Recent developments of CG Policy in Hong Kong … and why progress has been so slow

1. Recent developments of CG Policy in Hong Kong…and why progress has been so slow David M. Webb editor of Webb-site.com at the inaugural conference of Asian Institute of Corporate Governanceat Korea University 14th December 2001

2. Recent Developments • Takeover code amended (19-Oct01) • “Trigger threshold” reduced from 35% to 30%, in line with UK • “Creeper” limit reduced from 5% to 2% per year • David Webb appointed to Takeovers & Mergers Panel (5-Apr-01) • Standing Committee on Company Law Reform (SCCLR) • Formed in 1984. Consultant’s report on Companies Ordinance (CO) commissioned in 1994, delivered in 1997, put to market consultation in 1998, then SCCLR wrote a “report on the report” published in Mar-00. Slow progress! • In 2000, commenced review of CG aspects of Companies Ordinance. • Formed 3 sub-committees on: Directors, Shareholders and Corporate Reporting. • Good news: David Webb appointed to Shareholder Sub-committee. • Bad news: David Webb is the only investor on Shareholder Sub-committee. • SCCLR published “Phase 1” Recommendations in Jul-01 for market consultation, and results are awaited.

3. SCCLR Recommendations: Directors • SCCLR chose not to enact directors’ duties into statute; compares badly with UK, Australia, Malaysia, Singapore. • No intention to create criminal penalties for breach of directors’ duties generally. • Law to contain general provision that director cannot vote in board meeting on transaction in which he is interested. • Statutory requirement for circulation of notices to allow shareholders to nominate directors before the election. • Companies should be “encouraged” to adopt cumulative voting procedure on directors’ election (not clear how this “encouragement” will make it happen).

4. SCCLR Recommendations: Shareholders • Shareholders to have statutory right of derivative action, replacing common law right. SFC to have right to bring derivative actions without first obtaining court approval (but will they?) • Clarify the statutory unfair prejudice remedy so that court has clear powers to award damages and interest. • Court to have clear power to award costs to shareholders taking action. • Shareholders to have statutory method of securing access to company records subject to court approval and other safeguards. • Disinterested shareholders’ approval required for related-party transactions (all companies, not just listed companies). • Generally, intent is that CO should apply to all companies with a place of business in HK, including oversea companies registered under Part XI. This includes the 75% of listed companies which are incorporated in Bermuda or Cayman Islands. • Still no class or quasi-class action system - these laws are not worthwhile unless shareholders can afford to use them.

5. SCCLR Recommendations: Corporate Reporting • Private companies to be required to file accounts, available to public inspection. • Floats the idea of a body like the UK’s Financial Reporting Review Panel to review problems with audited accounts. • Proposes a system for amending audited accounts if they are subsequently found to contain material misstatements

6. Listing Rules • Listed companies are regulated by a listed, for-profit monopoly - Hong Kong Exchanges and Clearing Ltd (HKEx) which owns SEHK. Big conflict of interest: incentive to under-spend on regulation to maximise profit. • SEHK consulted market on key sections of main board listing rules in early 1999. Results sank without trace. Now they are preparing a full-scale review of entire rules. • Some of the things we have called for on Webb-site.com: • Independent directors to be re-elected by minority shareholders only • All resolutions to be on a poll: 1-share-1-vote, not 1-hand-1-vote • Reduction of disclosure and approval thresholds • Quarterly and prompt reporting, including balance sheets and cashflow statements • SEHK Listing Division to be transferred to the SFC, creating single securities regulator • Statutory backing for Listing Rules, with power to fine directors and companies for breach. • Full on-line disclosure • Limitation of general mandate for non-pre-emptive share issues for cash.

7. Securities Law • SFC Bill is now in its 3rd draft since 1996 • Legislative Council is examining the draft, and hears lots of complaints from issuers and advisers (but no input from investors) • Maybe it will pass early next year • Bill proposes: • Market Misconduct Tribunal (MMT) - broader than current Insider Dealing Tribunal, to including market manipulation and false or misleading disclosures, but cannot make punitive penalties - only disgorgement of profits plus interest and costs. • Option to treat insider dealing as criminal offence with jail time and fines. • Reduction of ownership disclosure threshold from 10% to 5% (UK=3%)

8. Other areas • Dematerialization • Currently scrip is immobilised in Central Clearing & Automated Settlement System (CCASS) run by Hong Kong Securities Clearing Company Ltd (HKSCC), a monopoly owned by HKEx. • Almost all public shareholders hold stock via brokers/ custodians, and then via HKSCC, which registers as HKSCC Nominees Limited • Hence there is only one shareholder, which creates big problems with voting and shareholder communications. • Need to move to electronic register with “voter of record” as well as “holder of record”. Then we can think about electronic voting with digital certificates. • Reform in this area was accelerated by the MTRC duplicate share certificate fiasco. Typical of the crisis-driven approach to reform in HK.

9. Key Dynamics in CG Reform • Company representation • Issuers are represented by chambers of commerce, and leading companies have representatives on Government bodies such as SFC, Stock Exchange Listing Committees, Standing Committee on Company Law Reform and Takeover Panel. • Indirect Company representation via professionals • Issuers are also represented by professional firms, such as leading local law firms and accountancies, who are present on aforementioned bodies and derive the bulk of their income from the companies they advise. • Professional bodies • “Issuer-side” professionals also reflect their wishes through industry bodies such as the Law Society, Society of Accountants, Institute of Company Secretaries, Stockbrokers Association and Institute of Directors. • Investors have almost no representation • Consequently the debate is one-sided, normally arguing for status quo and against reforms, and the reform process is slow. For example:

10. Why Activism is Rare in Emerging Markets • Short-term investment • Local pensions markets are underdeveloped, so there’s less focus on long-term absolute returns. Asset managers are often judged on short-term performance. Long-term overseas investors have minimal portfolio allocations to EMs. • Relativist fund management targets • Most funds track, or benchmark, against market indices, so bad CG affects funds and the indices fairly evenly and relative performance is unaffected. Same applies to “league table” peer-group rankings – the whole group is dragged by bad CG. • Conflicts of interest • Fund managers are often affiliated with banks, so cannot criticise bad governance of the bank’s corporate or Government clients. • Defeatism • Circular problem – with a dominant shareholder and an unfavourable legal and regulatory framework, no point in making a noise. Investors will pay a premium for good governance, but they discount “emerging markets” for the risk of bad governance. This lowers the market ratings of EM issuers and increases the cost of equity and debt capital, making them less competitive globally.

11. Catalysing Activism:Hongkong Association of Minority Shareholders HAMS

12. Governance of HAMS • Investor membership • HAMS would admit any shareholder or potential shareholder as a member, for a nominal annual fee to cover communications: • HK$100 - individual with internet communication • HK$200 – individual with postal communication • HK$1000 – others (institutions) • Practice what you preach • The non-executive governing board of HAMS would be elected by HAMS members annually and hence accountable. One member, one vote. Full-time executive staff would be accountable to the board of Governors through the CEO. • 7 Governors elected by individuals • 7 Governors elected by institutions • 1 Chief Executive Officer • Possibly 1 representative each from SFC, LegCo, MPFA, Consumer Council

13. HAMS: Three divisions • Policy • Appraisal • Enforcement

14. HAMS – Policy Division • Aggregation of opinion • HAMS would poll members on proposals and speak with authority. Institutions would have no conflict in speaking anonymously. • There are an estimated 500,000 regular investors in HK stocks. We would expect 50,000 to join within one year of full launch. • Promote CG Reform • Provide the “missing voice” of investors in the CG debate. Promoting CG reform at the governmental, legislative and regulatory levels (HKEC, SFC, HKSA, Law Society etc). Both proactive and reactive. • Professionally staffed • with experienced lawyers, accountants and practitioners to formulate and lobby for proposals.

15. HAMS – Appraisal Division • Numeric and objective ratings system for CG • Skilled professionals would continuously assess all 800 companies on multiple parameters. Summary ratings would be freely published - next to P/E and Yield in newspaper listings, on web sites and via HKEx trading system. • Upgrades and downgrades would be explained, and voting recommendations would be given if HAMS analysts found resolutions against minority shareholders interests or in breach of Good Governance Guidelines. • Incentive/Deterrent for good/bad CG • Increased demand for stocks with higher CG Ratings. Good score = Higher p/e = lower cost of capital and increased competitiveness. Will fuel HK economic success. Badly rated stocks will suffer more discount. Some funds may refuse to hold stocks below a specified CG Rating as being “non-investment grade”. • Mutual Fund Disclosure • SFC/MPFA could require disclosure of portfolio CG Rating in authorised mutual fund and MPF reports. • Statutory immunity • HAMS staff would need statutory immunity, which is already granted to staff of SFC and Consumer Council.

16. HAMS – Enforcement Division • Deterrent • This division would produce a credible deterrent both from existing laws and from future laws achieved by the Policy division. • Professional • HAMS would run a team of lawyers to select and pursue targets for claims based on merit and recoverability. If a settlement is not reached, litigation would be pursued. Cannot afford to pursue all cases, but a representative sample. • Quasi-class-action • HAMS would represent any member who held the stock in question at the relevant time, at no charge. Non-members could join HAMS to participate. • Costs would be drawn from the HAMS budget and deducted from winnings. This would produce a quasi-class-action system without reforming the entire legal system. It overcomes the prohibitive costs for most investors to enforce their rights. • Compensation net of expenses would be distributed pro rata to shareholdings.

17. Endorsing and Funding HAMS • No spontaneous combustion • No material shareholder activism has happened yet, and shareholders have no voice. HAMS has not and will not happen spontaneously. Private sector effort would not achieve critical mass of funding or action. • Government catalyst required • Government should care about HK’s competitive position. Good CG lowers the cost of equity and debt capital for our issuers, increases the quality of market and attracts new issuers and investors. A “World class” financial centre cannot be achieved without good CG, which will take years without shareholder participation in reform. • No taxpayer support needed - “User pays” • HAMS should be funded by the people it represents, the public investors, proportionately to their financial interest. The closest practical proxy for portfolio size, which does not rely on investor disclosure, is the volume of trading. Therefore a “Good Governance Levy” is the fairest way to go. “User pays” principle. • Year 2000 transaction volume was HK$3,048bn (US$391bn). A levy of 0.005% on the purchase and sale (total 0.01%) would raise over HK$300m per annum. A reserve would be needed to cover volume fluctuations, but this should support running costs of up to HK$200m (US$25m) per annum.

18. The Good Governance Levy • Minimal or no effect on transaction cost • Currently, investors pay government stamp duty of 0.1%, an SFC/SEHK trading levy of 0.01%, and brokerage of 0.25% or less. SFC gets most of its funding from levy. The recent budget cut stamp duty by 0.0125%, two and a half times the Good Governance Levy. • Levy works out at 0.008% of free float - it would take 125 years to pay 1%. You lose more than that each year from bad governance or outright theft. • LegCo as a balance • The Good Governance Levy and enabling legislation would require Legislative Council approval. Although HAMS Board of Governors would be investor-elected and would determine policy, HAMS would report regularly to LegCo on its progress, and the check and balance lies in the levy which can be amended or removed. • Start-up loan • Based on the certainty of an income from the Good Governance Levy, an initial start-up loan could be obtained from banks on normal commercial terms.

19. Hong Kong’s Competitive Position • Bad CG costs far more than a Good Governance Levy • The estimated bad governance loss of 2.5% p.a. is 300 times the Good Governance Levy as a percentage of free float. • HAMS won’t prevent all CG failures, but if just 1 in 10 “bad CG” events could be avoided by the action of HAMS, then it would reduce the “bad CG” drag factor by 0.25%, giving a 30-fold payback on investment. • WTO and Globalisation • Increasing globalisation forces HK issuers to compete at home and abroad with better-governed western companies who have lower cost of capital. We need good CG to remain competitive. Funding costs will be a key issue in competing in China post-WTO. • HK is now a Service Centre • HK’s manufacturing sector has moved to Southern China. Now more than ever, HK relies on Services – and at the heart of its services are trade and finance. Without a strong financial infrastructure, including good governance, the economy will suffer.

20. Hong Kong’s Competitive Position • An example to the Mainland and rest of Asia • Aside from its world-class aspirations, Hong Kong must not forget its leadership role as an Asian and Chinese financial centre. With the continued opening and reform of the mainland economy, and its need for strong and viable markets, it is crucial to Hong Kong’s role as a financial centre that we take the lead on CG reform. • The CSRC is serious about reform • Recent appointment of an ex-SFC Deputy Chairman to be Vice-Chairman of the CSRC underlines CSRC’s reform goals. Announcement of quarterly reporting from 2002 overtakes HK in disclosure for the first time! Latest news is a proposal to establish entity to take legal actions for damaged investors - is this CAMS? • China’s role in reform • A bubble market in mainland stocks forces regulators to address the bad corporate governance of the past decade since the market opened • The goal is to produce underlying fundamental substance when the bubble deflates. • If a burst makes the mainland equity markets dysfunctional, then the whole economic reform process from central planning to free market will be derailed, threatening the stability of the whole mainland system.

21. The Government’s Position • “ the HAMS proposal is a novel idea… we would welcome the views of the public on this proposal” • - HKSAR Financial Services Bureau 24th May 2001

22. Some Names from the HAMS Endorsement List