Waivers Galore for Tom.com

The SEHK, demonstrating the inherent conflict between its regulatory role and its future role as a profit-making company, has begun waiving listing rules in a wholesale fashion to attract new listings. We look at the 3 major waivers granted to Tom.com on placings, lock-ups and a five-fold increase in share options, and at the wider issue of regulatory decay through competition.

Waivers Galore for Tom.com
21st February 2000

This week's listing of Tom.com gives us a taste of things to come in the new world of a listed monopoly stock exchange. Readers will know that, subject to the passing of enabling legislation, the SEHK and HKFE are to merge into the new Hong Kong Exchanges and Clearing (HKEC).

We have explained before that if the Exchange is to become part of a listed, for-profit entity then this status is incompatible with its regulatory role. As a profit-making entity, the HKEC, whose management will be motivated by share options and bonuses, has a fiduciary duty to maximise profits. One way to do this is to loosen regulations to attract more listing candidates, lowering the entry barriers at the expense of reduced investor protection. Even worse, rather than amending the rules, the Exchange seems capable of just waiving them whenever it chooses, creating regulatory uncertainty and a somewhat bumpy playing field.

But in Hong Kong, the interests of profit and listed companies have been put before the interests of investor protection, and the listing division will be left as part of a for-profit company.

Waivers galore

In addition, it is questionable whether transferring a few assets and web domains from Metro Radio into a portal company with a proud post-launch history of 5 weeks, and throwing in a couple of recently acquired businesses, really gives it the 2-year track record under the same management that the listing rules normally require. But we'll pass on that (for now), and focus on the 3 waivers.

1. Placings Within 6 months

The SEHK which granted this waiver is the same SEHK which recently refused permission for entrepreneur Jimmy Lai's Next Media (which is also an internet business) to issue shares for a placing within 6 months of its reverse takeover (which was deemed to be a new listing).

GEM rule 17.29 prohibits such issues within six months but states in a note that

Clearly the circumstances described in that note do not apply, because the Tom issue is fully underwritten. We can see nothing "exceptional" about Tom which makes it necessary for the Exchange to allow the possibility of further issues even before they have even been proposed.

2. Grant of share options in excess of 10%

Under GEM rule 23.03(2), share option schemes are limited, in aggregate, to 10% of the issued share capital of a listed issuer from time to time.

The Substantial Shareholders in this case are Hutchison, Cheung Kong and a Ms Chau Hoi Shuen. The definition of "Associate" in this case has no bearing on companies since they cannot be employees, so the only people affected by the proviso are Ms Chau, her spouse (if she has one) and children or step-children under 18 (who are unlikely to be employed). Anyone else (including, for example, a Director) is eligible to receive the options without shareholders' approval.

This waiver amounts to a huge variation to the listing rules for no good reason. Tom.com is not the first high-tech company with a need to attract employees, so that is no justification in itself.

In a wide-ranging consultation paper on the main board listing rules released in May-99 (the results of which we are still awaiting), various changes were proposed to the rules governing option schemes on the main board, and although these have not been implemented, they are recognisable in the current GEM rules.

Webb-site.com made a written submission on that consultation in which we advocated that, to provide flexibility in recruitment of key personnel, it should be possible to grant options outside the terms of a general 10% option scheme, but that any options granted outside the scheme should be made subject to independent shareholders' approval on a person-by-person basis. We also said that, in order to remove concerns about reciprocity in the board room (you approve mine and I'll approve yours), all directors and substantial shareholders should be excluded from voting, regardless of whether they were involved in the particular option. We have nothing against special option packages to hire special people, but they should have independent shareholders' consent to remove the conflict of interest.

A strange kind of consultation

We now find it necessary, in the public interest, to reveal that subsequent to the May-99 consultation, the SEHK quietly wrote on 29-Nov-99 to each person who had made a submission (including us) and proposed further changes, including the ability for shareholders to grant a renewable 10% general mandate to grant options, which could be renewed every time it ran out. Since the controlling shareholders would be allowed to vote on this, and they are usually the same people as the board, it effectively allows them to keep renewing their own mandate (the same way that some companies abuse the placing general mandate to repeatedly issue shares) and this could be disastrous. The only limit the Exchange placed on this repeat renewal was a proposed limit of 50% of the issued shares from time to time.

We didn't bother to reply to this informal consultation because we felt our views were clear enough from our first submission. Besides, the general public was not being consulted in the normal way.

The discretion to grant options over 10% of the issued shares is quite enough for general purposes. If a board has more discretion than that, then there is a serious risk that it could be abused. For example, there have been several cases of share option schemes being exhausted just a few weeks prior to a major corporate move, such as a takeover or acquisition, which has allowed management to benefit from the uplift. These grants happen far enough from the event that you cannot prove insider dealing, but it is obvious what is going on.

Another possible abuse is to blow the option scheme as a defensive move prior to a hostile takeover. Imagine, if a company had the ability to grant options in this way over 50% of its issued shares (or 33% as enlarged by the exercise), this could have a major effect on the control position and would heavily dilute other shareholders. This is why independent shareholders should approve each grant outside the 10% limit.

3. Waiver of lock-up rules

GEM Rule 13.16 imposes a 2-year prohibition on sales by "initial management shareholders", which basically means people (other than professional funds such as venture capitalists) with more than 5% of the company. The reason that the 2-year lock-up was put into the rules (as opposed to the 6-month lock-up required on the main board) was that GEM companies are in general very new and depend heavily on their management founders, therefore they should stick with it. However, GEM Rule 13.17 says that

It then lists 6 specific circumstances (including takeover after 1 year, or death), none of which applies to Tom.com at the present time, and concludes with a seventh sweep-all clause:

We see no exceptional circumstances to justify this, and if the Exchange does, they had better be good. What prior circumstances mean that we should allow, in advance, for 48.4% of the company to be dumped on the market at any time after 6 months? Are they planning to sell out? Couldn't they seek permission at the time? We trust that the "exceptional circumstances" do not include the identity of the controlling shareholders. If the Exchange has one rule for conglomerates and another for "less trustworthy" companies then it is failing to understand the purpose of rules.

In the last few GEM listings there have been a few other relaxations of this rule for small management shareholders but they were not on this scale, and followed a refusal by the SFC to amend the rule back in November. Since then, the SFC has remained silent on the increasing audacity of the Exchange's waivers. To us, this silence implies either incompetence or complicity on the part of the SFC.

Playing fields and Rules

There's a bigger issue at stake here. Whether or not you agree with the principles behind the 3 waivers, the resulting changes are so fundamental that they should be done by amendment to the listing rules (which require SFC approval), not by waiving the rules for one or two companies.

If the Exchange waives the rules for one company, then everyone else will surely request the same. If those rejects are rejected, then the first waiver looks like favouritism. In the alternative, If the requests are all accepted, then the Exchange has effectively changed the rules without going through the proper procedure. Then every case becomes "exceptional" and to be unexceptional is an exception to the rule. There will be one set of printed rules and then an unwritten set of known waivers. Investors will no longer be able to rely on the listing rules for protection from minority abuse.

It may well be that, in order to compete with overseas exchanges such as Nasdaq, the Exchange needs to change some rules, but that need should be carefully weighed by the SFC against the need to protect investors. As it is, the Exchange, by granting wholesale waivers, has taken matters into its own hands, and the SFC has remained silent.

There is also the question of global reputation to think about. Lower the standards too far, and some investors will shy away, because their risk is increased. That would increase the cost of capital. Do we want to be a world-class financial centre or a free-for-all cowboy exchange? In our view, the SEHK has less to fear from defections than from regulatory decay, for a simple reason - local companies need the local market. Most local tech stocks would not get the kind of frenzied retail market needed to sustain their shares if they weren't listed in Hong Kong.

Regulatory Decay

The logical conclusion of "regulatory competition", if it is allowed to persist, is a decay of the listing rules to the point where the investor has only the law to protect him or her, not the listing rules. In the US, the securities laws are strong and the system allows class action suits and no-win-no-fee plaintiff action. Both act as a deterrent. The Hong Kong legal system does not permit either, which makes it even more important that the Exchange and the SFC do their job.

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