Building a Value Proposition for HK
4 October 2006
Thank you for your letter of 22-Sep-06, received on 25-Sep-06, inviting views for the government-appointed Working Group on cash, derivatives, clearing and listing under the Focus Group on Financial Services under the Economic Summit on China's 11th Five-Year Plan and the Development of Hong Kong. I don't know who is on your working group, because it hasn't been disclosed, but I will spend time on this submission in the hope that it includes a fair measure of investor representatives, and as ever, I offer my time to serve in moving HK forward.
As you requested submissions within 4 days, somewhat faster than the typical consultation, I am already past your deadline. So I will try to keep these remarks broad. I have expressed many of these views in more detail in the past, and you can easily find the relevant articles by using the search box on the Webb-site.com home page, or from the links in the online version of this letter.
The key thing that HK policy makers need to bear in mind on our financial sector is that a crucial part of mainland China's epic shift from centrally planned economy towards market economy is the gradual lifting of capital controls, which has been underway for some years. Within a few years' time, the RMB will become a freely convertible currency and take its place alongside the major economic currencies of the world, and there will be open competition between Hong Kong and other financial markets in China.
What then will be Hong Kong's competitive position? This depends very much on the action or inaction of our policy makers in recent years, and the actions they may take in the remaining time before open competition. Having put so many proposals on ice for so long, they had better get their skates on.
In the past, mainland companies have chosen their equity capital markets largely based on non-valuation factors, such as political fiat, the wish for convertible foreign currency, private companies obtaining out-and-back tax breaks as "foreign" investors, or the simple matter that the CSRC has periodically suspended IPOs, making the domestic markets unavailable, and even when they were open, authorities ran a queuing system prioritised in favour of state-owned enterprises.
In the future, however, there will be fewer mammoth SOE listings, and more private sector listings where price is key. Mainland companies are more likely to choose their market based on value considerations, the most important of which will be
"where can I get the highest price for the securities I am issuing"?
The answer comes in in part from the legislative, regulatory, judicial and fiscal frameworks in the markets available, because all of these have an impact on the valuation of securities, i.e. the prices investors are willing to pay. Imagine, in a thought experiment, that an investor can buy the shares of two identical companies, Company A and Company B, with identical businesses and management. Company A is listed in Market A, and Company B is listed in Market B. Then:
- If Market A requires more frequent financial reporting (e.g. quarterly) while Market B does not, then the investor will pay more for shares of Company A than Company B, because he can be more confident of the current financial state of the company. Greater certainty equates to lower risk, and lower risk equates to higher prices. He can also be more confident that the gap between what he knows and what insiders know is reduced, and that reduces the potential for insider dealing against his interests.
- Similarly, if Market A requires faster financial reporting, then the investor will be confident of getting information from Company A before he gets it from Company B. Again, greater certainty equates to lower risk and lower risk equates to higher prices.
- If Market A has statutory backing for Listing Rules, and a regulator empowered to fine directors for breaking them, or to bring criminal prosecutions in the courts, then there is a greater deterrent to breach, so they are less likely to break them. That reduces the expected loss from bad governance, so again, if market B does not have such a deterrent, then the investor will pay more for Company A than Company B.
- If Market A allows independent shareholders alone to elect independent directors, while Market B allows controlling shareholders to vote on the elections, then investors in Company A will be able to hold INEDs accountable, giving investors greater confidence that the INEDs will act in the interests of the company and not favour the interests of the controlling shareholder. Investors will pay more for Company A than Company B, for the greater likelihood that INEDs will act to protect their interests.
- If Market B allows directors who are also controlling shareholders to escalate their pay without any approval from minority shareholders, while Market A requires approval (beyond a certain rate of increase) for what amounts to a connected transaction or preferential dividend to the director, then investors will pay more for Company A than Company B, because there is a lower risk of Company A overpaying its directors and thereby expropriating shareholder value.
- If Market A allows investors to overcome the prohibitive costs of legal action by allowing cases to be admitted to court as actions on behalf of the entire affected class of investors (class actions), and allows lawyers to negotiate fees structures, including contingent fees, on a free market basis, then there will be another deterrent to defrauding investors, and that again will reduce the incidence of it. A properly designed class-action system would retain the best of the English Law tradition, namely that the loser pays the costs of the other side, thereby making frivolous, vexatious or nuisance actions unattractive. A lawyer working on a contingent basis and being liable for the other side's costs (in place of his client) would only take on a case if he was very confident of its merits. Similarly, less-well funded law firms may need to buy insurance to cover the risk of losing, and the premium would reflect the firm's success rate. I call this system "SCALP", an acronym for "Shareholder Class Action, Loser Pays". The deterrent effect of this system in Market A would reduce the incidence of fraud and increase the price investors would pay for Company A.
- If Market A gives investors a statutory right for investors to rely on auditors' reports until the next one comes out, and thereby have the right to sue them for negligence, then the auditors will be incentivised to do a more thorough job and detect problems sooner. The greater scrutiny would deter and reduce fraud losses, because crooks would know that they are more likely to be discovered. So an investor would pay more for Company A.
- If Market A has a more reliable judiciary than market B, then an investor will pay more for Company A, because he will be less concerned about getting unfair treatment in any dispute. However, to some extent Market B can overcome this by allowing listings of companies incorporated in market A or in other jurisdictions, in effect outsourcing the dispute resolution.
- If Market A has lower taxes on transactions, such as stamp duty, or lower transaction costs, then investors will pay more for shares in Company A than Company B, because what matters to the investor is the total cost of the investment, not who receives it.
Currently, HK scores highly in only one of these areas, namely its strong and independent judiciary with hundreds of years of English law case history behind it. It scores badly on the others, including the frequency and speed of reporting, the lack of statutory backing and meaningful penalties for breaking the Listing Rules, the lack of class action rights, the lack of contingent legal fees, unaccountable INEDs, unaccountable auditors, and stamp duty.
Main Board companies slide out their annual results in up to 4 months, while other countries require reports in 60 days. The mainland markets have required quarterly reports since 2003. Singapore requires them within 45 days.
There are no limits on the rate of increase in directors' pay, and since the controlling shareholders also get to vote on INED elections, the INEDs are often just golfing buddies and school friends, and the boards act like mutual appreciation clubs. As an investor, I attach no value to the INEDs on most of the boards of companies I invest in. This would change if INEDs were accountable, because boards would normally only propose candidates who are acceptable to independent shareholders and willing to be held accountable. Failing that, investors could nominate other candidates. I know this first-hand, as HKEx is one of the few HK-listed companies where (some) INEDs are accountable at the ballot box, due to the absence of a controlling shareholder, and where I was able to get elected on an investor nomination in 2003, displacing an incumbent.
Don't rely on the accounts
In Jul-06, a brave individual investor attempted to bring a court action against Ernst & Young, the auditors of a collapsed HK-listed company, Gold Wo International Holdings Ltd. The Court of First Instance had no choice but to quote the House of Lords case Caparo Industries plc v Dickman and Ors (1990), in which the auditors were held not to owe a duty of care to shareholders of the company, let alone to future shareholders who may buy in the market. The HK case was accordingly "doomed to fail" and was struck out in its entirety.
It is frankly ridiculous that no investor can rely on the audit report in the annual report when deciding to invest, or to remain invested. Only legislation can change this, as Deputy Judge Ian Carlson said:
"What [the plaintiff] seeks is the sort of consumer protection which is available in some of the state jurisdictions of the United States...That position has not been arrived at in Hong Kong."
Don't rely on the prospectus
On a similar theme, on Friday 22-Sep-06 the SFC announced that it had abandoned a proposal (Proposal 9 in the Consultation Paper on Possible Reforms to the Prospectus Regime) to allow secondary market purchasers to bring claims for fraud in IPO prospectuses. Again, the entire price discovery process relies on the truth of the prospectus, and subscribers have a right of recourse (subject to the limitation below), but anyone who purchases shares in the market from that subscriber, even on the first day of trading, is on their own, as if the prospectus did not exist. The subscriber who sells on day one is of course free and clear, and will not claim if the issuer subsequently collapses in a smoking heap of fraud, while the secondary buyer can't sue the subscriber because no representation was made by him in the market when he sold. So what are investors to rely on?
Another SFC proposal that was abandoned was Proposal 10, to remove the requirement for subscribers to prove that they actually read and relied on the prospectus when making a claim for fraud. Now, how many people can prove what they read yesterday, let alone what they read months or years ago? Do they have any witnesses? Of course not. Again, the relevant fact is that the IPO was priced on the basis of the prospectus and nothing else, and enough people read enough of it for the market to set that price. If it then turns out to be fraudulent, no victim should have to prove that they themselves read it. It should be enough to show that if the document had been known to be false, then the shares would not have fetched the price they did in the primary or secondary market. The SFC could not find any such "prove that you read it" requirement in Australia, Singapore or the UK.
Of course, all of this is rather theoretical in the absence of a class action system, because no IPO investor alone would find it worth the cost of bringing a case even if they had (a) subscribed and held the stock since the IPO and (b) could produce a witness to prove that they read the prospectus before subscribing. To my knowledge, nobody has ever brought such a case in HK.
There are some who believe that the path to HK's future success as a financial centre lies in deregulation, scrapping rules and diluting standards to win business. They are flat-out wrong. If we simply had a free-for-all in our securities markets, then we would have no competitive advantage over a flea market, a virtual exchange like eBay or any exchange which simply matches buyers and sellers. We could end up as the dodge city of China while our competitors take the high road. Where's the value proposition in that?
If we build a trustworthy and well-designed legislative, regulatory, judicial and fiscal framework, then Hong Kong can create a virtuous circle in which companies are willing to submit themselves to that framework in return for higher prices for their debt and equity, which investors will pay because they have greater certainty through improved disclosure, and reduced expected losses from bad governance or fraud. Build it, and they will come. We should reach for the sky rather than race to the bottom, as this is the only way to add value and differentiate Hong Kong. We must build a value proposition.
In his final budget speech of 7-Mar-01, Donald Tsang, now our Chief Executive, said:
"Our aim is to establish Hong Kong as a paragon of corporate governance, ensuring that those investing in Hong Kong are afforded the best protection..."
Since then, far too many of the initiatives I have referred to above, and others besides, such as scripless registration, have been proposed by authorities and then either withdrawn, diluted or iced in recent years. Last week, a newspaper carried a "kite-flying" story that your focus group had recommended that the SFC be stripped of its dual-filing role for new listings, leaving the Stock Exchange to vet prospectuses on its own. That is exactly the opposite of what the Government-appointed Expert Group recommended on 21-Mar-03, which was to get HKEx out of regulation and have a single statutory securities regulator, SEC-style, who in turn would be accountable to the public. Let HKEx focus on business, and let the regulator regulate. As you know, the Government briefly adopted this proposal before performing a U-turn under pressure from vested interests two weeks later.
While I am on the subject of regulators, there is a strong case for combining the overlapping regulators of the SFC, HKMA, Insurance Commissioner and MPFA into a single financial services regulator which has a consistent approach to the licensing, distribution and selling of financial products. The current situation is a mish-mash of overlapping responsibilities and uneven playing fields.
Listing of overseas companies
Although HK's economy is inextricably linked to the mainland, as it always has been, that does not mean we should ignore the potential for risk diversification in the economy by cultivating business from the rest of the region. I am in favour of allowing companies from other domiciles (besides the existing ones of HK, PRC, Bermuda, Cayman Islands) to list here, but not on any terms. If investors are to attach any value to our "brand", then they need to be able to take for granted a certain minimum set of standards that will apply to all companies listed here. That is part of our value proposition, part of the "Trustworthy Framework". Otherwise, each investor would have to do his own due diligence on the applicable law and constitutional documents of each issuer, which is so time consuming that they will just discount for risk instead. So we need (a) the constitutional documents to be brought up at least to a common standard which applies to all HK-listed companies; and (b) a deed of undertaking that the issuer and its directors submit to the jurisdiction of Hong Kong's courts. Furthermore, in view of the practical difficulties of cross-border regulatory reach and enforcement, the jurisdiction of incorporation should be a signatory to the multi-lateral IOSCO MoU on co-operation.
Beyond the impact of the Trustworthy Framework on Hong Kong's value proposition, there are other factors, such as the degree of expertise in the analytical and investment community. For example, many Chinese internet companies have chosen to list on Nasdaq, because they can get a higher price there. They are willing to sign up to the higher US regulatory requirements in order to get that price, and part of it is attributable to the greater pool of internet and technology analysts in the USA.
So one of Hong Kong's challenges is retaining and building its pool of professionals, and part of this in turn comes down to cost of office and residential accommodation, availability of private schools, and quality of life, notably including air pollution. If we are to attract foreign as well as retain home-grown expertise, then we need to improve on all these fronts. Otherwise, it may simply be cheaper and more pleasant for analysts and asset managers to base themselves elsewhere. Given that most of the future issuers in our market will be from outside Hong Kong, it matters little to the asset managers whether they live here or elsewhere.
Of course, these issues go beyond the scope of your working group, so I will only briefly touch on them in this paragraph. The Government needs to take a holistic approach to economic reforms. In the case of accommodation costs, this can only be addressed by busting the property cartel, and that can only happen if there is reform to the leasehold land premium system. A move towards higher land rents and lower premia (which are just capitalised land rents) on new leases and lease modifications would open the market to greater competition and reduce the margins of developers, making property more affordable in the long run. As for air pollution, there are a number of fiscal levers that the Government has failed to pull, such as charging diesel duty on franchised buses, raising diesel duty to at least the same level as petrol, and electronic road pricing. As Donald Tsang put it in that final budget speech of 7-Mar-01:
"why do we continue to exempt franchised buses from duty on diesel and indirectly undermine the competitiveness of railways which are more environmentally friendly?...we must as a community understand that if our environmental sores are left to fester, inaction will, over time, result in far worse pain and far greater costs than will an early cure. Most of the world seems to have woken up to that fact. When will Hong Kong?"
Over 5 years later, having gone on to be Chief Secretary and now Chief Executive, it is about time he answered his own question.
Turning briefly to the derivatives markets, I do believe that, while HK lacks the physical commodities trading that would allow us to run physically-settled futures or options markets, HK should be opening its market platform to a much broader range of cash-settled products. In principle, as long as there is a reliable reference price for the underlying item, allowing margin requirements and settlement prices to be determined, then a futures market can be made in it.
The futures market need not be restricted to traditional commodities, but could also include "event futures" - binary contracts which trade until they settle at either 100 or zero based on events, with 100% margin on the purchase price. Some may call that gambling, but in an efficient market, all current information is reflected in prices and any investment is a "gamble" on whether the investment value will go up or down, based on the outcome of future events. The only difference is the amount of uncertainty in the outcome. Derivative warrants, for example, already allow investors to lose their entire investment in a fixed space of time, and with their unlimited upside, warrants are more likely to attract gamblers than a binary futures contract, so no moral case should be made against the latter.
Although most events (such as sports and elections) would be on known timeframes, it is not actually necessary to know when the event will happen - just let the market take care of that. Some contracts, such as a binary contract which settles at 100 if and when a person walks on the Moon again, could run for years. As long as fair rates of interest were paid on the margin funds, people would be willing to buy and sell the futures. Other binary contracts could have much sorter timeframes - for example, paying out 100 if the Hang Seng Index rises today.
In other, more terrestrial examples, we could run "smog futures" on the average air pollution reading in a given future day or month, or the amount of rainfall recorded on a given day, allowing outdoor event organisers to buy insurance by going long on rainfall contracts. The "reference prices" are independent rainfall measurements which could be provided by the HK Observatory.
Contracts for differences, which would give the holder identical economic exposure to stocks but without ownership rights or stamp duty costs, are another form of derivative which could be implemented. In essence, they are rolling futures contracts which are dividend-adjusted and interest-adjusted. In Singapore you can already buy CFDs on leading Hong Kong stocks through IGmarkets, but if you log in and do so from Hong Kong then you will be committing a criminal offence under the Gambling Ordinance.
HK has fallen way behind in the evolution of risk-transfer markets. The Government should move to liberalise the market by licensing financial betting exchanges and bookmakers, subject to sensible capital adequacy supervision (so that bets will be honoured), and taxing their profits at the usual rate of profits tax.
© Webb-site.com, 2006
Organisations in this story
Topics in this story
- Air pollution
- Auditor liability
- Class action rights
- Corporate governance - general
- Directors' remuneration
- Financial regulatory structure
- Government policy - general
- Independent Non-Executive Directors
- Land leases
- Prospectus liability
- Quarterly financial reporting
- Statutory backing of Listing Rules