Principles of Responsible Regulation
26 May 2015
On 2-Mar-2015, the SFC announced a consultation paper on proposed Principles of Responsible Ownership (PRO), or a stewardship code for investors in HK. This is the submission of Webb-site.com to that consultation.
There is an irony to this consultation. At the same time, the SFC and Stock Exchange are considering moving to a full-blown consultation on reducing investors' ability to engage in governance, by allowing companies to list second-class shares with lower or no voting rights, or what the regulators euphemistically call "weighted voting rights". The objective of that would be to attract companies that would not otherwise have a controlling shareholder to list in HK while giving management voting control over the company. The possibility of listing second-class low-voting or non-voting shares is contradictory to the PRO's goal of greater investor stewardship over listed companies. It would allow insecure management to entrench themselves against shareowners' interests.
As noted in the paper, companies listed in Hong Kong are "disproportionally dominated by family and state-controlled ownership". Of the 50 stocks in the Hang Seng Index, at most 5 could be said to have no controller:
- HSBC Holdings plc (0005), a UK-incorporated company which is dual-primary-listed in the UK and HK
- AIA Group Ltd (1299), a HK-incorporated insurance firm
- Link Real Estate Investment Trust (0823) which has no controlling unit-holder, but is not a company
- Arguably the H-shares of Ping An Insurance (Group) Co. of China Ltd (2318), which has no controlling shareholder, although the H-shares are only 40.7% of its issued shares
- At a stretch, The Bank of East Asia, Ltd (0023) but it has 3 substantial shareholders who in aggregate hold about 47.6%.
So it is fair to say that at least 45 of the 50 stocks, or 90% of the Hang Seng Index, have controlling shareholders. This pattern repeats over the rest of the market.
In case you are wondering, we don't regard Hong Kong Exchanges and Clearing Ltd (HKEx, 0388) as having no controller. The HK Government controls HKEx by statute. Shareholders can only elect 6 of the 13 directors, the CEO (an unelected director) must be approved by the SFC and the Chairman must be approved by the Chief Executive of HK and has always been a member of the HK Executive Council.
Incidentally, in paragraph 49 of the paper, you say "we took into consideration the more ostensible dispersed shareholder base of the companies listed on the Stock Exchange of Hong Kong". Surely you mean less dispersed, as paragraph 25 notes that in the UK and Australia "a significant portion of listed companies have a dispersed shareholder base with no single shareholder holding a significant stake".
As a result of the prevalence of controlling shareholders, investors large and small are usually minority shareholders, and if they are to have any real influence in the ordinary decision-making of companies, then they should have proper representation in the form of truly independent directors in the board room. But they don't.
Under HK listing rules, a so-called "Independent Non-Executive Director" is only as independent as the controlling shareholder wants him (or occasionally her) to be, because the controller gets to vote on the elections in general meetings. The result is often a sham system of illusory checks and balances where rubber stamps fill the required 3 seats on the board (or 1/3, whichever is greater) and form the committees that are supposed to monitor the executive management of the company. See our article The Three Wise Monkeys of HK Boards, 15-Feb-2011. The same INEDs, having been elected by the controlling shareholder, are supposed to opine on whether connected transactions between the company and its controller, or privatisation proposals, are fair and reasonable.
In the 1990s the UK had the luxury of not worrying about the influence of controlling shareholders in INED elections, as there weren't many controlled companies, although with an influx of overseas companies with controllers this has become a problem which it attempted to address in 2014 by amending the UK main board (Premium) Listing Rules to require (LR 9.2.2E) that INEDs must not just be elected by a majority of all shares voted but also approved by a majority of independent shares voted. That's a start, although it does of course mean that controlling shareholders still approve the INEDs. Some companies, like the Jardine group, reacted by downgrading themselves from "Premium" to "Standard" (or bog-standard) Listing, avoiding the new rule. The UK Listing Authority also made a half-baked proposal worse by allowing companies, if they are shameless enough, to come back 90-120 days after an INED has been rejected by independent shareholders and ram him into office on an all-shareholder vote (LR 9.2.2F).
If the SFC believes in facilitating investor stewardship then it should push the Stock Exchange to amend the Listing Rules, or exercise the SFC's statutory power under Section 23(5) of the SFO to make Listing Rules, to require that INEDs, so long as they are a minority of the board, be elected by independent shareholders alone, with controlling shareholders abstaining. Only then could most INEDs have both a mandate and an obligation to think and act to protect the interests of minority shareholders. In such a system, INEDs should also be required to issue their own report, within the annual report, stating whether or not they are satisfied with the governance of the company, and if not, why not.
Quarterly financial statements
Proposed Principle 2 requires that investors should "monitor" their investee companies, but one can only monitor information if it is disclosed. This monitoring would be easier if companies disclosed information faster, more frequently and in more depth. For over a decade, all around Asia, including Mainland China, quarterly financial reporting has been the norm, but in Hong Kong, main board companies only produce one full set of financial statements each year, up to 4 months after the year-end, and one "condensed" set of half-year financial statements. This has to change. Investors deserve full quarterly financial statements with one set audited per year.
Transactions with named counterparties
Listed companies often announce acquisitions from purportedly "independent third party" vendors which are companies incorporated in anonymity havens such as the British Virgin Islands, and regulators do not require the listed company to disclose the identities of the humans who control the vendors. Investors are less able to "monitor" these transactions if they cannot investigate the independence of the vendors, or if a bare name is given with insufficient information to identify the human involved.
Similarly, grants of large chunks of options and placements of shares and unlisted warrants are made without naming the counterparties, unless there are fewer than 6 placees. This is so, even if 5 people get 1 share each and one person gets 1 million shares. The regulators should require greater transparency: if the listed company is not offering securities to existing shareholders in a rights issue, then it should name the persons who receive them instead. Allotment lists should be published and subjected to investor scrutiny.
HK has made no progress on pre-emption rights for over a decade since 2004. How can an investor be expected to effectively exercise ownership rights when the regulators allow companies to dilute those rights with placements of shares and voting rights to selected parties? The current maximum 20% general mandate to issue shares for cash at up to a 20% discount should be reduced to 5% per year (not per mandate), with a maximum discount of 5%. Anything more than that should be offered to existing shareholders.
Despite our repeated calls since at least 2002, and the recommendations of the OECD cited in the paper, the SFC has also not seen fit to facilitate greater retail investor involvement in governance. Most retail investors hold their shares through stockbrokers or through the stockbroking arms of banks. These intermediaries are all regulated in HK, but the SFC does not require them to seek voting instructions from customers for whom they hold the stock. By holding stock for clients, the intermediaries enjoy marking up scrip fees and dividend collection fees, and eventually receiving commission when the stock is sold, but to save costs, most of them include in their terms and conditions (T&C) a clause which states that they are not obliged to inform investors of shareholder voting opportunities. HSBC, for example, says in its T&C:
"5.1 The Bank is authorised, at its discretion, to take such steps as it may consider expedient to enable it to provide the Services and to exercise its powers under these Terms and Conditions, including the right:...
(g) not to notify the Customer of any Corporate Action information pursuant to Clause 4.1(c) including any proxy voting forms without notice to the Customer;"
Many firms now offer an online dealing system, but to our knowledge, no firm offers an online voting system for shares in client accounts. The result is that the approximately 40% of the free float still held by retail investors hardly ever votes, and bad proposals can get passed even when controlling shareholders are required to abstain, for example in the renewal of a general issue mandate, or approval of a connected transaction.
The OECD in its 2011 Asian Roundtable paper, in which the SFC participated, states on page 14:
"Legislators and regulators should promote effective shareholder engagement by reducing obstacles for shareholders to vote in shareholder meetings. In particular, rules on proxy and mail voting should be liberalised, and the integrity of the voting process should be strengthened. Greater use of technology for both the dissemination of meeting materials and to facilitate voting should be encouraged."
So if the SFC is serious about facilitating stewardship then it (and the HKMA in tandem) should require all regulated intermediaries in HK to seek voting instructions from clients for each shareholder meeting. If this were required, then intermediaries would find the most efficient way of doing it, possibly by outsourcing online voting platforms to one or more competing service providers. Alternatively, to meet the obligation, they could open a Stock Segregated Account (SSA) for each client with CCASS and provide the voting opportunities that way. CCASS can issue SMS and email alerts of Voting Notifications to SSA holders and accept voting instructions from the clients directly, while the intermediary keeps hold of the stock.
The proposed Principles
We have no objection in principle to the 7 proposed Principles of the PRO, it is just that they are all rather ineffective to governance in HK-listed companies so long as the bigger issues discussed above remain unaddressed. The proposal is more of a deflection and distraction than a meaningful step forward.
It is common sense, for example, that investors who seek to perform through portfolio selection (or even through enhancing the performance of an index which they passively track) should "monitor their investee companies".
We agree with the proposition that those institutions which are licensed or regulated by the SFC, HKMA, MPFA or Commissioner of Insurance to issue products such as mutual funds, ORSO funds and MPF funds to the general public, should be required to disclose whether they comply with the PRO and if not, why not (the "comply or explain" approach). However, for other asset managers which are dealing only with professional investors and institutions, it is probably better to allow market forces to work. Many institutional investors already have their own standards when selecting asset managers which would be more specific and go further than the proposed Principles.
We believe paragraph 38 of the paper is in error. It states that in the United States, there is no specific provision requiring shareholder engagement but notes that the SEC has proposed that institutional managers should report annually on how they vote proxies relating to executive compensation matters. This omits to mention that since 2003, US mutual funds, which then held 18% of all publicly-traded US equity, have been required to file annually Form N-PX disclosing how they voted on each and every resolution in shareholder meetings for which they held shares. This is something that the SFC should require HK-regulated managers of publicly-marketed funds to do (including authorised mutual funds, MPF and ORSO funds). See the SEC Final Rule for more details.
The discipline of having to disclose their votes would help address the conflicts of interests that many of HK's largest asset managers have between their commercial and investment banking business for corporates on the one hand, and their duties to fund-holders on the other.
On Principle 5, "be willing to act collectively with other investors where appropriate", this "collective activism" principle is frustrated by two things: first, if the act involves a battle to oust bad management from a board and replace them, then shareholders may be accused, if they act together, of "acting in concert" to acquire control of a company, thereby triggering an obligation under the Takeover Code to make a general offer. Currently Note 4 to Rule 26.1 of the Takeover Code states:
"Shareholders voting together
The Executive will not normally regard the action of shareholders voting together on [a] particular resolution as action which of itself should lead to an offer obligation, but that circumstance may be taken into account as one indication that the shareholders are acting in concert."
A clearer safe harbour should be established in the Takeovers Code so that mutually independent investors (who have no other connection between them) can come together to promote change in a listed company, even with nominations and elections to the board.
Second, if the "collective activism" involves litigation, then Hong Kong still has a number of barriers, including the lack of a class action system (which Australia has enjoyed since 1992), the prohibition on contingent legal fees, and the common law prohibition of champerty and maintenance, something that was abolished in the UK in 1967, which makes it nearly impossible for litigation finance companies to provide a service.
So, if the SFC wishes Principle 5 to have any real effect then the Government which appoints it needs to address these issues. A Government elected (or nominated) by tycoons will of course be slow to act on this; the Government on 28-May-2012 received a very mild proposal from the Law Reform Commission to introduce class actions for goods and services (but not investments). The Government sat on it for 6 months (the maximum allowed by law), and then the new Chief Executive kicked it into the long grass by appointing another committee to study the LRC's proposal. It has not seen the light of day since then.
Meanwhile, we wait for the Competition Ordinance to be put into effect, and wonder how consumers will ever receive compensation if there is no class action system to bring follow-on actions upon findings of anti-competitive behaviour.
Finally, in the detailed Principle 2 on page 20, we are amused that you think that "engagement mechanisms" for investors include "selling their shares". If selling shares is a method of engagement, than is buying shares a method of disengagement? Selling shares is only a method of damage limitation, and it is of little comfort to someone whose home has been torched by an arsonist to tell them that they can still sell what is left of it.
Proposed Principles of Responsible Regulation
So to refocus on the key issues above, we call on the SFC, Government and HKEx to adopt the following Principles of Responsible Regulation, or PRR:
- Independent directors should be elected by independent shareholders; any shareholder or the board can nominate candidates, but controlling shareholders must abstain from voting.
- Investors' rights to information should be addressed by requiring 3 quarterly sets of full but unaudited financial statements within 45 days of the quarter-end and 1 annual audited set within 90 days of the year-end; and by requiring full disclosure of the identities of counterparties to notifiable transactions, option grants and placements of shares or convertible securities.
- Investors' ownership rights should be protected from dilution by reducing the general mandate's maximum size to 5% per year at a maximum discount of 5%;
- Voting should be facilitated by requiring all regulated intermediaries who hold shares for clients to seek their voting instructions for each shareholder meeting.
- Investors' access to justice and legal remedies should be facilitated by the introduction of class action rights and the legalisation of champerty and maintenance and contingent legal fees.
- A safe harbour in the Takeover Code should be created for mutually independent shareholders to act together to change a board when such intervention is needed.
There you go. Only six. That shouldn't be too difficult if you really believe in facilitating the PRO rather than just joining a me-too club of places with a stewardship code. We look forward to receiving your response to our proposals.
Submit your views
What do you think? Please send your views by 2-Jun-2015 to ResponsibleOwnership@sfc.hk, stating whether you support the Principles of Responsible Ownership and call on the SFC, Government and HKEx to adopt the Principles of Responsible Regulation proposed by Webb-site.com.
© Webb-site.com, 2015