Rusal and the retail investor
20th December 2009 (updated 21-Dec-09)

Media reports in the last few days have indicated that the SFC has been toying with various ways to "protect retail investors" from the proposed Hong Kong listing of Russian aluminium and alumina producer United Company RUSAL (Rusal)

The reports say that the SFC is considering two measures:

1. Not allowing Rusal to have a public offer tranche in its listing, permitting only an institutional placing.
2. Requiring that the board lot (the minimum transaction size for automated trading on the Stock Exchange) be set at a very high level to deter smaller retail investors from buying the stock.

Both measures would in fact increase the risk for retail investors, and the second measure is downright dangerous. Not only that, but the SFC appears to be suffering from institutional amnesia - as we explain below, the idea of large board lots has been considered before, in 1998, and ruled out as a way to exclude small investors from the GEM board.

Public offers

In our view, whether to conduct a retail public offering should be a matter of choice for all listing applicants. Public offerings involve significant additional expense, including appointing a receiving bank, advertising in newspapers, bulk printing of prospectuses and application forms, and publishing allotments results. Such expense may not be worthwhile for some companies, particularly smaller ones, so the obligation to have a public offer can be a deterrent to choosing HK as a listing venue. Other companies, such as large banks, may consider that the public offering is a way to build goodwill with potential customers.

Public offerings are optional on the GEM board, but until now, virtually all main board listings involving the sale of new or existing shares have been required to have a public offering tranche, with the exception of Chapter 21 investment companies (see Rule 21.14). Public offerings are the rule, and if an issuer does not want to do one, then it has to convince the Exchange that there is unlikely to be significant public demand. Indeed, Rule 7.10 says:

"The Exchange may not permit a new applicant to be listed by way of a placing if there is likely to be significant public demand for the securities"

We are not aware of any such waiver from the public offer requirement ever having been granted.

But now, the SFC appears to be saying that Rusal, rather than being required to have a public offer, should be prohibited from having one. This is bizarre. The general public can buy the shares in the secondary market, so excluding them from the primary offering does nothing to protect them. In fact, as a matter of company law, excluding retail investors from the IPO reduces protection, because under the Companies Ordinance, investors can only rely on a prospectus (in terms of right to sue) if they are subscribers in the initial offering.

Companies and their directors are liable for fraudulent, reckless or negligent misrepresentations under Section 108 of the Securities and Futures Ordinance (SFO). However, subsection 108(4) says that Section 108 does not apply to any case to which Section 40 of the HK Companies Ordinance (CO) applies, i.e. to prospectuses. Under that section, purchasers of shares in the secondary market cannot sue against the prospectus. In a 2005 consultation paper, the SFC proposed allowing secondary buyers to sue, but abandoned that in 2006.

Giant board lots

What a short memory the SFC has. In May-98, the Stock Exchange published a consultation paper "On a proposed new market for emerging companies". The result formed the basis of the Growth Enterprises Market, or GEM board, which was launched in Nov-99 after the SFC approved the Listing Rules.

SEHK wrote in the Executive Summary on page 3 of the consultation paper:

"In light of the significant risks to investors, the Second Market should not be a mass market open to all investor groups but a specialised market targeting only sophisticated investors (i.e. professional and knowledgeable retail investors). It is proposed to set a high minimum transaction size to deter the participation of other retail investors and to raise investors' awareness of the need to conduct a thorough appraisal prior to investing in these companies."

and page 8 says:

"The Exchange is of the view that the minimum transaction size for Second Market companies should be set at a level not lower than HK$250,000."

They also proposed some lower limits for the market to consider. The minimum transaction size was to be effected by setting a large minimum board lot. Your editor served as a member of SEHK's "New Market Development Group" in the run-up to that consultation. In the committee and in our submission in 1998, we opposed the concept of a large board lot, for the following reasons:

• If an investor wants to own the stock, they might stretch themselves to buy a single board lot, taking excessive risk. They would be forced to make an "all or nothing" bet. They might even use a margin loan in order to afford the 1-lot purchase. Regulators should encourage risk reduction through diversification, not deter it.
• It would reduce the ability to use dollar-cost averaging and accumulate a holding over time.
• Small investors could just club together with, or borrow from, friends and family to share the risk, dragging in people who do not understand the investment.
• Not all small investors are unsophisticated - some are employees in financial services, and some are equipped with an MBA or a degree in accounting or finance. The rich do not have a monopoly on sophistication.
• Not all large investors are sophisticated. There are plenty of rich business owners and wealthy widows who have very little investment expertise. The poor do not have a monopoly on ignorance.
• There are plenty of other risky investments on the exchange, including highly-leveraged loss-making companies and derivative warrants. We don't set prohibitive minimum transaction sizes for those. Indeed, some of them have the smallest board lot values as a result of collapses in their share prices.
• Large board lots tend to reduce liquidity, particularly in smaller companies.
• There is no evidence that a large transaction size deters other forms of speculation - look at the property sector, where people often bet almost all their savings on the deposit for a single asset and then borrow twice as much in a mortgage.
• Large board lots would cause problems with rights issues and scrip dividends, because many more investors than normal would get fractions of board lots which are more difficult to sell.

As a result of the consultation and responses like ours, SEHK abandoned the proposal of large board lots and launched GEM with normal-sized board lots. They aim for a minimum board lot on all new listings of HK$2,000 in value at the issue price (see page D-18 of this document).

If HKEx and the SFC set a large board lot value for Rusal, then it would need to be substantially larger than existing board lots. The Webb-site database shows that the largest board lot of ordinary shares, as of Friday (20-Dec-09) was Sun Hung Kai Properties Ltd (0016) at $113,700, a stock which the SFC presumably perceives as within the reach of retail investors, otherwise they would have required a reduction in board lot by now.

The bigger issue

The SFC, and the Government which often prods it from behind the scenes, seems to be torn between running a disclosure-based market, which they usually claim to be, and a merit-based market, where the Government or its regulatory agency decides which companies are "good enough" for the public to invest in.

They should stick to the principles of a disclosure-based market. If there is something about the Rusal prospectus which lacks truth or credibility, then they should require further disclosure or verification, and not approve the listing unless and until they are satisfied. For example, we understand why the regulators might have required further evidence that the working capital sufficiency statement (which every listing prospectus must contain) is a reasonable one. But if the prospectus meets the disclosure requirements, then the SFC has no business trying to shield any investor from buying the stock.

Instead, what they should be doing is returning to the outstanding legislative issues of prospectus liability and auditor liability, and supporting the proposed introduction of a class action system, so that investors can have greater confidence through greater deterrence of false and misleading prospectuses. We addressed several of these issues at the bottom of our Asian Citrus article last month, so we won't repeat them here.

In an encouraging step, SFC CEO Martin Wheatley recently told Webb-site.com:

"I personally support having the option of class action within our legal system. We are going to look at the current proposals in more detail before we consider making a formal submission to the Law Reform Commission.

Regarding prospectus liability, I believe it is a good time for us to revisit some of the provisions that we left out last time. We are reviewing various areas of the Companies Ordinance and will likely put forth our proposals in stages."

Update 21-Dec-09

The FT reports (subscription required) this morning that the minimum subscription will be HK$1m (US$130,000) and the board lot will be 200,000 shares (no word on the indicative price). This is ridiculous. If this company does not meet HK's (not very onerous) disclosure and governance requirements then the SFC should block the Listing. If it does meet HK standards, then everyone should be able to buy it. They cannot have it both ways, approving a listing which does not meet HK listing standards and then trying to prevent the public from buying it. That is just what the Government wanted last year - to create a "professional board" for unprofessional companies that won't adhere to our disclosure/governance requirements and get a free ride on our reputation (which isn't that great to start with). It was one of the reasons your editor, David Webb, resigned as an independent director of HKEx on 15-May-08 - see paragraph 6 of his resignation letter.

On 4-Mar-09, HKEx announced that the Listing Committee had decided a month earlier to "suspend" (read: cancel) the "Professional Board" project. HKEx said:

"On the whole, overseas exchange experience does not provide compelling examples of successful equity market segments that exclude retail investors. In addition, some market practitioners expressed concerns about the practicality of the proposed exclusion of retail investors and others felt that the priority should be given to further enhancement of the Main Board rather than the launch of another new board."

© Webb-site.com, 2009