A New Year's Eve SFAT ruling reveals an SFC action against Moody's for its 2011 "red flags" report, following the recent launch of MMT action against a short-selling analyst. The SFC risks chilling publication of critical opinion and analysis - something we would hate to stop doing. We will be watching the cases carefully.

SFC actions risk chilling critics
1 January 2015

In a New Year's Eve ruling, Justice Michael Hartmann, a Chairman of the Securities and Futures Appeals Tribunal, has rejected an application by Moody's Investors Service Hong Kong Ltd (Moody's) to have its appeal held in private.

In a "Decision Notice" dated 3-Nov-2014, the SFC concluded that Moody's had breached a number of provisions of the Code of Conduct for SFC-licensed persons when it published a report on 11-Jul-2011 titled "Red Flags for Emerging-Market Companies: A Focus on China". The SFC wants to fine Moody's HK$23m (US$2.96m). At the time of the report, some of the companies involved disputed some of the "red flags" marked against them. The Moody's press release is here and you can find the full report online if you search for it.

There was certainly room for dispute - for example in at least two cases, the companies said that Moody's had incorrectly marked them as having changed auditors within the previous 3 years. One of them was Kaisa Group Holdings Ltd. (1638) which put out this clarification. But these were newly-formed and listed companies, and while it is technically true that the newly-created offshore listing vehicle did not change its auditors, the mainland subsidiaries had used different statutory auditors at the times of their audits. There was also no requirement to audit the offshore parent until it was listed. So it might be a reasonable statement to say that a listed company had "changed auditors" when looked at from the perspective of group accounts.

For example, the accountants' report in the Kaisa prospectus dated 26-Nov-2009 shows a variety of statutory auditors on pages 16 to 21. This is not unusual for listed companies with mainland subsidiaries; a big-4 accounting firm is usually only appointed in preparation for listing, and the most it can do is retrospectively "review" the subsidiary statements, but it cannot perform time-travel to go back and attend stock-takes, or visit development properties 3 years earlier to view their state of completion.

For what it is worth, let's look at the total returns on the stocks since the day before the report (8-Jul-2011) up to the end of 2014 to see whether Moody's scoring system was broadly right. Kaisa's stock is down 42.07% , but it wasn't one of the top 5 companies singled out by the report, which tested 61 companies with 20 possible red flags. The top 5 were: West China Cement Ltd (2233), down 69.76%, Winsway Enterprises Holdings Ltd (1733), down 92.14%, China Lumena New Materials Corp (0067) down 56.86% (and suspended), Hidili Industry International Development Ltd (1393), down 89.07% (source: Webb-site Total Returns) and last but not least, LDK Solar, which was US-listed and is now bankrupt. We'd say that's a pretty good hit rate, even though industry factors are involved in some of the declines. For all HK-listed stocks, the median (718th) stock in that period returned 0.32%.

One can of course argue with Moody's methodology, but that kind of debate on which factors matter for future performance is what makes a market.

The Moody's appeal has yet to be heard, and the SFC's Decision Notice is not yet a public document, so we don't know what the precise allegations are, the arguments in their favour are or what Moody's full appeal will be, but we hope that the SFC has more grounds for complaint than a few errors in a report covering numerous companies, because it would be unreasonable to expect that a report on 61 companies with 20 different flag-tests would be correct on all of the 1220 tests.

The lemon test

The action follows an SFC announcement regarding another case on 22-Dec-2014. The SFC is taking Mr Andrew Left of Citron Research to the Market Misconduct Tribunal, alleging market misconduct in relation to a negative research report on Evergrande Real Estate Group Ltd (3333) which he published on 21-Jun-2012.

The Notice to the MMT was sparse in its content, so we don't yet know what the core of the allegations is and what Mr Left's defence will be. Under Section 277 of the Securities and Futures Ordinance (SFO), market misconduct occurs if a person circulates false or misleading information that is likely to induce transactions or affect prices and the person knows that, or is reckless or negligent as to whether, the information is false or misleading. So it is not enough to show that Mr Left was wrong in his opinions or allegations. the SFC will need to show that Mr Left either knew what he was saying was false or misleading, or that he was reckless or negligent as to whether it was false or misleading, and furthermore, that it was "information" and not just his opinions.

Keep in mind that "information" is defined in the SFO as including "data, text, images, sound codes, computer programmes, software and databases, and any combination thereof". The word in general is taken to mean facts or purported facts, not opinions. "I think XYZ is insolvent" is not "information" but is an opinion which may be reasonably held even if it turns out to be wrong, and even if the analyst has misinterpreted the available facts. That's what makes a market.

The fact that Mr Left made a profit from short-selling Evergrande stock should not be relevant to the determination of this case, except as to motive. Similarly, if someone who owns a stock goes out and sings the praises of a company, he may also make a profit if other people agree with him and bid the stock higher. As long as he doesn't know that what he is saying is false or misleading, and reasonably holds his opinions, then our bullish analyst should have nothing to fear. If he turns out to be wrong in retrospect, then he has that in common with most professional stock analysts almost half of the time, and that is not a crime or misconduct.

We should note that although the MMT is a civil forum (requiring proof on the balance of probabilities), there is identical language in Section 298 of the SFO which would allow a prosecution and up to 10 years in jail after conviction on indictment (requiring proof beyond reasonable doubt).

The risk of a chilling effect

Free markets depend on free speech and the open exchange of opinions and analysis, whether it turns out to be right or wrong. The SFC will need to tread very carefully in this area and show good grounds for their actions in the SFAT and MMT, otherwise they are likely to have a chilling effect on critical research. That would be very bad for the market, for at least three reasons:

  1. There is a systemic skew in investment bank/broker research which produces far more "buy" or "hold" (don't sell) notes than actual "sell" recommendations, because banks face conflicts of interest in seeking business with companies and in maintaining open doors for their analysts. Often the diplomatic way out is just to quietly drop coverage rather than put out a "sell" note. So we need investors, short or long, to express their opinions freely.
  2. In China, as with other emerging markets, there are vast problems with corporate governance, fraud and corruption, and these need to be exposed, partly to improve market efficiency and partly to deter such behaviour by reducing the chance that it will remain unnoticed.
  3. One of Hong Kong's core competitive advantages over mainland China is supposed to be the ability to speak freely.

Webb-site Reports is now in its 17th year of critical reporting on listed companies (amongst other things); we would hate to have to stop, so we will be watching these cases very carefully.

© Webb-site.com, 2015

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