Options-R-Us
7 March 2000
In our article Waivers Galore on 21-Feb-00 we explained how Tom.com Ltd had been granted 3 exceptional waivers allowing the company to issue shares before 6 months after listing, allowing the major shareholders to sell after 6 months rather than 2 years, and perhaps worst of all, allowing the directors to grant options over new shares equal to 50% of the issued share capital, 5 times the previous limit.
After questions were raised by the print media, legislators and the SFC (which caused a delay in the hearing of at least one applicant) the SEHK issued on 24-Feb-00 what we regard as a defensive and misleading "clarification" statement which addressed two of these waivers and ignored the other. First, the SEHK wrote:
"For nearly a year, the Exchange and SFC have been jointly consulting the market on proposals to relax staff stock option plans for all listed companies to reflect changes in corporate cultures."
The SEHK is referring to a consultation paper on the main board listing rules that was released on 26-May-99, 9 months ago. Although that paper contained proposals relating to option schemes, there was no proposal to raise the 10% limit. In fact, the Exchange proposed only to set a timeframe on the limit of 10 years rather than the previous indefinite period, allowing a company to issue options over a further 10% after 10 years. That was quite reasonable, because each options scheme could not last more than 10 years anyway.
Referring to the 10% limit In that paper, the Exchange wrote:
"The Exchange is of the view that a limit should be retained to avoid unreasonable and on-going dilution of the shareholders' interests"
The Exchange also proposed that options should not be exercisable until 3 years after the date of grant, to provide a management incentive to stay for the duration and reduce cases of abuse. The paper also contained many important proposals on matters such as connected transactions and reverse listings.
The consultation period was extended to 31-Aug-99 then closed. Most of these proposals were adopted in the first set of GEM listing rules, but have yet to be implemented on the main board. It will come as no surprise to our readers that these proposals mostly related to stronger regulation and closure of loopholes. The Exchange seems ready to rush forward on relaxing rules, but is pitifully slow at tightening them when they are now a for-profit entity.
Financial Disclosure
Another example of this foot-dragging is the paper issued in late 1998 entitled Market Consultation Policy Paper on Financial Disclosure. The consultation on this paper, relating to the main board, closed over a year ago. This important paper proposed shorter reporting deadlines, full financial statements in interim reports, and even floated the idea of quarterly reporting for main board companies. We explained this in more detail in a previous article on 30-Sep-99.
Since then, nothing has been heard of these proposals. We've got more chance of hearing from the Mars Polar Lander. Even GEM companies, which must report quarterly, are allowed to give the same skimpy financial statements that we see on the main board. No balance sheet required.
How can we hope for a transparent market when the Exchange won't even implement the most fundamental reporting improvements?
The 50% limit
In its 24-Feb-00 statement, the SEHK says:
"Discussion about the 50 per cent share option limit has been continuing for about six months"
Discussions with whom, exactly? Internal discussions? Mutterings with favorite sponsors over lunches? The first time that we heard about this was when the SEHK wrote to us (and others who had commented on the May-99 consultation paper) on 29-Nov-99. That was not "about six months" ago, that was only 3 months ago. The letter was a private circulation.
The Exchange made a low-key announcement the next day (30-Nov-99), but unlike all recent consultation papers, this one was not made available on the web, and the announcement avoided giving any details of the proposals. Instead, only the small circle of people who had replied to the first consultation got the second paper. The announcement states that anyone else who wanted to see the proposals had to write a letter to Mr Lawrence Fok, the Head of the Listing Division. No fax, phone or e-mail address was provided. In our view, that's a deliberate attempt to avoid publicity. The SEHK must have been aware how controversial such a major change would be, but decided not to publicise it. The announcement said only that "the new proposal includes certain fundamental changes from the proposals included in the consultation paper". Needless to say, the media barely noticed it.
We had already made our views clear (see previous article) in the first round of consultation, so did not bother to reply to the private consultation.
In its 24-Feb-00 statement the Exchange continues:
"and some other GEM listing applicants have also been granted this waiver."
For the record, no GEM companies listed prior to Tom.com had been granted the waiver. It was a precedent, and since then some have received the waiver and others have not.
No approval
The Exchange continues:
"The increase to 50 per cent will require shareholders' approval for every 10 per cent to be issued, up to 50 per cent"
In the case of Tom.com, that simply was not true. The waiver is clearly set out on page 23 of the prospectus and contains no such requirement for shareholders' approval. This requirement was, as it happens, included in the 29-Nov-99 private consultation paper, but it was not imposed on Tom.com.
It is notable that the next GEM company to get the waiver is Hongkong.com, and in their case the requirement for shareholders' approval of each successive 10% mandate has been imposed.
In any event, the requirement is near-pointless because most companies have controlling shareholders who appoint (or are) the directors. Since these shareholders are allowed to vote, they can go on renewing their own mandate until they get to the 50% limit. Each meeting takes less than 3 weeks to convene, and if the controller has more than 50% of the votes then a meeting is redundant. The same abusive process is used by many main board companies to keep on renewing their dilutive placing mandate. The Exchange itself knows this, because in their May-99 consultation paper, in which they proposed to keep the 10% limit over 10 years, they wrote:
"Although there is no restriction on number of options granted by listed issuers in the United States and the United Kingdom, it should also be noted that the shareholders of listed issuers in these jurisdictions are generally professional and institutional investors who readily exercise their shareholder rights to prevent the management of listed issuers from abusing share schemes."
By contrast, in Hong Kong, minority shareholders have very little say against controlled companies. The solution here would be to require minority shareholders' approval on a poll, with controlling shareholders abstaining.
YAW - Yet Another Waiver
In Hongkong.com's case, a new waiver has been introduced - the option scheme applies not only to full-time staff, but to anyone who works (on average) for 10 hours a week, to any non-executive or independent non-executive director, and also to any "consultant or adviser". No further explanation is given. This would appear to allow the company to remunerate advisers without putting the cost through the profit and loss account. Does it apply to people like lawyers, bankers, sponsors, and PR agents? We are left to guess. The ability to dish out options to independent non-executive directors when they have a difficult decision to make (such as advising shareholders on a connected transaction) also raises a possible conflict of interest. Most such persons are normally just on fixed salaries.
Defensive Action
The Exchange remarks:
"The proposed rule changes to increase the limit to 50 per cent were submitted to the Exchange Council and approval was granted on February 21. The proposed rules changes were then submitted to the SFC for approval."
First of all, note that the Tom.com prospectus was published 3 days before the Exchange Council approved the rule change. This was almost the last act of the Exchange Council as it was disbanded on 6-Mar-00. Secondly, note that the changes have been "submitted" to the SFC but not approved. The cart is rolling way ahead of the horse, and it's not too late for the SFC to stop it.
Next, the Exchange says:
"All proposed waivers and rule amendments have followed market consultation and detailed deliberation. In addition, the Exchange believes it was acting with SFC consent pending formal approval."
We've already explained how feeble the consultation effort was. "We thought we had permission" doesn't cut it for us. It is interesting to note that the SFC had already contemplated the possibility of the Exchange waiving its own rules to effectively scrap them, and so the GEM rules have a rule which prevents that. Rule 2.07 says in part:
"The Exchange will not grant an individual waiver or modification of a rule, or agree not to require compliance with a rule, on a regularly recurring basis so as to create the same result as a general waiver."
Is the Exchange breaking its own rule? Perhaps if we just waive that rule as well, then all the other rules can be waived!
The balance between regulation and free markets
Let's take a step back here. The "big picture" is that Hong Kong wants to develop a "world class" financial centre. We're all on the same page there. What the Exchange fails to realise is that a strong framework of disclosure and minority shareholder protection is essential to this goal.
Such protections are not designed to hamper companies in their development. Professional investors are very happy to take business risks, but they detest having to take risk of minority shareholder abuses, or in the worst case, outright fraud. No framework can eliminate that risk completely, but a good framework can cut it down considerably. Put any reasonable proposal to minority shareholders and they are very unlikely to vote it down. On the other hand, give blanket authorities to directors who are also controlling shareholders, and some will always find a way to abuse them.
Reducing "governance risk" will increase returns for investors, which will attract capital and lower the cost of capital to companies. If you don't believe this, look at the state of mainland H-shares and B-shares. Despite years of strong economic growth in China, their overall performance has been appalling - not appealing.
Big Apples and Kum-Kwats
GEM spokespersons repeatedly make references to overseas competitors (including Nasdaq) and engage in a me-too argument to support the relaxation of rules. Unfortunately, they are comparing Big Apples and Kum-Kwats. The regulatory framework of any country includes not just exchange rules but also the legal framework.
In the US, that includes state and federal securities laws which impose harsh penalties and allow class-action lawsuits as well as speculative legal action. Even if shareholders so much as think the management should have issued a profit warning before a bad earnings surprise, then a lawyer will embark on speculative legal action with the prospect of winning millions for the whole class of shareholders. That system is not perfect, but it does provide a form of deterrent to bad behaviour and an incentive for transparency which Hong Kong simply doesn't have.
That makes the listing rules a very important first line of defence.
Legislators take note - it is high time the listing rules had statutory backing and meaningful fines were imposed on offending directors.
Out of the Pond
Secondly, let's take a reality check. Conglomerates here are big fish in a small pond, but with one or two exceptions their names mean little on main street USA. You will not get 450,000 people in Manhattan queuing up to buy shares in an internet spin-off which runs a web-site for a radio company it doesn't even own, and is controlled by a man most Americans have never heard of. Local stocks need local following.
History has shown us that there are very few successful examples of companies listing outside their natural market place, and issuers know this. Ask the Jardine group, now in the London and Singapore wilderness. Ask Huaneng Power and Brilliance China Automotive, which listed in New York and then came back to HK. Or Guangdong Building Industries, which listed in Australia and later in HK. The after-market glow of flotation soon fades as the foreign markets move on to the next deal. Sure, you can have a dual listing with an overseas exchange, like i-Cable or CTI, but HK still has a huge locational advantage. Let's not erode that with an inadequate governance framework.
"Buyer beware" is a valid maxim, but we cannot aspire to be Metropolis with a Dodge City framework.
© Webb-site.com, 2000
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