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New GEM Exemptions
30th July 2001

Just when everyone was looking forward to a quite weekend, out comes a joint press release from Hong Kong Exchanges & Clearing Ltd (HKEx) and the Securities & Futures Commission (SFC) with proposed new rules for the Growth Enterprises Market (GEM), which have at last been "agreed in principle" between them. In a separate addendum, they also published the results of the market consultation on the GEM rules together with an appendix summarising the responses of 165 respondents, including 60 readers who submitted comments via Webb-site.com.

Background

You'll need a long memory to recall what this is all about. Soon after GEM opened its doors in Nov-99, the Listing Committee began waiving listing rules in a wholesale fashion, prompting a strong rebuke from Webb-site.com and others. This culminated in the chaotic and massively oversubscribed offering of Tom.com in Feb-00, followed two weeks later by the IPO of Sunevision, both spin-offs from leading cash-rich conglomerates and not the kind of capital-starved Small and Medium Enterprises (SMEs) that the GEM was intended for.

The combination of the rules being waived (or waved) under the noses of the SFC, and the spectacle of 10% of the population queuing up and fighting for IPO forms, led to an enquiry by the Legislative Council's Financial Affairs Panel on 13-Mar-00 (agenda, briefing by the SFC (pages 5-9 of the PDF), and  minutes (paras 21-35).

Perhaps prompted by the pending Legislative enquiry, the SFC rolled up its sleeves and sat down with the HKEx, and on 11-Mar-00 they announced a freeze on the extent of the waivers but not before fixing a set of generous waivers (including a 1-year track record requirement) which would apply to all new listing candidates until the market had been consulted on what to do next.

The consultation paper was published on 23-May-00, and the submission period ended over a year ago, on 30-Jun-00.

Track Record Philosophy

GEM is only partially returning to the original track-record requirement of 2 years "active business pursuits". Webb-site.com editor David Webb was on the committee which designed that framework 4 years ago, and the reason for it was quite simple; public investors are not as sophisticated as venture capitalists, nor do they have access to the due diligence investigation process that VC investors can go through.

So we were trying to create a market for companies which had survived the filtration process of the private venture capital market, before taking money from the public. Through this process, the overall quality of the market would be stronger, and "get rich quick" scams with little or no track record would not be able to go straight to market.

The Stock Exchange should now heed its own warning, from the May-1998 consultation paper on the new market (which later became GEM):

"The principal purpose underlying the requirement to demonstrate Active Business Pursuits is first to give potential investors information on which to reach a judgement as to whether the applicant's business is likely to succeed, and secondly to make it more difficult for over-aggressive issuers and promoters to obtain a listing in the Second Market."

You cannot have a disclosure-based regime without adequate disclosure. Just as you can't draw a straight line without two points of reference, it takes at least two years to discern the barest of trends in company financial statements and put the "track" in the track record. It is mathematically impossible to deduce a trend from a single point of reference.

If you are looking to create a "pump & dump" stock scam, then you would often be too impatient to wait two years before you can list it on GEM, so you would take your scam to overseas markets, or reverse it into a main-board listed shell.

The Big Exemption!

In setting the new track record rule, GEM has included an exemption from the 2-year record, reducing it to one year for any company "of substantial size and with significant public following" which:

1. has pursued its focused line of business for at least 12 months;

2. has total revenue of no less than HK$500m in the last 12 month period as shown in the accountants' report in the initial listing document, total assets of at least HK$500m as shown in the balance sheet in the accountants' report, or market capitalization of at least HK$500m determined at the time of listing;

3. at the time of listing, has a minimum market capitalization of HK$150m in public hands which is held by at least 300 public shareholders, with the largest 5 and largest 25 of such shareholders holding in aggregate no more than 35% and 50% respectively of the securities in public hands. In determining the “300 public shareholders”, only a maximum of 100 shareholders who have obtained their securities through a distribution in specie may be counted as public shareholders; and

4. the initial public offer price of the securities must be at least HK$1. 

We'll ignore criterion (4) on the basis that it is just plain stupid. Nominal stock prices are more relevant to the price of snow in Antarctica than whether a company is suitable for listing. Any company can achieve a $1 price simply by consolidating its shares. The suggestion that by using nominal prices above $1, an issuer is psychologically less likely to attract unsophisticated investors, is wrong - look how many people bought PCCW at over $20.

The bigger they are, the more they hurt

Now looking at criterion (2), what this implies is that an investment decision based on a 1-year track record is more reliable if companies meet the "substantial size" criterion, and that this size makes them "quality companies with potential" and saleable to the public. That is just plain nonsense. Size has no bearing on quality and the only potential it affects are potential losses.

Due to the issue size and wider ownership, more investors have lost more money on big GEM companies than small ones. Take for example, Sunevision Holdings Ltd, the spin-off of Sun Hung Kai Properties (SHKP) sponsored by Jardine Fleming. Original investors (most stock went to placees chosen by the issue managers) bought 300m shares of this company at $10.38, and today it trades at $1.50. That's a loss of $8.88 a share (nice lucky number!) or HK$2,664m. Measured from the closing high on the second day of trading (20-Mar-00) of $16.10 (when the public was piling in to the stock), they've lost HK$4,380m (US$562m). So there's no safety in size.

The public probably thought they were buying into dot-coms and data centres, but in fact 100% of the (shrinking) revenue in the first 2 years of the 2.5-year track record was from a company called Sun Technology Services Ltd which installed satellite dishes and security systems, of which 94% came from related parties, including SHKP. In the final 6 months of the period, data centres (which were mostly converted office properties previously owned by SHKP) contributed 1.5% of the revenue, and  internet business 0.2%. So Sunevision's IPO track record was largely down to an imported subsidiary, and most of the "growth enterprise" being marketed was less than a year old.

An even more blatant case was that of Tom.com, which launched its IPO sponsored by BNP Prime Peregrine with a half-baked portal just a few weeks old, which everyone thought was the core business. In fact, the 2-year track record came from a tiny software outfit which did customs documentation packages for Shenzhen, as we explained in last year's article, A brief History of Tom. Only about 1 in 50 applications received allotments, so most of the retail public shareholders paid in the aftermarket up to $15.35 for a stock now trading at $2.025. The chosen ones who were on the discretionary placing list and received the bulk of the issue at $1.78 were very happy!

Another strange thing about the market cap test is that while you are preparing for listing, you cannot be sure what the market cap will be. That is only determined by the eventual offer price and the number of shares you issue. Companies on the border-line may stretch to reach the $500m figure.

Total Assets

If you can't meet the market-cap test, then you can try for "total assets" of $500m - that means gross assets and not net assets after deducting liabilities. This test is inconsistent with the market cap test, since market cap reflects the perceived value of equity after deducting the companies liabilities such as bank debts and other creditors. You might easily have gross assets of $500m but net assets of only $250m.

Total assets could also be inflated with intangible assets such as goodwill or brand valuations. These are easy to come up with. Scanner maker Syscan Technology Holdings Ltd, for example, included in its prospectus a valuation by American Appraisal Hongkong Limited of the company's trademark and patents, totalling intangible value of $1,527.3m. Today, the entire market value of the company is $265m.

The proposal is silent on whether "total assets" also includes IPO proceeds, property revaluations and so on. But of course, the other test, of market cap, does include IPO proceeds.

"Significant Public Following"

In effect, criterion (3) says "if you can con 200-300 people into buying your shares, then you don't need a 2-year track record". Surely this is not the point. It is a truism that anyone who chooses to buy an IPO has confidence in it - or else they wouldn't buy. But on what information have they based that decision?

To take an analogy that should be familiar to Dr Lo, head of GEM - should a new medicine be allowed to bypass clinical trials if 300 people think they want it? Taking the analogy further, if we had no clinical trials process, but simply allowed all new drugs to go straight to market (provided 300 people want them), then there would be so many failures and side-effects that the public would completely lose confidence in medicine - they would not be able to tell good drugs from bad. So many people would not buy any at all. That is the problem with GEM - due to the number of dismal failures, the good companies will find it hard to get attention.

The 2-year track record is the clinical trial of the GEM candidate, before they are let out into the public market, and this requirement should not be dependent on the marketing skills of its management or sponsor.

Easily faked

In any case, the 300-shareholder criterion is easily achieved, because brokerages have a tried and tested system, used for many years, by which they allocate shares to their employee accounts or to discretionary accounts in order to meet the required number of shareholders for the main board (100 shareholders, or 3 for every $1m, whichever is higher). Whenever you see a main-board issue 1.0 times subscribed with 110 applicants, 90 of whom applied for the minimum 2,000 shares each, you know what is going on. The same system will work just as well on the GEM. So we can assume this criterion is easily satisfied.

The $500m threshold

Even if you believe (as we do not) that a size criterion is appropriate to reduction of the track record, then look at the level the GEM has chosen. HK$500m (US$64m) is not that high. GEM opened for business on 25-Nov-99. There were 7 GEM listings in 1999, of which 4 had a market cap over $500m. In 2000, there were 47 new listings, including 1 by introduction (and hence no offer price on which to judge market cap for the prospectus). Of the 46 with ascertainable market caps, 29 (63%) would have met the $500m criterion. Others may have qualified based on gross assets (including intangibles) but we do not have the data to hand.

Of those 29 companies, 16 would have also met the $150m free-float criterion based on money raised, although in practice (faced with this criterion) several more would have enlarged their issues or counted pre-existing shares held by the public to reach the criterion.

And in a bull market, when speculative excesses (and risks) are highest, you will of course get higher market valuations, making both criteria easier to reach. Of the first 14 GEM listings in 2000 (when tech stocks were near their peak), 11 (79%) would have met both criteria of $500m market cap and $150m free float. Only one of those is now above its IPO price (just).

So we can expect this track-record exemption to be regularly obtained, particularly when companies are allowed to include intangible assets in the gross assets test as an alternative to the market cap test.

SFC's Stealth Committee

What we didn't know until now, was that the SFC in April 2000 quietly appointed an "International Committee on Listing of New Enterprises (ICLNE)", right after the freeze on waivers was announced with the GEM. As far as we know, the first time this committee was mentioned in a press release was last Friday, 27-Jul-01, although there's a glancing reference to it in the recent SFC annual report for the year ended Mar-01.

The members of the committee finished their report 6 months ago, but the executive summary was not published until last Friday. It makes interesting reading, and we only wish the whole report had been published in the interests of transparency. In conducting the study, one thing that the Committee (or more likely, staffers) did was to interview "key decision-makers" in 30 organisations characterised as either "issuer-based" or "investor-based". The report reveals that they were in the ratio of 2:1, so only 10 "investor-based" people were consulted. As you have gathered, we were not one of them.

The report is diplomatic in its language, and despite the obvious purposes, states that "above all, the study was not triggered by any perceived weakness in the GEM board" but later says that it is with a view to "consolidating and enhancing the strength of the market". Ah yes, "consolidating the strength" - isn't that government-speak for "targeting weaknesses"? In effect, the report was commissioned to bolster the SFC's arguments with the SEHK over the GEM rules.

Quality Attracts

K.S. Lo, head of GEM, has continually protested that "the waivers were an earlier move to retain good companies" and that "we need to be competitive, otherwise Nasdaq would take all the good companies."

We regard that argument as false - and so did the ICLNE. In their words:

"recent evidence of companies pursuing overseas IPOs indicates that most local issuers are still strongly predisposed to a 'home' listing where investor familiarity with the issuer's assets, brand name, business operations and management is greatest."

In short, you won't get 500,000 people fighting in the streets of Manhattan over IPO application forms for a half-baked portal controlled by a man most of them have never heard of. ICLNE continued:

"GEM staying with the 'status quo' [2-year track record requirement] is unlikely, therefore, to precipitate a flow of local companies listing overseas. Instead, companies with greater quality might gain reassurance from a sufficiently comprehensive regulatory platform."

Yes, a quality market attracts quality issuers and more investment, and a rodeo market attracts cowboys. Hong Kong needs a quality market for its growing SMEs. Instead, the GEM market has dried up, and in the last six months to 30-Jun-01, it has raised only HK$1.96bn (US$250m), including shares sold by management shareholders. That represents just 2.8% of the HK$70bn (US$9.0bn) market cap at the end of June. The report states:

"In the absence of a sudden upturn in high-tech sentiment or a drive to quality -as recommended in several interviews - the outlook for GEM is currently, perhaps, a little uncertain. A real, or merely perceived, trade-off of stock quality for listing numbers could have a debilitating effect on the market over the longer-term..."

Different environments

GEM Chairman K.S. Lo has regularly compared GEM with Nasdaq, pointing to more relaxed rules of Nasdaq and conveniently ignoring that the two markets are subject to very different legal and regulatory backgrounds. The ICLNE hits this one on the head:

"listing rule comparisons between GEM and Nasdaq have limited value since, in practice, US underwriters and issuers respond to the larger US legal framework. The due diligence expected of, and undertaken by underwriters and other professionals, may mean that certain 'requirements', not specified in listing rules, filter into the listing process in the form of unwritten protocols. Ultimately, these protocols may dictate the type of issuer coming to market.

They also commented

"Where institutional investors are key shareowners (as they are in the US, Germany and UK), they necessarily demand sound disclosure practices. The obligations imposed upon underwriters, through the US legal system, and the presence of class action suits (with attendant contingency fees) which make it easier for minority shareholders to seek redress, have a role to play in protecting minority investors. The environment in Hong Kong, which lacks the statutory framework of the US, and is not buttressed by institutional share-ownership, in the way that for instance the UK or Germany is, necessitates a different approach."

ICLNE arguments support HAMS

That neatly encapsulates our arguments for stronger regulation, and also brings us onto the need for HAMS to represent and act for minority shareholders in a majority-controlled market. Please see our HAMS proposal. Without shareholder activism, corporate governance reform will be slow, but without corporate governance reforms, there will be no spontaneous shareholder activism. As the ICLNE says:

"This is a 'chicken-and egg' problem...as the corporate governance practices that institutions help mould must be mature to some extent before such institutions are prepared to enter significantly as share owners."

Even where institutions are present, they are inactive. HAMS is the solution to that conundrum.

Market Making

The ICLNE recommends that "changes to market microstructure should also be considered" and suggests a market-maker based system.

We disagree with that. It is already perfectly possible for any broker to make a bid or offer on the exchange in any stock. So they can already "make a market" in any GEM stock if they choose to. That is what order-driven systems are all about. However, if they were given a monopoly on the trading system (so that clients could not post their own bids and offers, out-bidding or under-offering a broker. but instead had to take the price offered by a dealer) then all we would see is a removal of direct client participation in the market, and wider spreads. Nasdaq can teach us a lesson there - after its market making scandal a few years ago. No wonder some brokers interviewed by ICLNE were keen on the idea.

So if you want to make a competitive bid and offer, sure, go ahead, there's nothing to stop you, but don't cut the investors out of the action.

Conclusions

The GEM rule changes are disappointing. The fact that it took over a year to reach a conclusion, and the compromises made, reflect again the ongoing conflict between the HKEx and the SFC over market regulation. The proposals, when implemented in the coming months, will not be enough to salvage the tattered reputation of GEM. 

The HKEx is a for-profit regulator, and its powerful listing committees are "issuer-based" with very few "investor-based" representatives. The motivation is thus more towards short-term profits than long term quality of markets, and they are behaving rationally in accordance with that motivation.

We repeat our call for the Listing regulation to be moved to the government securities regulator, the SFC, as London did to its FSA. In Australia, from which Hong Kong took its structural precedent, a parliamentary enquiry is now underway into the framework for the market supervision of Australia's stock exchanges. Hong Kong authorities should wake up to this problem.

Oh and by the way, GEM closed at another record low today.

© Webb-site.com 2001

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