HAMS - Representing Minority Shareholders
4 March 2001
Latest update: 1st July 2001
Long time readers of Webb-site.com will know that one of our main focuses is on bad corporate governance (CG) and explaining how it can be improved. We've been encouraged by the depth of positive feedback and growth in our newsletter mailing list which clearly tells us we're on to something. Hong Kong's investors do care about the way companies treat them, and they are frustrated by the degree of minority abuse which pervades the market.
At the same time, the few companies that strive to upgrade their CG standards find themselves struggling for recognition against the discounts that professional investors apply to HK stocks for the risks of bad CG. When you are a nugget of gold in a river bed, it is hard to be found, and even when you are found, the prospector cannot be sure he isn't seeing fool's gold. The legal and regulatory framework still permits companies to change their mind and revert to bad behaviour.
We will not repeat in this article the many systemic problems that investors face. For that, read our many articles in the archive. Instead, we will explain:
- Why shareholder activism is rare in HK
- Why good CG is important to HK's competitiveness
- How HAMS can advance the interests of minority shareholders at the same time as boosting HK's competitiveness
- How you can HELP
Why shareholder activism is rare in HK
In those Western markets with the current highest standards of governance (which does not mean they are perfect), there is a pattern of wider share ownership. As a consequence of their particular histories, most public companies in the USA and UK do not have a controlling shareholder. As a consequence, public shareholders can and do exercise oversight of corporate policy. As a result of their voting powers, groups of institutional and retail investors spontaneously form, and exercise their votes so as to guide and shape policy in the boardroom. In the extreme, if directors do not perform, then shareholder pressure removes them. This is an important market discipline.
By comparison, in HK and most of Asia, most companies have a controlling shareholder or group of shareholders. In HK these controllers are normally either families or, for mainland entities, the various arms of the State. In either case, the ability of minority shareholders to achieve anything in general meetings is almost nil.
In addition, in the USA shareholders can instruct lawyers on a contingent fee basis (no win, no fee), which lowers the barriers to pursuing legal action, and claims can also reach class action status, representing a much larger group of shareholders affected by the matter under claim. From a practical point of view, individual owners of HK stocks, including institutional investors, normally cannot afford to go to court to enforce their rights. Even the first round of a claim may cost more than their investment.
There are essentially two approaches to improving CG - the "top-down" approach, at a legislative and regulatory level, and the "bottom-up" approach, by using existing rights at the shareholder level. In the US and UK, the bottom-up approach is already effective, but in HK, rights at the shareholder level are too primitive for this to be effective. You can make noise in shareholders' meetings, but you will normally be outvoted by controlling shareholders.
So we need a top-down approach to reform, but shareholders lack the co-ordination, resources and time to pursue reform from the top-down.
Short term and relativistic investment
In the retail market, HK investors are famous for their short term outlook. They often trade on rumour, lacking access to the facts, and they attempt to avoid bad governance by holding stocks for only a few hours or days. Many investors regard the stock market as little more than a casino, and it is indeed ironic that the Government is currently trying to outlaw internet-based casinos at the same time as the full blast of deregulated commissions and the new AMS/3 internet-enabled trading system are about to hit the HK market. Placing your bets will be easier than ever before.
Having said that, if the CG quality of the market were raised, the perceived risks of holding for the long term would be lowered, and more retail investors would start to see the potential of the market as a sensible place for long-term savings. This is even more important now that the Mandatory Provident Fund requires almost every working person in HK to invest in the markets for the long term.
So what about the institutional market? The economic history of HK and Asia (ex-Japan) means that there is an underdeveloped institutional long-term savings market. In Western economies, a large part of the market ultimately belongs to long-term investors such as the beneficiaries of pension funds, life insurance and college endowment funds. By their nature, these people care about absolute returns over long periods of time, and they object to bad governance which reduces these returns. That provides a motivator for them to speak up, and we see people such as the California Public Employees Retirement System (Calpers) making their voice heard.
In the UK, it is estimated that the members of the National Association of Pension Funds and the Association of British Insurers together own as much as 40% of UK listed equities. That gives them a strong influence in setting the rules for matters such as pre-emption rights (over the issue of new shares for cash) and share option schemes.
By contrast, Asian-based long-term institutional investors are still only a small part of the investor base. Most of the rest tend to focus on "relativistic" performance targets, such as their performance relative to a market index, or their performance relative to their peers. Since all investors, and the market indices, are affected fairly evenly by bad CG, this does not really affect their relative positions, so improving CG is not a priority. Instead, they all discount prices they are willing to pay to reflect the risk of bad CG.
Even those long-term "absolutist" Western investors tend to regard the small Asian part of their portfolio (typically 5%) as the "spice from the East" and price the stocks at a discount to reflect the risk, rather than fight for better CG. But Asian governments should note that, if their markets had better CG, they would attract higher prices and earn a higher percentage weighting in Western portfolios. Quality attracts.
A recent survey (PDF) by management consultant McKinsey & Co, partly funded by the World Bank, indicated that investors would pay an average premium of between 18-27% (depending on the country) for a well-governed company over a badly governed but otherwise identical company. Unfortunately China and HK were not in this survey, but you won't be surprised to learn that the average premium on good CG was highest in Indonesia and Venezuela (27%) and lowest in the US (18%) with several Western European countries close by. Of all investors surveyed, over 80% said they would pay a premium for good CG.
In HK, the Mandatory Provident Fund scheme will gradually increase the focus on the long-term returns, but it will not be a material amount for many years, and even then, much of it will be managed by the fund management arms of commercial and investment banks, which brings us on to:
Conflicts of interests
With the occasional welcome exception, such as independent fund manager Templeton, fund managers largely keep their mouths shut and their complaints to themselves. In private, a lot of them will voice sympathies, and Webb-site.com receives a steady flow of them, but in public, they keep quiet. Why?
The basic reason for the silence is conflicts of interest. Many fund managers are affiliated to commercial or investment banks, whose profits depend in part on their banking business with the same companies in which the funds invest. You don't win mandates by criticising your clients. This is the same conflict that is at the root of much of today's broker-led investment research.
In addition, even those fund managers which are independent of the banks face difficulties. In a market with inadequate corporate disclosure, they often depend on access to the management of companies for their information. They may make complaints in private to these management, but any public criticism of the companies is likely to see them shut out, and scraping around the market for information like everyone else. The "company visit" is often a fund manager's greatest asset.
Why Good CG is important to HK's Competitiveness
Over the next few months, as support grows for our proposal, you will probably hear some vested interests, particularly in the plutocracy, trotting out specious laissez faire claims that HK does not need reform, that the markets work well, and that HAMS should not be given any government endorsement. "There's too much corporate governance already" one businessman was recently quoted as saying.
Don't believe a word of it. It is no coincidence that the long-run average p/e ratio of HK is so much lower than the USA or UK. Our stocks are discounted for their risk.
If you control and run one of the major HK-listed blue chips, then you are indeed very happy with the status quo. You seldom need to tap the equity markets, and you can rely on the fact that many fund managers hold your stock not because you have good CG, but because you are in the benchmark index. If you need to raise equity, then you put on your best behaviour for a few months or even a year, open your doors to transparency, hit the roadshow circuit and allow your investment bankers to put out optimistic research reports promoting your stock. Then once you've raised that equity, you can lapse back into bad behaviour and set about expropriating as much of the new equity as the legal and regulatory framework allows. That's how the game is played.
But what about the newcomers to the market? How is HK going to finance its growing emerging companies, that will power us forward into the nirvana and white heat of technology that the Government has in mind?
At present, the answer is that these companies will be financed expensively (with low p/e ratios for bad CG risk) or not at all. If other markets raise their CG standards, then this will attract investors, which will attract issuers in a virtuous cycle.
HK cannot go back to making plastic flowers and Christmas crackers. We are now a service and financial centre, and we need to maintain our lead in Asia and mature into the "World-class financial centre" in "Asia's World City" that the government aspires HK to be. To reach that maturity requires amongst other things, a long process of fundamental CG reform. And if we don't do it, then another market will, and Hong Kong will be the loser.
Much investor interest has focused on the entrance of foreign investors to China's protected markets after it joins the World Trade Organisation (WTO). Many of these foreign companies will be from markets with higher governance standards, were the cost of capital is lower. HK companies will be at a competitive disadvantage in the mainland if their costs of capital are not reduced to Western levels.
Catalysing Activism - the HAMS Initiative
The proposed Hongkong Association of Minority Shareholders is designed to fill the void of shareholder activism in HK. It would admit any individual or institutional investor or potential investor as a member, both local and overseas, and would operate in three key areas:
- Policy - to promote and lobby for improvements to the legislative and regulatory framework for investment.
- CG Ratings - to incentivise good CG and deter bad CG, by means of a comprehensive and objective CG rating system
- Enforcement - converting the framework into a meaningful deterrent to bad CG, by quasi-class action litigation of the worst cases on behalf of investor members.
Governance of HAMS
Direct charges for membership of HAMS would be designed to cover solely the cost of communications with members. Keeping the entrance fee low will attract as broad a participation of the public investors as possible. A rough annual fee might be HK$100 for individuals and HK$1,000 for institutions (corporates). Those individuals who wish to receive hard-copy mail communications may be charged an additional $100 to cover postage and printing.
We estimate there are at least 500,000 regular investors in HK's markets (both local and overseas), and would expect membership of at least 50,000 in the first 2 years, and more as the benefits of HAMS begin to materialise. With those kinds of numbers, HAMS would be truly authoritative and investors views would carry real weight in the CG reform process.
The overall direction and policies of HAMS would be determined by a non-executive Board of Governors. In order to be truly representative of investors' wishes and accountable to investors, the Board of Governors must be elected by its members. To provide a balance between the occasionally differing interests of individual and institutional investors, half of the board would be elected by individual members and the other half by corporate members. If HAMS were run by Government-appointed directors, then it would be unable to fulfill its goals.
HAMS would promote and lobby for better laws and regulations to protect investors. This is the "top-down" approach to reform, with the eventual goal of establishing a framework which allows "bottom-up" action at the shareholder level to have real effect. HAMS would seek the opinions of its members, using the low cost of internet communication and internet polling as a key tool. This provides a mechanism for conflicted fund managers and timid retail investors to say what they really think through the anonymity of HAMS.
Proposals for structural reforms, and responses to other proposals, would be produced by a full-time professionally staffed Policy Division which would include experienced lawyers, accountants and practitioners.
The Policy Division would interact with other players in the corporate governance system. These players include the Government's Financial Services Bureau, the Legislative Council, the SFC, the Stock Exchange, the Law Society, the Society of Accountants, the Bar Association, the Institute of Directors, the Chambers of Commerce, and so on. By bringing investor representation into the system, HAMS would put the spark plugs in the engine of market reform.
CG Ratings Division
HAMS would run a CG Ratings Division which would again be staffed with experienced lawyers, accountants and investment professionals. They would continuously assess each and every listed company with an objective scoring system for various aspects of governance, including quality and frequency of disclosure, dealings with related parties, independence and accountability of directors and so on. One overall score would then be assessed.
Like credit ratings on debt, this system provides a "carrot and stick" approach to CG. Good CG will be rewarded with a high score, attracting more demand for the stock, and bad CG will receive a lower score. Unlike credit ratings, CG Ratings will be comprehensive, all companies included. When a major event occurs at a company, such as a takeover or a large "connected transaction" with a related party, the CG Rating would be reviewed, and otherwise it would be reviewed at least annually.
HAMS would explain the reasons for upgrades and downgrades, and if its analysts believed that a company proposal was obviously against shareholders interests, and if minority shareholders had the opportunity to vote on the proposal, then HAMS would publish voting recommendations, increasing shareholder turnout and responsibility.
The CG Ratings would be freely published, allowing any investor to check on the rating of any company. Newspapers would add a new "CG" column next to "P/E" and "Yield" in their stock listings. Investors would begin to take more notice of CG risks.
The Policy Division would lobby the SFC to require all authorised mutual funds (including MPF funds) for sale in HK to regularly publish the average CG rating of their equity portfolio, so that fund holders can take it into account when selecting a fund. This mechanism would help focus fund managers' attention on the better CG stocks. If their portfolio has a low average CG rating and if it under-performs, then the manager will be under pressure to explain why they held these stocks.
Good laws and regulations, when we get them, are worth nothing if they are not enforced. As we have explained, many of the existing and promised rights of shareholders are practically unenforceable on the grounds of legal costs.
The solution is the HAMS Enforcement Division. A team of highly skilled lawyers and other professionals would use the shareholder rights won by the Policy Division on behalf of all members. When you have 50,000 members or more, you can be almost certain that several of them will have held any target stock at any time in the past.
The division would target the worst cases of abuse, with the highest chances of success, by claiming, and if necessary, suing, for damages. It would also leverage off the findings of any Market Misconduct Tribunal under the new SFC bill, using these findings as evidence. Once a case was in progress, HAMS could advertise for any member who would be a plaintiff (having been a shareholder at the appropriate time) and this would include anyone who joins HAMS to participate in the action. The hundreds or even thousands of members would be represented by HAMS and would receive a proportionate share of the damages recovered if the case was won.
In this way, HAMS would achieve a quasi-class action without actually reforming the entire legal system, and would overcome the costs of individual legal representation. The size of the potential claims would then form a greater deterrent to bad CG.
The Enforcement Division would press claims against companies and their directors for bad governance, such as false and misleading statements, breach of fiduciary duty, oppression of minority shareholders and expropriation of assets. Like other units, the Enforcement Division would be financed from the HAMS operating budget, but it would also seek to recover its costs plus a surplus on those cases that it won.
The creation of a credible well-funded litigation deterrent will deter bad CG and will increase the willingness of offenders to reach a settlement without necessarily admitting liability.
Ah yes, there's always the question of money! Who's going to pay for HAMS? The same people that benefit from it, that's who.
The functions of HAMS that we've outlined above do not come cheap. If you want experienced professionals to perform the functions, you are going to have to pay for them. But it will be a drop in the ocean compared to the amount you lose each year through bad CG.
The cost of bad CG
On a conservative estimate, a typical investor might hold 20 stocks, with a weighting of 5% in each, and one of which suffers a major CG failure which eliminates half of its value in a year, thereby taking the portfolio down 2.5%. Of course, the effect is more subtle than that, with smaller events affecting more than 1 in 20 stocks each year and occasional disasters which wipe out 100% of a company. Anyone care for an Indonesian taxi loan?
Another way of looking at it is to look at the premium an investor would pay for good governance. McKinsey's survey put that at 18-27%. So take the mid-point and we have 23%. The only reason for the premium is the perceived increase in stock value for better CG, which is a reflection of discounted future earnings. If you assume a p/e ratio of 9x, they are in effect suggesting that bad Governance takes away about 2.5% per annum. So we are in the right ball-park.
The cost of HAMS
HAMS should be paid for by all investors, since they would all benefit from a higher quality market, regardless of whether they join HAMS as voting members. The HAMS Policy Division would accelerate CG reforms, the CG Ratings would be freely available, and the Enforcement Division would benefit everyone by creating a credible CG deterrent and reducing investment risk.
Of course, on a dollar basis, large investors benefit more than small investors, so it is fair that people should pay in proportion to their investment size. Unfortunately, it is practically impossible to find out who owns what, and unreasonable to expect shareholders to voluntarily disclose their portfolio size and pay up. Any "pass the hat around" approach to funding would create a distorted representation of interest groups while allowing other investors (including hard-to-reach overseas investors) a "free ride" on the reforms.
Therefore the fairest practical method is through a levy on the market, which we propose be named the Good Governance Levy or GG Levy for short. The volume which an investor trades is roughly proportional to the size of their portfolio. Frequent traders would pay a little more than long term investors, but no system is perfect. The Government has already recognised the fairness of a levy by partly funding the SFC in this fashion.
The existing transaction costs for a buyer or seller on the market are as follows:
|SEHK trading fee||0.005%|
We believe a reasonable funding level for HAMS would be afforded by a 0.005% levy, or $1 for every $20,000 of purchase or sale. Part of this would be used to accumulate a contingency fund, since market volume and value fluctuates whereas operating expenses are more fixed.
If a Good Governance Levy is authorised, providing certainty of income, then initial set-up costs of HAMS can easily be financed from bank or government loans on commercial terms.
Based on market turnover in 2000 of HK$3,048bn, the levy would have raised around $300m (since both buyer and seller are charged). Allowing for a contingency of one third, this would leave room for an operating budget of $200m (US$26m). A typical partner in a law firm in HK would earn HK$3-6m, while an experienced solicitor would earn $1-2m, so this money does not go as far as you might think, but you get what you pay for, and HAMS must pay the going rate if it is to function effectively.
By way of comparison, the SFC's expenditure last year (to Mar-00) was $403m, of which 5 directors earned more than HK$4m and the highest paid director earned more than $6.5m. This is not a criticism of the SFC but a reasonable benchmark for what good people cost.
There are now some 800 listed companies, so we are talking about an average HAMS budget of just $250,000 per company. In terms of the market value, that is currently around $5,000bn, of which about half is held by the public. So the annual cost represents 0.008% of the free float value held by the public.
As we have already estimated, bad CG costs investors upwards of 2.5% per annum, or more than 300 times the GG Levy. If HAMS can prevent just 10% of these losses by incentivising better governance and deterring bad governance, then the payback ratio for investors will be 0.25% per annum, or 30 times the GG levy. That's a return on investment that you will seldom see in the market!
Consider it this way. If you have 30 years left to run on your retirement scheme, and half of that money is going into local equities, then you could lose 1.25% per annum, for an average of 15 years in which the money is invested. That's 18.75% off your retirement money. Ouch!
The Government's Chief Secretary, Donald Tsang (No.2 to the Chief Executive), emphasised the need for better CG in his final budget speech (scroll to section 66-68) as Financial Secretary in March. Mr Tsang said in part:
"Our aim is to establish Hong Kong as a paragon of corporate governance".
Webb-site.com sees no chance of that paragon being established without shareholder representation in the process.
Some senior figures in Government and regulators are well aware of the economic cost of bad governance, but find themselves offset by powerful vested interests who would have HK stand still as the World moves ahead with better CG. To make substantive progress beyond lip service, the Government needs a shareholder representative body in the debate.
Unfortunately, for the reasons we have explained, there is no concerted shareholder voice, and it will not happen spontaneously in the foreseeable future. Instead, we need Government to catalyse the reaction by endorsing enabling legislation for HAMS.
A spokesperson for the Financial Services Bureau recently commented:
"As the HAMS proposal is a novel idea... we would welcome the views of the public on this proposal."
Good Governance Levy
To approve a levy on the market, the Government will need to propose a bill to be passed by the Legislative Council.
Government can seize the initiative in this proposal by making room for the levy by a corresponding cut in stamp duty. The 0.005% Good Governance Levy would amount to 5% of the current rate of stamp duty (as reduced in the 2001-02 budget), but in dollar terms this would be revenue-enhancing because the permanently higher CG quality that HAMS brings would lead to higher market values for both existing listed companies and new entrants, and hence greater value of turnover and greater stamp duty revenue. Better CG and higher prices will attract some of the issuers and investors that would otherwise choose different markets, also enhancing government revenue.
And by lowering the cost of capital, HAMS benefits the HK economy too. So HAMS is a winning proposition to issuers, investors and taxpayers.
At the same time, in order to publish CG Ratings and criticise companies without being sued for defamation when the score is bad, HAMS staff will need the same statutory immunity that the staff of the SFC and Consumer Council enjoy. Credit ratings agencies can avoid this by only rating those companies which agree to be rated, but HAMS cannot, since otherwise portfolio ratings would be impractical.
Since the Good Governance Levy, and any change to it, needs the approval of the Legislative Council, there is a direct mechanism of accountability to Legislators. The Chief Executive of HAMS, and his or her senior colleagues as needed, could appear before LegCo perhaps twice a year to give testimony to lawmakers on the progress and activities of HAMS.
It would also be appropriate for the Board of Governors to include a non-voting observer from each of the Legislative Council, the Securities & Futures Commission, the Mandatory Provident Fund Authority and the Consumer Council.
HAMS would be an innovative style of semi-statutory body - that is, its funding would be drawn from a statutory levy on investors' activity in the market, so it would be accountable to LegCo for its funding, but the governing body would be directly elected by (and accountable to) a membership made up of investors. Any investor can join for a nominal fee, so anyone who is paying the levy has a chance to express their views through HAMS.
By contrast, controlling shareholders, who already have their representation in the corporate boardrooms, would pay very little of the levy because they retain the bulk of their shareholdings throughout the year.
Declaration of intent
Don't get the wrong idea - Webb-site.com Editor David Webb has no intention of designing himself a job. He would volunteer to serve the board of HAMS as a non-executive governor (if elected) but HAMS would have to find someone more experienced and qualified to be the CEO.
Webb-site.com has almost reached the practical limit of what one person with a web site and occasional helpers can achieve. A kitchen group of part-timers, or a low-budget body with charitable funding and false teeth won't crack this problem either. Webb-site.com can keep on regularly highlighting bad governance and ways to improve it, but the functions and impact of HAMS would go way beyond that.
How you can help
If you are at a senior level in an asset manager, listed company, investment bank, brokerage, law firm, accountancy, financial media, investor relations firm or any other market participant, then we need your public endorsement of the proposal. A list is growing and your firm should be on it! No financial sponsorship is involved.
The Government has made the right noises about shareholder involvement in corporate governance, but it cannot oppose vested interests without meaningful support from the market. If you want representation for shareholders in the corporate governance system, then you must speak up. Contact us by e-mail for details on how to endorse the HAMS initiative.
Webb-site.com Editor David Webb was appointed to the Shareholders Sub-committee of the Standing Committee on Company Law Reform. He will be promoting HAMS through that Sub-committee, and visiting other interested parties to promote the proposal, but you can really make a difference by giving your firm's endorsement.
© Webb-site.com, 2001