Disclosure of Pledges
7 September 2004
In the last three months, there have been spectacular one-day sell-offs in shares of three small-cap companies, and this has brought renewed attention to the major gap in Hong Kong's regime for disclosure of interests in shares.
Paul Chow, CEO of Hong Kong Exchanges and Clearing Ltd (HKEx, 0388), has reportedly asked the Listing Division of the Stock Exchange to consider whether shareholders should be required to disclose pledges of shares on a continuing basis. A number of commentators have supported this proposal. While we believe the disclosure is needed, this is the wrong approach to the problem, and we'll explain why.
The current situation, under Listing Rule 10.07, is that for 12 months after listing, if a controlling shareholder (holding 30% or more of the shares) pledges any shares as security for a loan, then he must disclose that to the company, and the company must announce it. This is a achieved by way of a written undertaking provided by the controller before listing is approved. The 12 month period corresponds to the lock-up undertaking which prohibits controllers of newly listed companies from disposing of any shares for the first 6 months, and requires them to hold at least 30% for the second 6 months.
However, after the first year is over, there is no longer any general obligation for pledges by a controlling shareholder to be disclosed, unless it relates to a loan or guarantee provided to the company, in which case the company must disclose it under Rule 13.17.
Right approach, wrong regulator
The Stock Exchange implements Listing Rules on a contractual basis under the Listing Agreement with listed companies. As part of that process, listed companies and their directors agree to abide by the Listing Rules.
The problem with the proposal to require shareholder disclosure is that the exchange has no jurisdiction over shareholders, who are not a party to the Listing Agreement. In some cases, directors may also be controlling shareholders, holding shares in their own name or in BVI companies that they control. In those cases, the exchange can expect compliance due to the obligations of directors, which includes companies they control.
But in many cases, the controlling shares are held by offshore trusts (to avoid estate duty) and the trusts are not legally controlled by the director, so he cannot force the trustee to follow Listing Rules.
In another set of cases, there are controlling shareholders who are not directors of the company at all - sometimes because they have criminal records, or simply because they don't like the disclosure obligations and dealing restrictions of being a director. So they get hired hands to run the board instead.
So any effort by the exchange to extend its jurisdiction beyond directors to plain shareholders would fail. The only time the exchange has any leverage is at the time of listing, when it can and does require controlling shareholders to enter into the 1-year undertakings described above. But after listing, any subsequent controlling shareholder is not within reach of the exchange unless they are a director.
The most the exchange could do would be to require directors who are also substantial or controlling shareholders to disclose pledges of shares in which they are interested. While that would be an improvement, it doesn't go far enough.
Legal obligations under the SFO
The solution to this problem is actually very simple. Hong Kong already has a legal disclosure regime in Part XV of the Securities and Futures Ordinance (SFO). Under that regime, interests of 5% or more in the shares of a listed company must be disclosed. These "interests" include "security interests". A person receives a security interest in shares when someone pledges shares to that person. So the good news is that the law already requires pledges to be disclosed! If you pledge 5% of a company to a friend, your friend has to disclose it.
"So what's the problem", we hear you ask?
The bad news is that there is a giant loophole. Under Section 323(1)(f), an "exempt security interest" does not have to be disclosed. This is defined by Section 323(6) to be an interest which is:
"held by a qualified lender by way of security only for the purposes of a transaction entered into in the ordinary course of his business as such a qualified lender"
And a "qualified lender" is defined by Section 308(1) to be a bank (including a restricted licence bank or a deposit taking company), a stockbroker, insurer or anyone licensed by the SFC to provide margin finance on shares.
The security interest only becomes discloseable if the lender effectively forecloses and starts selling the stock, and then he has the usual 3 business days in which to make the disclosure. By then, of course, it is too late to be of much use to investors as the stock will already have crashed. The exact conditions in which disclosure is triggered are set out in Section 323(7).
The principle behind the disclosure law is that it should require sufficient disclosure for investors to be aware of positions which may affect the market in the shares. That is the basis of the 5% threshold - because for most stocks, the disposal of such a large holding would represent several weeks of turnover in the market and could impact the price, even if done gradually, and similarly, someone who is consistently increasing their holding may have an upward effect on the price which may not be sustained if they stop.
If a person has pledged more than 5% of the shares in a company to a lender, then the probability of a rapid disposal is materially higher than if the shares are held "free and clear" because there is an additional risk that the borrower may not keep up repayments on the loan, or may fail to meet a margin call when the stock price falls, and this could immediately trigger a default and a right of the lender to sell the shares. In such circumstances, the lender's only concern is not to get the best price in the market but to cover his loan (as any surplus belongs to the borrower), so he is likely to sell far more rapidly than a substantial shareholder who is voluntarily reducing his holding.
That's actually a best-case scenario. There are other cases in which the lender may actually act in cahoots with a third party to push down the price, trigger a margin call and take control of a company through a fire-sale of the stock.
So the sensible solution is to remove the "qualified lender" exemption from the SFO, and require all security interests of 5% or more to be disclosed.
Despite the recent incidents, this is not a new problem. Regulators have looked at it in the past, but have always been under pressure from vested interests (tycoons, banks and brokers) not to lift the veil on security interests.
In Jun-98, the SFC consulted the market on this but set out on the basis of proposing not to make any change, and sure enough, it didn't. It wrote:
"As the existing provisions are in line with international standards and the imposition of a duty on banks to disclose share pledges before enforcement of security might create undue burden on their normal business activities, it is not currently the SFC's intention to change the Ordinance in this respect."
and on the suggestion that the borrower should disclose the pledge, they wrote:
"The informational value of the pledge itself may not serve particularly useful purpose without the knowledge of the financial position of the substantial shareholder at a particular point in time."
In the Mar-99 conclusions paper, the SFC wrote, regarding lenders:
"In the SFC's view, imposing a duty on banks and licensed brokers to disclose share pledges before enforcement of security would create undue burden on their normal business activities."
and on borrowers:
"There is a need to balance a substantial shareholder's right to privacy in relation to his personal financial affairs against the usefulness to the market of disclosure of share pledges."
"disclosure of the pledge itself would not provide meaningful information on the likelihood of a forced sale"
Let's take a look at these concerns
These arguments don't stand up to much scrutiny.
First, on the "undue burden" argument, asset managers, whose "ordinary business" is to hold interests in shares, are already subject to the 5% disclosure regime and there have not been any serious difficulties in complying with this. So it is really far-fetched to claim that banks and brokers could not handle the "undue burden" of filling in disclosure forms when asset managers have complied.
What is really behind this is not any practical difficulty in complying, but a wish on the part of banks and brokers for secrecy in their dealings. That is outweighed by the public interest in fair and orderly markets. If a lender wishes to keep its loans private, then it should not take such large positions (over 5%) as collateral.
"Disclosure is meaningless"
Second, on the "disclosure is meaningless" argument, we strongly disagree. If a shareholding has not been pledged, then the probability of a forced sale by a lender is zero, but if it has been pledged, then the probability is greater than zero. That is what we call informational value. It provides notice to investors that if they hold the stock, there is a non-zero risk of a sudden sell-off by a lender, and furthermore, if there is a sudden and unexplained fall in the price, then an investor will know that there is a strong likelihood that the lender is selling the stock. This is valuable information. Indeed in some cases, this knowledge might reduce the market impact of a forced sale, because knowledgeable investors would know that the business still has some value and they would go into the market and buy stock from the lender at a fair price. In the absence of a known pledge, they might think there is something wrong with the company and stand back until the smoke clears.
Investors will not treat the information that stock is pledged in isolation. They may well have other knowledge about the borrower. For example, the borrower may be a listed company, for which financial information is disclosed, and the investor can assess the gearing and reach a view on the risk of sale. The borrower may also be a person who is known to have other financial commitments, for example, a property speculator. Mortgages against property are filed with the Lands Registry, and mortgages by companies over assets are filed at the Companies Registry - so it is an ironic fact that there is more information available on pledged private assets than there is on pledged listed shares.
Privacy v public interest
Third, on the "privacy" argument, this is outweighed by the public interest. If you are a controlling shareholder who wants privacy, then don't float you company on the Stock Exchange, and don't ask the public for their money. If you want their money, then you must be willing to live with the transparency that goes with it. If you are an investor who wants privacy, then stay under 5% and you will be private. The same privacy arguments were trotted out by listed companies when the Exchange proposed requiring named disclosure of directors' pay, but in the end the public interest prevailed and next year we will see these disclosures in annual reports.
There is no way that HKEx can extend its jurisdiction to shareholders at large. They can only deal with directors and listed companies, and that doesn't take us far enough. The SFC is currently in the process of conducting a promised review of the disclosure provisions in the SFO, so it has an ideal opportunity to fix this problem by removing the qualified lender exemption. Legislation is expected sometime in 2005, when lawmakers will also deal with the amendments to provide statutory backing to certain listing rules. If the lender's exemption is removed, then there will be no need for HKEx to make any changes to the Listing Rules because the law takes precedence.
The alternative approach would be to require the borrower to disclose the pledge rather than the lender, but we think that would be an inferior choice. The law as it stands imposes the obligation on the person holding the security interest (or any other type of interest), so that is the way it should stand. There will be better compliance with a lender-disclosure obligation because (a) this will be a regular occurrence that their compliance departments can deal with professionally and (b) the lenders are all regulated entities who would have pressure to comply in order to keep their licenses. In contrast, investors are often not regulated by anyone, may be unaware of their obligations, and are also often overseas (including mainland China) where they are beyond reach of the HK courts.
© Webb-site.com, 2004