The report by the Government-appointed Panel of Inquiry into the recent "Penny Stocks Incident" was released on Tuesday. looks beyond the blame game and into the recommendations for structural reform of the regulatory system.

PIPSI Report
15 September 2002

The two-man Panel of Inquiry on Penny Stocks Incident (PIPSI), appointed on 31-Jul-02 by the Financial Secretary, released its report on Tuesday. There is no link to the report on the Government's news index, and it took us some time to find it deep in the Government web site. Click here to read it but be warned, it runs to 189 pages plus 97 pages of appendices.

If you are new to this subject, you can read our article PIPSI Submission including the download of our actual submission.

The Blame Game

To us, the apportionment of blame is the least important part of the Panel's work, so we will deal with it briefly before moving on to the weightier conclusions. On the subject of Fred Ma, Secretary for Financial Services and the Treasury, the panel wrote (12.27):

"[Mr Ma] joined the Government on 1 July 2002 and...he had a great deal of catching up to do...We have seen his engagement diary. [Mr Ma] clearly had a very full plate".

That's an interesting choice of words in relation to a keen diner who told the press on 16-Jul-02, just a week before the penny stocks incident and in relation to market hours:

"To have a nice lunch is not important for Westerners but it is very important for the Chinese. I think we need to respect this cultural difference."

He was dishing up baloney, perhaps after a particularly good dish of abalone. Maybe his lunch diary impeded his ability to digest his in-tray. In relation to a summary table of the HKEx delisting proposals from the SFC, which was placed in his in-tray on 17-Jul-02 by an assistant, he told LegCo on 31-Jul-02:

"since the papers and files in my office were piling up like a mountain...I could not possibly have read every document"

We give him credit for admitting this even though it shows disorganisation and does not excuse ignorance. Whatever the height of his paper mountain, he should have informed himself of the HKEx proposals, and then he would probably have recognised their likely consequences and intervened. The Panel, by contrast, seems to think that honesty was not a good quality in front of LegCo, calling it a "sub-par performance". The panel wrote of his session (9.21):

"It would have  required the skills and experience of a much more seasoned bureaucrat to have come out of that barrage relatively unscathed."

The Panel implies that a "par" performance would be to obfuscate to Legislators and not to admit any errors. This may be politically desirable from the Government's point of view, but it surely is not the objective of accountability. "Performance" should not be measured by the degree to which a politician deflects criticism or avoids blame.

Incomplete record

The Government held a press conference on Tuesday afternoon, in which Chief Executive Tung Chee Hwa, Financial Secretary Antony Leung and Mr Ma came out for sequential stand-alone sessions like ducks in a fairground shooting gallery. Mr Leung's statement (but not his Q&A) and Mr Ma's statement and English portion of his Q&A are online. The written record does not include Mr Tung's statement, and only the English portion of his Q&A.

You can watch the whole conference with simultaneous translation in streaming video. This in fact is the only way to get the full version of what was said, because the Government does not produce English transcripts of Cantonese Q&A or vice versa. So much for transparency in "Asia's World City". The sporadic production of written statements also raises the broader question of whether the Government is being selective in publishing the statements of its officials for the record. Historians and academics will not find it easy to research this in years to come.

In Tuesday's statement, Mr Ma pointed to the Panel's conclusion that he had not "failed in the discharge of his responsibilities" (12.27), but finally on Wednesday afternoon, with a typhoon causing the cancellation of a LegCo Financial Affairs Panel, and the political storm continuing, he came out to a hastily convened selection of media and apologised with a Japanese-style bow. Better late than never.

HKEx apologises to shareholders for the reaction of shareholders

Kwong Ki-chi, the Chief Executive of Hong Kong Exchanges and Clearing Ltd (HKEx), in a statement to LegCo on 31-Jul-02 said:

"I send my heartfelt apologies to shareholders who have suffered as a result of the market's response to some of the proposals in our consultation paper" (emphasis added)

No doubt that statement was carefully drafted to avoid admission of any legal liability, by inclusion of the words "the market's response to" - after all, "the market" is in fact the collective body of investors, so he is blaming the suffering of shareholders on shareholders themselves, not directly on the HKEx proposals. The "market reaction"  was again included in an apology in Tuesday's statement by HKEx.

Incidentally, in material supplied to the Panel, HKEx included a collection of "over 100 media reports on penny stocks and delisting mechanism from 11 January 2001 to 25 July 2002". This was included as Annex 7.2. The Panel describes this as "an extremely useful document" (7.69(a))  - but it is useless to us, since it is in Chinese only - even the quotes from The Standard, which is an English-language paper, are produced in Chinese. Only one quote appears in English.

Bad governance, not bad shareholders

In several places, the Panel appears to confuse the quality of the market with the performance of companies. In their conclusions, they write (13.2):

"There is overwhelming market and public support for the enhancement of the quality of the securities market in Hong Kong. There is a clear consensus that the authorities should work minimize market misconduct and to weed out under-performing companies which damage the reputation of the Hong Kong market"

It is not clear what is meant by "under-performance" in this context. If they mean it in a regulatory sense of "companies which break the rules and laws" then it should be recognised that companies are just legal entities run by directors, who make the decisions. We need a system to penalise and deter the directors from rule-breaking behaviour, not to penalise the minority shareholders by delisting the company. Put simply, it is the weak regulatory and legal structure that "damages the reputation of the market" by facilitating and failing to deter bad governance.

Alternatively, if the Panel mean "under-performance" in a financial sense, then they seem to forget that this is a market economy with winners and losers. Shareholders of a company which have lost money should not be penalised by delisting their stock, so long as the company is solvent. If a company is already in liquidation, then this is not a penalty. We already have a delisting mechanism for such cases, and it can be improved. Financial under-performance does not in itself "damage the reputation" of a market, and since under-performance is a relative term, by definition, there will always be companies which "under-perform" others.

Relationship between HKEx and SFC

The report offers the public some insight into the strained relationship between the HKEx and SFC. As we noted in our submission, the SFC cannot direct that changes be made to the Listing Rules and can only approve or reject changes proposed by HKEx, which gives the HKEx the upper hand in any negotiations. Indeed, although the original discussion on Penny stocks between HKEx and SFC centred on proposals to require them to consolidate, and what price level would be appropriate, somewhere along the line, it morphed into a proposal to use the most draconian penalty (delisting) for those companies who failed to comply - rather than the usual procedure for breaches of Listing Rules (which focuses on a system of reprimands). So consolidation was combined with delisting. The proposal was clear:

"We will amend the Main Board Rules to introduce a minimum share price of HK$0.50 as a continuing listing eligibility criterion"

The SFC does not have the power to stop the HKEx from consulting the market on any proposals, so this gives them somewhat limited influence in the drafting, which is driven by HKEx.

In our PIPSI submission, we explained how in 2001, on draft proposals for corporate governance aspects of the listing rules, the SFC Shareholders Group gave views to the SFC, which were then communicated to HKEx. The report reveals (7.72) that Karen Lee, Head of the HKEx Listing Division, wrote to the SFC on 12-Dec-01:

"I am very surprised indeed, and rather concerned, to note that our draft paper was discussed at the Shareholders Group meeting, and comments on the papers have been officially passed to us"

In other words, "how dare you consult your Shareholders Group on matters affecting shareholders". To which Ashley Alder, Head of Corporate Finance for the SFC replied (7.73):

"I am convinced that had we not consulted the Group at this stage we would have been subject to justifiable criticism, including by members of the Group. Exercises like this are what the Group is for."

The comments of the Shareholders Group were largely ignored in this matter. The report notes (7.74) that:

"The SFC has since this incident not discussed any Listing Rules changes with its Shareholders Group"

In relation to the delisting proposals, the report notes (7.76) that:

"the SFC felt inhibited from consulting its Shareholders Group on the HKEx's actual proposals. The previous attitude of the HKEx... had the effect of preventing the SFC from fully engaging its network in gauging market feedback which would have benefited the HKEx."

One has to wonder who is in charge of whom here, which brings us neatly on to:

Structural reform

In its description of the so-called "three-tier regulatory structure", the Panel notes:

"the only a regulator in a limited sense since it possesses no statutory powers of investigation and its powers, such as they are, are conferred by the Listing Agreement entered into by issuers... There are those who would consider it a straining of language to describe a party with the right to enforce a contract as a regulator."

In other words, the Listing Rules have no teeth. As far as we know, the HKEx (or more accurately, the SEHK) has never sued a company for breach of the Listing Agreement. It would not be appropriate to give statutory powers to a commercial entity such as HKEx, which is one of the reasons that listing regulation should be moved to the SFC, so that these powers can be granted to the SFC, to fine directors for breaking the rules.

The most important part of the report is the recommendations section, and here we see encouraging signals. The Panel wrote (14.21):

"The handling of regulatory issues by both the HKEx and the SFC and the splitting of roles and functions between them not only lead to inefficiencies but also to confusion...We consider it timely for the present arrangement to be particular, most [commentators] have suggested that if a Listing Committee is to be retained, as most believe it ought to be, it cannot be housed under the HKEx. Within the current structure, the only entity under which it can be accommodated is the SFC. We see the sense of all these comments and commend them to the authorities for further consideration." (emphasis added).

Is a commendation a recommendation? It certainly looks like one. has been calling since Mar-99, when the creation of HKEx was first announced, for the HKEx to get out of regulation, and it looks like this ball is now rolling. It can be assumed that by moving the Listing Committee to the SFC, the Listing Division goes with it, lock, stock and barrel.

The Government has said it "accepts" all the recommendations in the report. This hopefully removes the roadblock which Mr Ma imposed the day before the delisting proposals were announced, when he announced that the HKEx would remain the frontline regulator pending a review which would not happen for at least another 2 years. We covered this in our article "Listing Chaos".

Listening to Investors

The Panel appears to have accepted our submission that unlike the SFC, which has a Shareholders Group of which your Editor is a member, the HKEx has no sounding board to gauge investor opinion. By implication, they also accept that the HKEx Listing Committee does not reflect investor opinion, which is hardly surprising given that only 4 out of its 25 members can be fund managers. The Panel writes (14.11):

"We note that the HKEx does not have within its structure any group specifically reflecting the views of consumers or shareholders...We recommend that the HKEx consider setting up its own consumer panel or shareholders group."

We agree, but we also suggest that the HKEx should use the existing Shareholders Group which was formed by the SFC rather than duplicate the effort with a second group. There is no conflict in having the same Shareholders Group advise both the SFC and HKEx. Whether or not Listing regulation is moved to the SFC, the HKEx still needs to hear the views of investors on matters such as new products, the clearing system, trading spreads, price dissemination and scripless registration.

The government should also reconsider enabling the HAMS proposal which contained a democratic mechanism for investors to elect their own representatives as a board of governors. If HAMS existed, then its Policy Division would have engaged the authorities on matters such as the delisting proposals, and then the Penny Stock fiasco need never have happened.

Empowering investors

The Panel also touches on the fact that minority shareholders are relatively powerless to protect their interests. The Panel writes (14.23):

"We recommend that further and continuous consideration be given to how minority shareholders' rights can be better protected."

One of the keys to this is empowering investors to help themselves, and create their own deterrent to bad governance. There is no class action system in Hong Kong law, and no contingent legal fees. The lack of class actions fragments the value of claims that investors would have against offending parties, making legal action unaffordable. HAMS was designed to create a quasi-class action system, with an Enforcement Division producing joint actions on behalf of thousands of investor-members.

However, in the absence of enabling HAMS, we believe the Government must instead introduce a statutory right of class action, where a lead plaintiff can represent an entire class of minority shareholders (other than those who opt out). Lawyers should also be permitted to conduct work on a contingent fee basis, working for free in return for a negotiated success fee. They would then accept cases that had a reasonable chance of success, and large awards for the whole class would begin to create a deterrent effect.

Until shareholders have effective legal remedies, all of the burden of deterrence will fall on the Government's regulatory and law enforcement agencies.

©, 2002

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