GEM Waivers Reviewed

Following our recent criticisms of the confetti of waivers granted by GEM, the SFC and SEHK have hammered out a compromise which relaxes some rules but contains some encouraging news and a minor victory for minority shareholder protection. However, the new proposals are being effected before public consultation, and by the time this is over too many horses will have bolted. The whole affair underlines the need to transfer the listing division to the SFC and let the Exchange focus on exchanging.

GEM Waivers Reviewed
12th March 2000

In a Saturday afternoon joint announcement, the SFC and SEHK set out proposals designed to end the controversy over the way in which the GEM listing committee has handed out listing rule waivers faster than a sponsor can hand out dot-com application forms.

Option limits imposed

The good news is that the proposals will slash the waiver on share option schemes from 50% to 30%, half way back to the existing limit of 10%, reducing the potential dilution of investors' interests. The proposals also include a rule limiting options granted to connected persons who are also substantial shareholders or independent non-executive directors (INEDs). This is a small but significant victory for the protection of minority shareholders. However, it does not apply to executive directors or anyone who owns less than 10% of the company, and that's a major gap.

If the total grant of options in a twelve month period to a substantial shareholder or INED exceeds 0.1% of the issued share capital and HK$5m of share value, then the latest grant must be subject to shareholders approval, and all connected persons, including substantial (10%) shareholders, must abstain from voting (or vote against).

The announcement does not state that such votes should be held on a poll (one share, one vote) rather than a show of hands (one shareholder, one vote) but we presume that this will be confirmed and will follow the existing GEM poll requirement as set out in rule 20.15 and 23.03(14). That is essential to prevent meetings being rigged with employees holding as little as 1 share each.

The proposals also include a rule in which the 30% limit is broken down into 3 slugs of 10%, each one requiring shareholders approval. It's better than nothing, and slows down the potential rate of issue (10% every 3 weeks), but in most cases it will make little difference because controlling shareholders will vote to back the directors they already appointed, effectively allowing them to renew their own mandate.

Yearlings allowed

On the downside, the proposals shorten the required period of "active business pursuits" from 2 years to 1 year. So far no listed GEM company had applied for a waiver of that requirement, so we can only presume that GEM has received an application along those lines and was about to grant it. In practice, they had already been waiving the rule by allowing companies like Tom.com and Sunevision (both of which launched their portals only in the last few months) to list by transferring older subsidiaries into their listing vehicle and then calling that a track record.

Tom.com did it by acquiring a Shenzhen developer of software for electronic customs documentation, and Sunevision included a company which installs satellite dishes on the roofs of apartment blocks. Neither of these had much to do with the core businesses on which the stocks were promoted.

The GEM market was not designed to be a market for seed capital. One-year-old start-ups are highly risky investments, and a line has to be drawn between helping to fund young companies and protecting public investors from their own stupidity. That is why we have laws against the free market in heroin, cocaine, guns and explosives.

Your correspondent was on the committee which designed GEM, and much time was devoted to finding a way to exclude inexperienced investors from the market. One suggestion (not from us) was to have an enormous board lot (or minimum transaction size), up to HK$250,000. It was ultimately determined that this was impractical, since small investors would end up putting too much money into one stock or "syndicating" a board lot amongst friends and relatives. It would also impede liquidity. So instead a risk disclosure statement was produced which every GEM investor must sign before dealing.

Recent weeks have shown that this is not a practical deterrent, as some 10% of the adult population has applied for dot-com concept stocks. Accepting this fact, we therefore need to ensure some level of quality on new issuers entering the market.

Remember that venture capitalists are experienced investors and are probably a better judge of start-ups than the mass market. The VC industry in Hong Kong has been developing rapidly on the back of the technology boom, and any firm which cannot raise sufficient venture capital to survive its first 2 years, probably does not deserve to be taking public money. We therefore believe the requirement for a 2-year trading record should stay and should be more rigorously enforced.

Lock-ups reduced

In another concession, the proposals scrap the 2-year lock-up on management shareholders and reduce it to 6 months. For the following 6 months, the management must retain 35% control of the company. That brings the GEM into line with the main board rules.

A certain amount of misinformation has been spread suggesting that the current rules prevent venture capitalists from selling their shares for 2 years, but this is not true. They were only subject to a 6-month lock-up under Rule 13.18, no worse than underwriters typically require on Nasdaq. Therefore the relaxation is aimed solely at management shareholders (including controlling shareholders).

The proposed reduction of the lock-up period, coupled with the reduction in the track record period, mean that after 12 months of listing, and with a trading history of only 2 years, the management of a start-up may dump all their shares. They can start this process when the company is only 18 months old (aside from any shares that they may sell in the IPO). Buyer beware, be very aware.

What about the existing waivers?

The announcement by the SEHK and SFC makes no comment on the 50% share option limits already granted to Tom.com and Hongkong.com, which exceeds the proposed 30% limit. In addition, Tom.com has an implicit waiver permitting new share issues within the first 6 months.

This requires urgent clarification. The same rules should apply to all companies, and if the regulators are going to implement rules by way of continual waiver then the terms of the existing waivers should be revised immediately to be consistent with the proposals.

The proposals also make no mention of the waiver granted to Hongkong.com which allows them to issue options not just to full-time staff but also to advisers, consultants, independent directors and part-time employees. As we said in the previous article, this waiver raises accounting questions if options are used to remunerate advisers and avoid recording the true cost of services in the profit and loss account. No reason has been given for the grant of this waiver and it should be revoked immediately.

Stable doors

The announcement states that the new proposals will be implemented by way of continual waivers until the consultation period is over. The SFC and SEHK have painted themselves into a corner on this by allowing precedent-setting waivers to be granted before reaching this agreement. Now they are compounding it by lowering the barriers before public consultation on the proposals. It's like implementing laws and then asking Legco to approve them.

It would have been better to call a halt to all waivers and revert to the listing rules (remember them?) pending amendment to the rules. By the time the consultation is over, so many listings will have taken advantage of the waivers that raising the barriers again would create a two-tier market of those who got in before the stable doors were shut, and those who are excluded. This will put great pressure on the regulators not to tighten any of the proposals.

The SEHK and SFC have frequently been at loggerheads in past years, and it is clear from yesterday's compromise announcement that ground had to be given to the SEHK in order to prevent them continuing on a path strewn with waiver confetti and complaining that the SFC is hampering market development.

This whole affair serves to underline the more general point that we should not continue with the regulatory function sitting in the for-profit SEHK, now a subsidiary of the HKEC. What we need is a clear separation of functions. The HKEC, as its name suggests, should focus on developing an efficient market for transactions in securities, and the listing division and listing committees should be transferred to the SFC. It now seems unlikely that this problem will be resolved prior to the flotation of the HKEC, which is reportedly being brought forward from September to June to capitalise on the record market conditions.

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