Suitability in a disclosure-based market
8th June 2009

It was another Friday-night policy announcement from the Stock Exchange of Hong Kong Ltd (SEHK), wholly-owned by Hong Kong Exchanges and Clearing Ltd (0388). Indeed, if an SEHK policy announcement comes out any day other than Friday, it's usually some kind of emergency or U-turn.

This wasn't an emergency, although they do get bingo points for using the word "crisis", as in "financial". SEHK said that in certain circumstances it "will consider" waiving  the profit criteria for main board listing applicants, which are currently HK$20m of net profit in the latest financial year, and $30m in the two preceding years combined.

The circumstances include having made net profit of at least $50m in the last 3 financial years - so the possible waiver just allows the applicant to have made less than $20m in the latest year as long as they made more than the difference above $30m in the first 2 years. They also need positive cash flow before changes in working capital and tax in the latest financial year.

Webb-site.com has no objection to these changes, but the profits test system itself has no place as an entry criterion to a disclosure-based market. In any given year, there are several hundred existing listed companies which neither made a profit nor had positive cash flow, but remain listed on the main board - indeed some companies have not made profits for many years. Hong Kong is supposed to be a disclosure-based market, where investors decide what to buy and how much to pay for it on the basis of information provided, not where regulators decide which companies are "suitable". If anything, establishing profit hurdles to listing gives companies one more reason to fake their accounts.

So the profit criterion should be abolished, and as a corollary to that, the Growth Enterprise Market, which primarily exists for companies that can't meet the main board profit criterion, should be scrapped too. All existing GEM stocks would just become listed stocks. What is far more important is that investors must have adequate information on which to base investment decisions - otherwise they have to speculate on what they don't know. The Exchange should require that:

1. the listing applicant was audited by the same firm of auditors throughout the 3-year pre-IPO period and that this firm signs the accountants' report in the prospectus, without qualifying their opinion on trueness and fairness; and

2. the same audit firm (or in the case of foreign subsidiaries, its related firm) should have audited all the material subsidiaries of the listing applicant in each year; and

3. all listed companies produce full-format quarterly financial statements, so that investors have enough financial disclosure to make an informed investment decision.

The first two items should be phased in over the next 3 years, otherwise companies which plan to list in 2009-2011 might not be able to meet the "same auditor of the group" criterion. So it would apply to 1 year in 2009, 2 years in 2010 and 3 years in 2011.

A big problem in the past has been big-4 audit firms coming in at the last minute, only auditing the final year of the track record, and often not having audited the subsidiaries, where skulduggery has been going on. After-the-event auditing is impossible - you cannot step into a time machine and go back to do year-end stock-takes and fixed asset verification - you have to rely on the historic data you are given, and that may not be reliable. Customers and suppliers from years past may also be gone or uncontactable, making it impossible to verify invoices and receipts. Cases that spring to mind include Fu Cheong (Ernst & Young), Gold Wo (Ernst & Young) and GKC (Deloitte Touche Tohmatsu). Fraud was discovered in each case, but too late to protect investors. Which bring us to another issue:

Auditors have no duty of care to shareholders

In Jul-06, a brave individual investor attempted to bring a court action against Ernst & Young, the auditors of Gold Wo. The Court of First Instance had no choice but to quote the House of Lords case Caparo Industries plc v Dickman and Ors (1990), in which the auditors were held not to owe a duty of care to shareholders of the company, let alone to future shareholders who may buy in the market. Their only duty was to the company itself. The HK case was accordingly "doomed to fail" and was struck out in its entirety.

It is frankly ridiculous that no investor can rely on the audit report in the annual report when deciding to invest, or to remain invested. Only legislation can change this, as Deputy Judge Ian Carlson said:

"What [the plaintiff] seeks is the sort of consumer protection which is available in some of the state jurisdictions of the United States...That position has not been arrived at in Hong Kong."

If the Government is serious about establishing a competitive advantage for HK, then it should legislate on this, so that auditors carry the can for sloppy work. That doesn't escape the directors who are responsible for financial statements, but it would also impose a duty of care on auditors to do their job properly, and if they knew that they had that duty, they might be a bit more careful in their work. But that legislation in itself, would not be sufficient, because:

Secondary-market purchasers cannot rely on the prospectus

Yes, it sounds amazing, doesn't it? Let's say it again: if you buy shares in the market, even on day 1 of trading, you cannot rely on the prospectus. You cannot sue the auditors, the sponsors or even the directors if the prospectus turns out to be a pack of lies.

On 22-Sep-06 the SFC announced that it had abandoned a proposal (Proposal 9 in the Consultation Paper on Possible Reforms to the Prospectus Regime) to allow secondary market purchasers to bring claims for fraud in IPO prospectuses. The entire price discovery process in the secondary market relies on the truth of the prospectus, and subscribers in the IPO have a right of recourse (subject to the limitation below), but anyone who purchases shares in the market from that subscriber, even on the first day of trading, is on their own, as if the prospectus did not exist. The subscriber who sells on day 1 is of course free and clear, and will not claim if the issuer subsequently collapses in a smoking heap of fraud, while the secondary buyer can't sue the seller because no representation was made by him in the market when he sold.

Another SFC proposal that was abandoned was Proposal 10, to remove the requirement for subscribers to prove that they actually read and relied on the prospectus when making a claim for fraud. Now, how many people can prove what they read yesterday, let alone what they read months or years ago? Do they have any witnesses? Of course not. Again, the relevant fact is that the IPO was priced on the basis of the prospectus and nothing else, and enough people read enough of it for the market to set that price. If the prospectus then turns out to be fraudulent, no victim should have to prove that they themselves read it. It should be enough to show that if the document had been known to be false, then the shares would not have fetched the price they did in the primary or secondary market. The SFC could not find any such "prove that you read it" requirement in Australia, Singapore or the UK.

Beneficial owners

Incidentally, all of these rights need to apply to beneficial owners, not just registered nominee shareholders. Otherwise we will be caught by the fact that nearly all publicly held shares are held in the name of HKSCC Nominees Limited, the de facto central depository, which will never bring any court action of its own. In turn, many people and institutions hold shares through banks, brokers and custodians, who won't take action either.

Still no class action system

Of course, all of the above is rather theoretical in the absence of a class action system, because no IPO investor alone would find it worth the cost of bringing a case even if they had (a) subscribed and held the stock since the IPO and (b) could produce a witness to prove that they read the prospectus before subscribing. To our knowledge, nobody has ever brought such a case in HK.

So the Government needs to adopt the proposals which the SFC abandoned in 2006, and we need a class action system. On the latter point, there is now a sub-committee of the Law Reform Commission, chaired by former SFC Chairman Anthony Neoh,  which is considering whether Hong Kong should have a class action system, as Australia has had for 20 years. The sub-committee has been running more than 2 years, so it's about time they sent out some proposals. Such a system would cover not just shareholders but other cases such as consumer product defects or compensation for consumer price-rigging after a competition law makes it illegal.

Don't believe the scaremongers who say that Hong Kong would end up like the USA with meritless class actions being brought for nuisance value. Hong Kong, like many other jurisdictions but unlike the USA, has a "loser pays" costs system which means that lawyers would only bring cases, and insurers would only fund them, if they had a high probability of success.

It's never the right time, is it?

At the end of its announcement, SEHK says:

"We also note that certain market participants have expressed the view that the existing profit test may not be a useful indicator of an applicant's future performance and questioned its appropriateness as an eligibility requirement for listing. The Exchange will review the existing profit test and other components of the eligibility requirements at a suitable time."

There you go again - deciding "suitability". Surely now is a suitable time, for all of the above - SEHK should abolish the profits test, and the Government should legislate to give shareholders rights against auditors, rights to rely on the prospectus in the secondary market, and class action ability to enforce those rights. It has been repeatedly shown in IPO frauds that front-end criteria like the profits test are no substitute for effective legal remedies and deterrents.

Copyright Webb-site.com, 2009