Listing Rules Review Part 4: Show us the Money
28 March 2002
The first three articles in this series contained heavy criticism of the Stock Exchange of Hong Kong Ltd (SEHK) for bending to the tycoons' wishes and putting form over substance. We told you in Part 1 how they proposed no limits on dilutive non-pre-emptive share issues, in Part 2 that they do not want independent shareholders to elect independent directors, and in Part 3 on how they think counting 1 vote per share is a waste of time and should only occur on certain occasions. Now for credit where it is due: on financial reporting, they've actually got it almost right - and that means they are running into opposition from the issuers.
The vast majority of HK-listed companies have a controlling shareholder, or group of shareholders, who are represented on the board. As a consequence, that shareholder has daily access to any information they want from the company. This creates what is known as "information asymmetry" amongst shareholders - or put simply, they know some things that you don't. Of the 33 companies in the Hang Seng Index, only one (HSBC Holdings plc) has no controlling shareholder, and that is a UK company with a head office in London.
Several of the incentives to voluntary disclosure, which exist in markets such as the UK and US, are nearly absent in Hong Kong. Most of the difference is due to the fact that US and UK blue chips are normally "diversely held" with no controlling shareholder, and also to the different legal system in the US. For example:
since there is no controlling shareholder to dilute, equity is often used as a currency for acquisitions or expansion - so it is important to maintain a strong share price;
conversely, management who ignore their shareholders and let their share price drift down are at risk of being taken over and losing their jobs (the market for corporate control is open);
a strong share price supports the value of management share options; and
in the US case, management can easily find themselves in receipt of a class action if they trade the company's shares in the knowledge of undisclosed information.
As a consequence, diversely held companies are more likely to put out a stream of voluntary disclosure well above the minimum regulatory requirement, such as trading statements, profit warnings, announcements of new contracts and business development.
In a controlled-company market such as HK, most companies do no more than the minimum required disclosure. Others go through occasional bursts of transparency when they want your money, and then lapse into opacity when the need has passed, and often begin expropriating it for the benefit of connected persons. Consequently, compulsory financial statements represent your main source of information flow on the performance of a HK-listed company, unless of course you are the controlling shareholder.
Having read the background, you will appreciate why the SEHK's proposal to require quarterly reporting represents such a major breakthrough. This issue has been on the drawing board for many years, and was last mooted by way of a question in a 1998 consultation paper. Webb-site.com at the time made a submission in support of quarterly reporting.
However, like so many reforms, the issuers successfully blocked it and it went no further. This has been the history of Hong Kong corporate governance, a reform process dominated by family-controlled issuers in which investors are unrepresented. The HAMS Proposal seeks to level the playing field with investor representation, and government response to this is still awaited.
In early 2001, the China Securities Regulatory Commission (CSRC) which regulates the two mainland markets, announced that quarterly reporting would be introduced from 2002 onwards. Shock, horror! Hong Kong has been overtaken by mainland China. Clearly, something had to be done. So thanks to the CSRC, the quarterly reporting proposal is now back in the Hong Kong market.
Let's be clear - any company that doesn't know where it stands financially on at least a monthly basis, should not be allowed to take public money and be listed in the first place. They should all have monthly management accounts, so producing every third set of those accounts for public consumption as an unaudited quarterly report should not be a major exercise in accounting.
Reviewing those accounts with auditors (not a full audit) and having them passed under the noses of the audit committee (including independent directors) is again, something that should be happening whether or not they are published. Producing a management discussion and analysis (MD&A) of those accounts should not be difficult either, and is necessary for the independent directors to understand the figures provided by management.
Right from its launch in Nov-99, companies listed on the Growth Enterprise Market (GEM) have had to report unaudited quarterly results within 45 days of the period end, the same as for US markets. So GEM has demonstrated that even for small companies with limited resources, quarterly reporting is achievable and not prohibitively expensive.
The larger the group, the more capable they should be of building modern accounting systems. Low-margin businesses such as retailers normally know even on a daily or weekly basis how much money has passed through their tills and goods through their warehouses. They have to, in order to squeeze a profit. Banks are little different - they are highly leveraged companies with tight supervision from central banks and highly computerised systems which calculate accrued interest daily, and market positions in their trading arms often minute by minute.
David Eldon, a director of HSBC and chairman of its local banking subsidiary, has complained that it would mean "many more board meetings and many more auditing committee meetings, and much more work for the company's accountants and external auditors" - but this indicates that independent directors at HSBC only see internal accounts twice a year and cannot cope with a doubling of this work load. Shame on you Mr Eldon - it sets a poor example to your borrowers if you think it is acceptable for independent directors to have such a minimal knowledge of their business.
Some of the basket cases of Hong Kong corporate governance, which have resulted in large write-offs by your bank and others, could have been prevented if truly independent directors had more frequent oversight of the accounts. Such comments also make us wonder just what kind of accounts your loan officers receive from highly geared borrowers - do they not receive management accounts more often than half-yearly? Assuming the answer is yes, then you appreciate the value of frequent reporting in monitoring your loans - so why don't investors deserve the same in monitoring their equities? Investors, after all, rank behind lenders in a liquidation, and so have even riskier positions. And if the answer is no, then we'll take our deposits elsewhere.
HSBC purports to be a global banking group and competes with firms like Citicorp, Chase and Bank of America who have been quarterly reporting in the US for as long as anyone can remember. If they do it, why shouldn't you?
Mr Eldon proposes that quarterly reporting should be "recommended" but voluntary, which misses the point - companies have always been at liberty to report as often as they like, as long as they comply with the minimum. And a very few (CLP Holdings and Legend, for example) do report quarterly. Mr Eldon hastens to add that if it were voluntary, HSBC would not report. This is very disappointing from a company that has regularly won corporate governance awards in Hong Kong, not least because as a UK-listed company, it has to conform to generally higher standards on matters such as disclosure of directors' pay and non-pre-emptive share issues.
Less information - more speculation
Some opponents of more frequent disclosure, including Mr Eldon and Ronnie Chan (controlling shareholder of Hang Lung Group and former director of Enron), have suggested that quarterly reporting forces managers to focus on short-term plans to achieve better quarterly profits, rather than concentrate on developing long-term strategies. Such opponents fail to explain why corporate America, which has been reporting quarterly for decades, has been so successful - did it really make them pursue the "wrong" strategies at the expense of the long-term? Their record of strong economic growth and financial performance suggests the opposite.
Take those arguments to their logical extreme, and one could argue that even interim and annual reporting disrupts business planning for the long-term - so let's cut back reports to every five years, more in line with the business cycle. Between five-yearly reports, investors would simply have to speculate on what the company is doing and how it is performing financially, trading on rumour, hearsay and inside information. And there you see the problem - lack of transparency promotes speculative investor behaviour. The increased uncertainty also increases the discount factor on future earnings that must be used when assessing the fair value of stocks, and that in turn lowers P/Es and increases the cost of capital for issuers.
Quarterly reporting did not cause Enronitis
There are certainly managers in corporate America who have been abusing loopholes in accounting standards, shifting exposures and losses off balance sheet, and "smoothing" the quarterly earnings by means of provisions and other subjective adjustments. This points to weaknesses in accounting standards, not to problems with the frequency of reporting. Even if companies had been reporting only yearly, the same problems would exist with the accounting standards. It has become popular to invoke the name of Enron in every debate, but this one doesn't stick. In fact, Enron's problems first came to light with the 3rd quarter results of 2001 - so without quarterly reporting, the insiders might have been able to cover up their problems for an extra 3 months (and keep selling their stock) before the bomb dropped.
How frequent is enough?
It would be wrong to presume that quarterly reporting is necessarily optimal. As information technology has improved, the time and effort needed for beancounters to count their beans has improved with it. But there is certainly a trade-off between frequency and cost of reporting. There is a case of diminishing returns - the information content is roughly proportional to the time it covers. We would not learn a great deal more about companies if they reported hourly or daily rather than weekly or monthly - and the CEO would spend all his time doing investor presentations. But let it be noted that a number of industries have some form of monthly reporting already - for example, we get passenger and cargo load factors from the local airlines, and hotels report occupancy rates to their association which aggregates them and reports them to the public. The investment funds association also reports monthly sales and redemptions of mutual funds, and so do motor dealers for new vehicle sales. In America, retailers produce same-store sales comparisons after holiday weekends at the drop of a hat. These figures are readily extracted from management information systems.
Now don't worry, we are not advocating mandatory monthly reporting at this stage. We think the costs would outweigh the benefits - we are just pointing out that quarterly reporting is far from extreme and still leaves information time-lag between managers and investors.
Timing of reports
The SEHK has proposed a 45-day deadline for quarterly reports, the same as for the GEM, and also proposes shortening the reporting deadline for interim (half-year) results from 3 months to 2 months after the period end, and the annual results from 4 months to 3 months. These last two deadlines are in fact what they proposed in 1998 consultation paper, only to back off under tycoon pressure. Instead, we got a modicum of progress - the annual results deadline was shortened last year from 5 months to 4 months. As of today, we only have to wait another month to find out what some companies did last year. Meanwhile, America prepares for its first quarter results.
Webb-site.com supported these changes in 1998, and we support them now. GEM companies have demonstrated that Hong Kong is not in some way "different" and that they can report quarterly in 45 days just as US companies do. We also suggest that the ultimate goal (next time) for half-year (interim) reports should be the same 45 days, because their content should be the same. The second quarter should be no more difficult than the first or third quarter. But for now, let them take the extra 2 weeks.
On the content of reports, this is where the SEHK has got itself tied up in confusing knots and at the same time seeks to compress the information. It proposes to have 4 different types of non-annual reports. These are "quarterly results", "quarterly report", " half-year results" and "half-year report". As if that wasn't enough, they also propose a new "summary half-year report", containing the same information as the half-year results, but a bit less than the half-year report, which would be mailed to those who did not choose to receive a full half-year report.
This is a recipe for chaos and confusion. The idea of summary reports derives from the treatment of annual reports. After the wave of UK privatisations in the 1980s resulted in millions of shareholders for companies like British Telecom, the authorities realised that the vast majority would not be able to read and understand a hundred-page annual report, and that it would be kinder to forests and cheaper for companies to print a summary report and make the full version available on request. The Hong Kong authorities adopted this approach about a year ago after the MTRC float had the same consequences.
That's all well and good, but in the case of interim reports, which are seldom that lengthy anyway, it is hardly worthwhile to produce the dumbed-down version. Furthermore, since all reporting is moving to electronic filing, and the requirement for newspaper paid announcements will soon be dropped (and never existed on GEM), this is no longer about saving space and money in advertising. The web places no restriction on space, so it make little sense to have two versions of the quarterly and interim reports.
Give us full balance sheets
On the content of quarterly reports, the SEHK proposes "balance sheet information" but not actually a full balance sheet. Instead, they suggest a condensed version. For example, there is a requirement for "current assets" rather than the usual breakdown of a figure into debtors, inventory, cash on hand, investments and so on. This is both secretive and bizarre, because they propose separate disclosure of bank borrowings, so you can find out how much debt they have, but not how much cash or net debt (cash minus debt).
Let's cut straight to the chase. There is no reason why quarterly reports (3 times a year, including the 2nd quarter) cannot show a full balance sheet, which the company must have internally in order to work out the profit and loss account (income statement). One follows from the other. Secrecy and obfuscation of the balance sheet just promotes information asymmetry between insiders and outsiders. Enron did at least demonstrate that.
Give us full quarterly cashflow statements
The SEHK also proposes that quarterly reports should not require cashflow statements. Again, since all companies have a balance sheet and profit and loss account, producing the cashflow statement is a fairly simple exercise which will add great value to the information. The cashflow statement is more important than ever, since after recent changes in accounting standards, the number of non-cash items in the profit and loss account, such as goodwill write-offs and fluctuations in investment valuations and contingent liabilities, makes the income statement very different from cash earnings.
And give us proper cashflow statements - the ones we get today in interim reports are so condensed as to be pretty meaningless. It's like looking at Victoria Harbour from the Peak on a typical smoggy day - you get the general outline but you have no idea what's underneath.
To see what we mean, compare the level of detail in the cashflow statement from Hang Lung Group's interim report with the one from its annual report - and notice that the annual report also comes with a note (a) which explains in a separate table how operating cashflow differs from operating profit. We're not singling out Hang Lung here - they are no different from most other companies in this respect.
You are beginning to see a theme emerging - the "break them in gently" school of thought in the SEHK Listing Committee - as if they were saying "if we really have to propose quarterly reporting because the mainland is doing it, then let's just be seen to do a bit of it, and then object like crazy to doing it in the first place."
Not a Mini-MD&A
Another piece of "not too much disclosure" is the SEHK proposal that quarterly results, quarterly reports and half-year results should have:
"a fair review of business developments which will be less detailed than the management discussion and analysis required for a full half-year report. However, such review of business developments should still enable an user (sic) to gain an understanding of the underlying trends in an issuer's business".
This is incredibly vague - and conjures up the idea of statements like "things are going well this quarter, the outlook is good, and we'll tell you more in the interim report".
Once again this proposal exhibits the controlled-company tendency to secrecy. We believe each quarterly report (including the second quarter) should have the full management discussion and analysis. It should not take that long for management to write a report on what the numbers mean and the business outlook, and the audit committee of independent directors would need that information from management to help them understand the numbers anyway, so take the extra step and publish it.
Disclosure of interests
The SEHK proposes not to require disclosure of directors' and substantial shareholders' shareholdings in quarterly reports. They propose to drop this requirement from the GEM. We disagree. Investors are entitled to know what directors and major shareholders have been doing with their shareholdings, because that is a proxy for the information advantage that insiders have over outsiders. They see monthly management accounts, they know what the order book looks like, they know what you don't, and their dealing behaviour incorporates that information. It is theoretically possible to glean the shareholding data from the daily transactions disclosures, but in practice this takes hours for each company and is not a substitute for a quarterly snapshot. So for all 3 quarters and the annual report, we should receive a full table of shareholdings.
There you are, enough said. We want three quarterly reports each year, with full balance sheets and cashflow statements, a proper management discussion and analysis, and disclosure of shareholdings. We want them within 45 days after each quarter, and an annual report within 3 months after the year end.
The submissions deadline for this consultation exercise is 22-Apr-02, so after the Easter break we will be setting up the usual Webb-site.com electronic submission system for our readers to make their own views and support known to the SEHK. If you want what we want, then you'll have to back us up. This is one set of votes the SEHK will have to count!
© Webb-site.com, 2002