HKEX: shoot patients to prevent illness
30 September 2018
On Friday (28-Sep-2018), HKEX (0388) announced a proposal to change the Listing Rules to suspend trading in shares of companies where the auditor issues a disclaimer of opinion or an adverse opinion on the financial statements. This comes after a recent rule change which allows the Exchange to delist a company if it has been suspended for 18 months on the Main Board, or only 12 months on the GEM.
HKEX and the SFC (which approved the delisting change) appear to believe that the way to improve (or euphemistically, "maintain") "market quality and reputation" is to more quickly delist suspended companies, and in combination with that, to make it easier to suspend them in the first place. This is a complete fallacy. In medical terms, it is a belief that the incidence of disease, accidents or self-harm can be reduced by walking around the intensive care ward and shooting the patients. Put simply, this confuses cause and effect.
The result of this corporate euthanasia is to penalise minority shareholders who might have had at least some recovery of their investment if the company had been able to work through its difficulties, perhaps with fresh capital, new management or the acquisition of a new line of business, and emerge from its corporate coma to satisfy the requirements for resumption of trading, if necessary by being treated as a new listing applicant.
Some victims are in fact perfectly healthy and their shares are suspended not because of any internal corporate problem but because their public float has fallen below the 15% threshold due to purchases by large (often minority) shareholders, allowing the Exchange to suspend the stock and depriving the remaining minorities of a market for their shares. That can happen even if the remaining float has a market value exceeding the entire market value of some other small listed companies. It makes no sense whatsoever and we've called before to scrap the public float rule. The disclosure of large shareholdings and the resultant float is sufficient information for investors on this point.
By the Exchange's own data, there were 50 long-suspended issuers whose securities resumed trading between 2012 and 2016. Of these, 46 resumed trading within 36 months. By cutting the recovery period to 18 months (the new Main Board rule), only 33 of them would have survived, and in 12 months (the new GEM rule) only 26 would have survived.
If HKEX, the SFC and Government really want to address the root causes of corporate illness, then there are plenty of ways to improve HK's laws and Listing Rules - for example, by prohibiting controlling shareholders from voting in the elections of so-called "independent" non-executive directors, giving the INEDs a proper mandate and accountability by having them elected or removed by independent shareholders alone; by introducing legal class action rights for shareholders and allowing contingent legal fees and litigation funding; by preventing directors from picking shareholders via the general issue mandate; and by requiring banks and brokers to seek voting instructions for client shares they hold, facilitating the retail investor vote.
The proposals
The latest proposals take the corporate cleansing campaign one step further, by shoving more patients into the intensive care ward. The regulators are aware that some companies publish their results on time (avoiding suspensions for late filing), but for various reasons, their auditors either disclaim their opinion on the accounts or (rarely) give an "adverse opinion" that the accounts are not a true and fair view.
According to the consultation paper, for periods ending in 2017, 43 issuers received a disclaimer of opinion (excluding 14 long-suspended companies), or about 2% of listed companies by number. There were none with an "adverse opinion". 13 of the 43 were disclaimed only because of their financial difficulties leading to doubt about whether they should be accounted for on a "going concern" basis.
You might think that given the purported concern of the Exchange, it would have included a list of these companies in the paper or elsewhere, to give investors fair warning that if the companies' 2019 audits are disclaimed, they will be suspended and probably delisted. Perhaps by making them harder to find, the Exchange is seeking to avoid a repeat of the infamous Penny-Stocks Incident of 26-Jul-2002 when stocks were dumped on misguided delisting proposals announced the night before, one of which was to delist companies with a disclaimer or adverse audit opinion. Yes, 16 years later, part of that proposal is back - but these days all proposals are announced on Friday nights to avoid immediate market reaction.
However, although there is no list of disclaimed opinions, the Exchange does maintain a list of filings under the broader category of "Auditors' Reports with "Qualified Opinion" and/or Explanatory Paragraph" so journalists or other readers can wade through that to find the ones with "disclaimer of opinion". Alternatively, you can search for the exact phrase "disclaimer of opinion" on the page at this link. Perhaps someone would be kind enough to send us a list of the doomed companies before trading resumes on Tuesday.
To be clear, a "qualified opinion" is not a disclaimer, merely an opinion that the accounts are true and fair but with a qualification. The milder "Explanatory Paragraph" is just an audit report with an emphasis on some matter that does not amount to a qualification.
To be sure, companies with disclaimed audit reports should be treated with extreme caution by investors, but anyone who does their homework on a company before investing will see the disclaimer. For those who don't, as a further step, the Exchange could add a "D" suffix to the short name of the stock, to warn investors of the risk - after all, they are doing that now in the 15-character short names with the "W" flag for second-class shares with inferior voting rights in companies such as "XIAOMI-W" (1810) and "MEITUAN-W" (3690).
Meanwhile, if the SFC suspects wrongdoing by directors of listed companies, it can launch a formal investigation and if necessary intervene and petition the courts to wind up the company or order other remedies, in which case the stock would likely be suspended anyway. If the SFC suspects that directors are withholding material Inside Information, then that is Market Misconduct and the SFC can direct a suspension until the situation is remedied. But if they lack sufficient suspicion (let alone evidence) of wrongdoing to act, then it is not fair to suspend and delist the stock and destroy the interests of minority shareholders in the process, or to deprive a financially distressed company of an opportunity to recapitalise. Nobody has to buy such a distressed stock if they don't want to, but the regulators appear biased towards protecting those who don't own it rather than those who do.
Auditor pressure and opinion-shopping
There would be another consequence of this proposal. It would increase the pressure on auditors, from the directors who hire them, not to issue a disclaimer of opinion, as it would be like issuing a (suspended) corporate death sentence. This pressure would sometimes result in a milder "qualified opinion" just to retain or win the audit business, and that would be against the interest of investors who deserve to know what the auditor really thinks rather than what it is paid to think. So by linking the audit reports to the listing status, the proposal works against the principles of an informed, disclosure-based market.
Squeeze-outs
For some controlling shareholders, the prospect of a mandatory suspension and delisting would be music to their ears. It would put them in a position to buy out the minority shareholders, now deprived of a market for their shares and the disclosures required by the Listing Rules, at a knock-down price. The controller would avoid the normal delisting approvals needed under Rule 2.2 of the Takeovers Code, even if the company is still regarded as a "public company" by the SFC.
HKEX's conflict of interest
Finally, let's not ignore the financial interest that HKEX has in these proposals. It makes the vast majority of its monopolistic profit on the trading, clearing and settlement fees of larger listed companies in HK and the derivatives linked to them. From HKEX's perspective, small troubled companies are loss-makers, because they consume a disproportionate amount of regulatory staff-hours relative to the overall fees they generate. Ranked by size, on the Main Board at the end of September, 344 companies (18% of 1881) accounted for 90% of the market value. Including GEM and Secondary listings, 362 companies (16% of 2268) accounted for 90% of the market value. Their proportion of turnover and transaction fees is even greater than 90% because the market-value figure includes many large H-share issuers, most of which have nearly 100% free float (the mainland A-shares not being counted towards market value).
The regulatory staff-hours consumed by small companies in financial or other difficulties can be dispensed with if they are quickly delisted rather than rehabilitated, thereby boosting profits for HKEX and its shareholders, including the Government. Put simply, it is cheaper to kill the patients than to cure them.
Since the Expert Group Report of 2003, the Exchange and the Government have refused to address the inherent conflict of interest in being a for-profit regulator, by transferring Listing regulation to the SFC. Even a half-baked proposal (which we supported as a step in the right direction) to transfer regulatory reform to a 50:50 committee between HKEX and SFC was shot down.
The Exchange remains a statutory monopoly stock market and HKEX remains exempt from the Competition Ordinance, so there are no alternative exchanges and no competition to drive down exchange fees. If there were, then HKEX and the other exchanges could make commercial decisions on which stocks to trade, and the actual listing would be a matter for the SFC, as it is for the UK's Financial Conduct Authority and the USA's Securities and Exchange Commission, separating the listing regulation from the trading venues. That would be the smart approach - but then HK was never the Smart City that it claims to be.
© Webb-site.com, 2018
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