HKDF newsletter - 18 - Corporate Governance as a factor in Hong Kong’s Competitive Position

"In the US and the UK, the bottom-up approach to corporate governance is already effective, but in Hong Kong, rights at the shareholder level are too primitive.

Practical powers
In those Western markets with the best standards of governance (which does not mean they are perfect), there is a pattern of wider share ownership. As a consequence of their particular histories, most public companies in the USA and UK do not have a controlling shareholder. As a consequence, public shareholders can and do exercise oversight of corporate policy. As a result of their voting powers, groups of institutional and retail investors spontaneously form, and exercise their votes so as to guide and shape policy in the boardroom. In the extreme, if directors do not perform, then shareholder pressure removes them. This is an important market discipline.

By comparison, in Hong Kong and most of Asia, most companies have a controlling shareholder or group of shareholders. In Hong Kong these controllers are normally either families or, for mainland entities, the various arms of the State. In either case, the ability of minority shareholders to achieve anything in general meetings is almost nil.

In addition, in the USA shareholders can instruct lawyers on a contingent fee basis (no win, no fee), which lowers the barriers to pursuing legal action, and claims can also reach class action status, representing a much larger group of shareholders affected by the matter under claim. From a practical point of view, individual Hong Kong shareholders normally cannot afford to go to court to enforce their rights. Even the first round of a claim may cost more than their investment.

There are essentially two approaches to improving CG - the "top-down" approach, at a legislative and regulatory level, and the "bottom-up" approach, by using existing rights at the shareholder level. In the US and UK, the bottom-up approach is already effective, but in Hong Kong, rights at the shareholder level are too primitive for this to be effective. You can make noise in shareholders' meetings, but you will normally be outvoted by controlling shareholders.

So we need a top-down approach to reform, but shareholders lack the co-ordination, resources and time to pursue reform from the top-down.

Short term and relativistic investment
In the retail market, Hong Kong investors are famous for their short term outlook. They often trade on rumour, lacking access to the facts, and they attempt to avoid bad governance by holding stocks for only a few hours or days. Many investors regard the stock market as little more than a casino, and it is indeed ironic that the Government is currently trying to outlaw internet-based casinos at the same time as the full blast of deregulated commissions and the new AMS/3 internet-enabled trading system are about to hit the Hong Kong market. Placing your bets will be easier than ever before.

So what about the institutional market? The economic history of Hong Kong and Asia (ex-Japan) means that there is an underdeveloped institutional long-term savings market. In Western economies, a large part of the market ultimately belongs to long-term investors such as the beneficiaries of pension funds, life insurance and college eendowment funds. By their nature, these people care about absolute returns over long periods of time, and they object to bad governance which reduces these returns. That provides a motivator for them to speak up, and we see people such as the California Public Employees Retirement System (Calpers) making their voice heard.

In the UK, it is estimated that the members of the National Association of Pension Funds and the Association of British Insurers together own as much as 40% of UK listed equities. That gives them a strong influence in setting the rules for matters such as pre-emption rights (over the issue of new shares for cash) and share option schemes.

By contrast, Asian-based long-term institutional investors are still only a small part of the investor base. Most of the rest tend to focus on "relativistic" performance targets, such as their performance relative to a market index, or their performance relative to their peers. Since all investors, and the market indices, are affected fairly evenly by bad CG, this does not really affect their relative positions, so improving CG is not a priority. Instead, they all discount prices they are willing to pay to reflect the risk of bad CG.

Even those long-term "absolutist" Western investors tend to regard the small Asian part of their portfolio (typically 5%) as the "spice from the East" and price the stocks at a discount to reflect the risk, rather than fight for better CG. But Asian governments should note that, if their markets had better CG, they would attract higher prices and earn a higher percentage weighting in Western portfolios. Quality attracts.

A recent survey by management consultant McKinsey & Co, partly funded by the World Bank, indicated that investors would pay an average premium of between 18-27% (depending on the country) for a well-governed company over a badly governed but otherwise identical company. Unfortunately China and Hong Kong were not in this survey, but you won't be surprised to learn that the average premium on good CG was highest in Indonesia and Venezuela (27%) and lowest in the US (18%) with several Western European countries close by. Of all investors surveyed, over 80% said they would pay a premium for good CG.

In Hong Kong, the Mandatory Provident Fund scheme will gradually increase the focus on the long-term returns, but it will not be a material amount for many years, and even then, much of it will be managed by the fund management arms of commercial and investment banks, which brings us on to:

Conflicts of interests
With the occasional welcome exception, such as independent fund manager Templeton, fund managers largely keep their mouths shut and their complaints to themselves. In private, a lot of them will voice sympathies, and Webb-site.com receives a steady flow of them, but in public, they keep quiet. Why?

The basic reason for the silence is conflicts of interest. Many fund managers are affiliated to commercial or investment banks, whose profits depend in part on their banking business with the same companies in which the funds invest. You don't win mandates by criticising your clients. This is the same conflict that is at the root of much of today's broker-led investment research.

In addition, even those fund managers which are independent of the banks face difficulties. In a market with inadequate corporate disclosure, they often depend on access to the management of companies for their information. They may make complaints in private to these management, but any public criticism of the companies is likely to see them shut out, and scraping around the market for information like everyone else. The "company visit" is often a fund manager's greatest asset.

Why Good CG is important to Hong Kong's Competitiveness
Over the next few months, as we lobby for our proposal, you will hear a lot of vested interests, particularly in the plutocracy, trotting out specious laissez faire claims that Hong Kong does not need reform, that the markets work well, and that HAMS should not be given any government endorsement.

Don't believe a word of it. It is no coincidence that the long-run average p/e ratio of Hong Kong is so much lower than the USA or the UK. Our stocks are discounted for their risk.

If you control and run one of the major HK-listed blue chips, then you are indeed very happy with the status quo. You seldom need to tap the equity markets, and you can rely on the fact that many fund managers hold your stock not because you have good CG, but because you are in the benchmark index. If you need to raise equity, then you put on your best behaviour for a few months or even a year, open your doors to transparency, hit the roadshow circuit and allow your investment bankers to put out optimistic research reports promoting your stock. Then once you've raised that equity, you can lapse back into bad behaviour and set about expropriating as much of the new equity as the legal and regulatory framework allows. That's how the game is played.

It is no coincidence that the long run average p/e ratio of Hong Kong is so much lower than the USA or the UK. Our stocks are discounted for their risk.

We are now a service and financial centre, and we need to maintain our lead in Asia and mature into the "World-class financial centre" that the government aspires Hong Kong to be. To reach that maturity requires amongst other things, a long process of fundamental CG reform. And if we don't do it, then another market will, and Hong Kong will be the loser.

Much investor interest has focused on the entrance of foreign investors to China's protected markets after it joins the World Trade Organisation (WTO). Many of these foreign companies will be from markets with higher governance standards, were the cost of capital is lower. Hong Kong companies will be at a competitive disadvantage in the mainland if their costs of capital are not reduced to Western levels.

Catalysing Activism - HAMS
The Hongkong Association of Minority Shareholders is designed to fill the void of shareholder activism in Hong Kong. It would admit any individual or institutional investor or potential investor as a member, both local and overseas, and would operate in three key areas:

Policy - to promote and lobby for improvements to the legislative and regulatory framework for investment.

CG Ratings - to incentivise good CG and deter bad CG, by means of a comprehensive and objective CG rating system

Enforcement - converting the framework into a meaningful deterrent to bad CG, by quasi-class action litigation of the worst cases on behalf of investor members.

Promoting good CG
HAMS would promote and lobby for better laws and regulations to protect investors. This is the "top-down" approach with the eventual goal of establishing a framework which allows "bottom-up" action at the shareholder level to have real effect. HAMS would seek the opinions of its members, using the low cost of internet communication

and internet polling as a key tool. This provides a mechanism for conflicted fund managers and timid retail investors to say what they really think through the anonymity of HAMS.

Proposals for structural reforms, and responses to other proposals, would be produced by a full-time professionally staffed Policy Division which would include experienced lawyers, accountants and practitioners.

CG Ratings
HAMS would run a CG Ratings Division which would again be staffed with experienced lawyers, accountants and investment professionals. They would assess each and every listed company with an objective scoring system for various aspects of governance, including quality and frequency of disclosure, dealings with related parties, independence and accountability of directors and so on. One overall score would then be assessed.

Like credit ratings on debt, this system provides a "carrot and stick" approach to CG. Good CG will be rewarded with a high score, attracting more demand for the stock, and bad CG will receive a lower score. Unlike credit ratings, CG Ratings will be comprehensive, all companies included. When a major event occurs at a company, such as a takeover or a large "connected transaction" with a related party, the CG Rating would be reviewed, and otherwise it would be reviewed at least annually.

Enforcement
Good laws and regulations, when we get them, are worth nothing if they are not enforced. As we have explained, many of the existing and promised rights of shareholders are practically unenforceable on the grounds of legal costs.

The solution is the HAMS Enforcement Division. A team of highly skilled lawyers and other professionals would use the shareholder rights won by the Policy Division on behalf of all members. When you have 50,000 members or more, you can be almost certain that several of them will have held any target stock at any time in the past.

The division would target the worst cases of abuse, with the highest chances of success. It would also leverage off the findings of any Market Misconduct Tribunal under the new SFC bill, using these findings as evidence. Once a case was in progress, HAMS could advertise for any member who would be a plaintiff (having been a shareholder at the appropriate time) and this would include anyone who joins HAMS to participate in the action. In this way, HAMS would achieve a quasi-class action without actually reforming the entire legal system, and would overcome the costs of individual legal representation. The size of the potential claims would then form a greater deterrent to bad CG.

Funding HAMS
The fairest practical method is through a levy on the market, which we propose be named the Good Governance Levy or GG Levy for short. The volume which an investor trades is roughly proportional to the size of their portfolio. Frequent traders would pay a little more than long term investors, but no system is perfect. The Government has already recognised the fairness of a levy by partly funding the SFC in this fashion.

The existing transaction costs for a buyer or seller on the market are as follows:

We believe a reasonable funding level for HAMS would be afforded by a 0.005% levy, or $1 for every $20,000 of purchase or sale. Part of this would be used to accumulate a contingency fund, since market volume and value fluctuates whereas operating expenses are more fixed.

Government Endorsement
There are personalities in Government and regulators who are very receptive to these arguments, but find themselves offset by the vested interests who would have Hong Kong stay still as the World moves ahead with better CG. The supporters of better CG tell us how they wish that shareholders were more active, that they should speak up and co-ordinate their voices.

Unfortunately, for the reasons we have explained, this has not happened, and it will not happen spontaneously in the foreseeable future. Instead, we need Government to catalyse the reaction by endorsing enabling legislation for HAMS.

There are personalities in Government and regulators who are very receptive to these arguments, but find themselves offset by the vested interests who would have Hong Kong stay still as the World moves ahead with better Corporate Governance.

The outgoing Financial Secretary, who will soon become Chief Secretary (our top civil servant) emphasised the need for better CG in his budget speech last year, and we can expect more of the same in this Wednesday's budget speech. We hope that in his new role he will not lose sight of this important factor in Hong Kong's future success or failure, and we look to his successor, commercial banker Antony Leung, to add to the momentum.

Statutory immunity
At the same time, in order to publish CG Ratings and criticise companies without being sued for defamation when the score is bad, HAMS will need Government and legislators to approve the same statutory immunity that the SFC and Consumer Council enjoy, so long as they act in good faith. That is the only way to get a comprehensive CG Ratings system in place. Credit ratings agencies can avoid this by only rating those companies which agree to be rated, but HAMS cannot, since otherwise portfolio ratings would be impractical.