takes a tougher approach than the Listing Rules and is more "pro investor". For example, under the Takeover Code, all voting takes place on a poll (1-share-1-vote), whereas under the Listing Rules, voting normally takes place on a show of hands (1-person-1-vote), disenfranchising investors who cannot attend the meeting.

Checks and balances

Another recurrent theme of Mr Chow and Chairman Lee is that the existing "3-tier" system contains checks and balances which would be destroyed by a transfer of regulatory power to the SFC.

This argument carries the unproven implication that like lasagne, the more layers you have, the better. But the reality is different, particularly when the oversight is structurally blocked. For example, the Listing Committee has 25 members, including the Chief Executive of HKEx. Of the other 24, a maximum of 4 can be fund managers. Meanwhile, listed  companies get 6 seats, exchange participants (investment banks and brokers) get 6 seats, and advisers who earn a living from listed companies (accountants, lawyers and investment bankers) make up most of the rest. It would be better to think of it as the Issuer's Committee with a few guests, and in effect this is a self-regulatory entity, for the regulation of issuers by issuers and their advisers.

Another structural block: the composition of the Listing Committee is itself set out in the Listing Rules, and therefore it cannot be changed without the approval of the Listing Committee.

There has been some effort by HKEx, under the heat of the PIPSI and Expert Group spotlights, to toughen up regulation and appoint some fresh blood to the Listing Committee, but this "on its best  behaviour"' mode does not solve the fundamental conflicts, and it must be remembered that the Thursday-afternoon Listing Committee can only consider what is placed before it by the HKEx full-time staff.

In his letter, Mr Chow speaks of a "separation of powers between the HKEx board and the listing committee". Let's remember that until this year, the Chairman of the GEM Listing Committee was K. S. Lo, a director of HKEx, and to this day, the Chief Executive of HKEx is also a member of the Listing Committees. But even if there were no overlap  of individuals, that does not in itself destroy the chain of command. The recently-appointed Chairman of the Listing Committee, Marvin Cheung, gave his first major interview this month to HK Accountant magazine, and refreshingly told it like it is. He said:

"My priority is to make sure that the role of the Listing Committee is transparent.. so that people are aware that we are not a committee that has accepted from the Board of the Exchange the full responsibility for listing matters. From time to time, the chairman of the Exchange, and others, have loosely suggested that they have delegated items or functions to the Listing Committee - if that is the case,  where is my budget? Do I have the right to hire and fire people? If not, how have you delegated it to me?"

In relation to disciplinary investigations of listed companies (for breaches of the Listing Rules), he correctly stated:

"If they do not put such matters before us, the Listing Committee is powerless...We do not have the power to direct the staff [of HKEx] to investigate a particular incident... we are not running the supervision or policing of listing matters."

These remarks make the truth plain for all - and if the Listing Committee is not in control, and the board of HKEx take no part, then who exactly is running the regulatory "business" of HKEx, in its subsidiary, SEHK? Clearly, the full-time management of HKEx/SEHK, including Mr Chow as their boss, are heavily involved in regulation. This is another reason why option (B) in the PERL paper would not work, because any part-time board or committee which oversees a new subsidiary would find itself in the same position as the Listing Committee, and the budget and operations would still be a matter for the management of HKEx.

Let's face it, if HKEx were unable (as management claims) to influence the operations of the new subsidiary, then there would be no benefit in keeping it in the group - it would be like owning a car without having the keys or license to drive it.

As regards the claim that the SFC would be overly powerful, the evidence from its existing front-line role as maker and administrator of the Takeover Code refutes that claim. Anyone affected by its decisions can appeal to the Takeover Panel (of which your editor is a member) and the Expert Group similarly proposed that the "Listing Panel" of market practitioners would hear appeals of the SFC's Hong Kong Listing Authority decisions. Beyond that, there are other potential avenues of appeal, such as the Securities and Futures Appeals Tribunal and ultimately the courts. The danger Mr Chow speaks of simply isn't there.

Budget

Now let's deal with Mr Chow's claim, again in the letter to the SCMP, that:

"The statement in your editorial that 'nearly a fifth of HKEx's income comes from listing fees' is misleading..."

"The approval of new companies for listing is not a profitable activity for HKEx. Revenues from new listings constitute only a small part of HKEx's total listing revenue"

Now who's being misleading? Think about it. What happens to new listings? They become old listings. And they keep paying annual listing fees. And investors pay HKEx transaction fees, settlement fees and often scrip fees every time they trade the stock. Let's not be coy about it, without listed companies, there wouldn't be any stock to exchange on the stock exchange. HKEx is a for-profit company, and listings are essential for profitability.

Even if you look at the listing fees (initial and annual)  in isolation from all the other transaction-related revenues, and compare that with the costs of the Listing Division which administers the Listing Rules, there is no doubt that this division is a highly profitable business. After all, that is why it is important to HKEx that the transfer of regulatory powers to the SFC be achieved on a "bottom-line neutral" basis, as recommended by the Expert Group. That means that HKEx would keep to keep that portion of its listing fees which represents the profit, while giving up the costs and the revenue to match it.

If Mr Chow still disputes that HKEx makes a profit from the Listing Division, then we challenge him to publish separate figures for the Listing Division in the next audited statements instead of blending them in with the "cash market" segment as is present practice.

The Reason for Resistance

Despite the fact that there is a very real conflict of interest between being a for-profit company and a regulator, the truth is that this is not the main reason why HKEx is fighting so hard to keep the regulatory function. From a financial point of view, in any other company, when someone offers you the opportunity to shed costs without reducing profits, you jump at the opportunity to boost your gross margin.

So what is really going on here? It's not about the money. Shareholders of HKEx would not have elected your editor if they thought his views were damaging to their financial interests. No, this is about power, and the ability of a small group of vested interests to go on making their own rules, against the interests of investors.

Mr Chow claims that, other than disclosure rules, the enforcement of which he is willing to be transfer to the SFC, the "vast majority" of the Listing Rules "deal with matters related to the operation of the marketplace".  This is simply not true. Anyone who has spent any time studying the Listing Rules or even glancing at the contents page will know that they are about far more than disclosure obligations. In fact, the marketplace rules Mr Chow refers to are set out in several separate books including the Rules of the Exchange, which can stay where they are, and these should not be confused with the Listing Rules. By cherry-picking which Listing Rules to give up to the SFC, Mr Chow and Mr Lee seek to retain the powers that matter most to vested interests, including the rules governing entry criteria, post-IPO lock-up periods for controlling shareholders, the composition of the listing committee, the (lack of) pre-emptive rights for shareholders, the (lack of) poll voting requirements, the ability of controlling shareholders to elect their buddies or paid advisers as "independent" directors, the limits on share option schemes, and the provisions for articles of association of listed companies relating to director elections and removal.

Cast your mind back to the days of 2000. GEM was new, and the Exchange set about waiving or bending its rules to allow companies with no real track record to list. We're thinking of companies like Tom.com, Henderson Cyber and Sunevision  and many smaller imitators. Only a small fraction of those issues were allocated to the public offer, while the bulk was placed with selected friends and clients of the organisers, and the placees made massive multi-fold premiums in the next-day market.  For sure, this was highly profitable for the placees, investment banks, brokers, lawyers and accountants who make the wheels of the market go around, but tens of thousands of retail investors lost billions of Hong Kong dollars as they got sucked into the post-listing hype, and in the process, GEM, which started as a sensible idea to provide capital for small and medium enterprises, was hijacked into a tycoon's and con-artists playground, destroying its credibility.

That's the kind of power that the existing three-tier structure  brings you, and that has nothing to do with the financial interest of HKEx and everything to do with external vested interests.

A word for our American readers

If you are sitting in New York and any of this seems familiar, its because you've got the same problem with the NYSE. Although your SEC is a more powerful and better-funded regulator than our SFC, you still have an NYSE which makes corporate governance rules for listed companies on matters like board composition and share option schemes, and allows brokers to vote shares they hold for clients without any instructions from those clients, stacking votes in favour of management. Until the "coup de Grasso", HKEx often backed its lobbying with a desire to adopt a "North-American-style model" - a model which has now been shown to be just as riddled with conflicts as HKEx is. It was, after all, by comparison to the option-inflated packages of listed company CEOs that Mr Grasso sought to justify his own exorbitant pay, calling himself "two-thirds businessman and one-third regulator" (in that order). Self-regulatory organisations  simply don't work, and the NYSE should get out of the regulation of exchange members and listed companies and move these responsibilities to the SEC.

© Webb-site.com, 2003


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