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With the announcement of Shenzhen Connect, we’ve begun to see a substantial increase in the Southbound trading of Hong Kong shares by Mainland investors, particularly after Mainland insurance companies got the green light to access the Connect programme. With growing interest in the Hong Kong market, we have also begun to notice that Mainland investment commentaries have become increasingly focused on one particular area of the Hong Kong markets: the easy access to refinancing through instruments like deeply discounted rights issues and share consolidations, which happen occasionally. Citing individual cases where some Mainland retail investors felt “trapped” in some of these transactions, the commentators cried foul and asked why Hong Kong regulators don’t “weed out” such practices all together.
We clearly recognise the continued need to enhance our market quality. In light of the increasing pace of regulatory actions to strengthen the oversight of the secondary markets, I wrote a blog directly in Chinese to offer our Mainland investors some perspectives on how the Hong Kong markets operate, particularly some of the philosophical differences in market regulations between the Mainland and Hong Kong. The following is a summary of the key underlying messages, but not a direct English translation of the blog which was written to answer some typical questions from a Chinese retail investor.
Should the regulators be smart enough to identify the bad guys and take decisive actions to weed them out?
As much as the regulators want to “weed out” the bad guys, the regulator cannot possibly tell who is good or bad until a violation has taken place. Hong Kong regulators typically don’t pass their own judgment on good companies against bad companies in terms of investment. All it cares about is whether a market player has committed any legal or regulatory breaches and if so, take action. Since our system is based on due process and rule of law under which one is presumed innocent until proven guilty, it will take time, resources and efforts to prosecute and convict offenders in Hong Kong. While this means bad guys may not always be effectively caught, it is extremely unlikely that an innocent person would be wrongfully convicted.
Why can’t regulators in Hong Kong do more to prevent bad acts from happening?
There are two fundamentally different approaches in regulating a market. The first is to set up a system of strict pre-approvals so that regulators can try to screen out bad actors before they act. This is a great approach in theory, but in reality it does not always work and it has significant negative side effects. Such an approach might be appropriate in a market that is dominated by retail investors like the Mainland; Hong Kong, however, which is primarily an institutional investor market, follows a different practice: it assumes that people have good intentions and will follow the rules, but monitors the market closely and will punish those caught doing something wrong. An excessively stringent system of prior approvals would impact the freedom of all players and undermine normal market activities.
So instead, with a focus on compliance and enforcement, we have Listing Rules that contain mandatory disclosure requirements and give shareholders the right to participate in the decision-making process for major transactions. Regulators in Hong Kong can’t dictate the business decisions of listed firms, but they do ensure shareholders have a say. This is a fundamental difference between the approaches in the Mainland and Hong Kong.
Some market instruments in Hong Kong, such as deeply discounted rights issues and share consolidations, can be easily abused. Why don’t Hong Kong regulators ban them or make them much more difficult to use?
Again, philosophically, rights issues, placements, share consolidations, and other re-financing tools are not inherently problematic and are merely neutral tools available to companies that allow them to raise funds more easily, conveniently, and efficiently at lower costs in the secondary market. But we know that some bad guys may use these tools for nefarious purposes; lots has been done to clean them out and more is still needed. In doing so we need to strike the right balance between providing the right tools to support normal market operations and doing our best to follow-up on those who use the tools for the wrong reasons. Think of it like a kitchen knife: it’s great for chopping meat and seafood, but it can also be used for much worse things. But we don’t ban sharp kitchen knives because of what they might be used for. Regulators in Hong Kong work very hard and very diligently to try and maintain this balance.
What can Mainland retail investors do to protect themselves?
The first thing Mainland investors need to know is that the Hong Kong markets are different from the Mainland markets and they need to understand the differences and act accordingly. They need to take responsibility for their investment decisions and not hold out unrealistic hope that someone else, like the government or regulators, might come to their rescue should they make a bad investment decision.
They should therefore focus on companies that are well known, well traded and well covered by the analyst community. They should seek advice and counsel from investment professionals. If they choose to invest in some “special situation” companies where they believe they have a “tip” or some other advantage, they need to exercise extreme caution. Shareholder approvals are typically required for major transactions and in some cases the controlling shareholders are not allowed to vote. So Mainland investors must pay attention to these events and exercise their rights to reject transactions they don’t believe are in their best interests. They should also stay vigilant, regularly review their investments and make timely decisions.
Finally, the differences in the two markets are why investor eligibility requirements and eligible stock lists were introduced with Stock Connect in 2014 and why some restrictions remain in place for the upcoming Shenzhen Connect. We feel over time, as Mainland investors become more comfortable and more familiar trading in Hong Kong, these restrictions will be relaxed.
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