Speech By Mr Charles Lee Yeh-Kwong, Chairman Of Hong Kong Exchanges And Clearing Limited At Amcham Financial Services Committee Luncheon Meeting - Corporate Governance And Hong Kong's Listing Regime

Introduction

Corporate governance is very much in the news today, in government policy discussions, and in the minds of world investors. The failure of a number of prominent corporations in North America, have brought to the fore the serious consequences of lapses in corporate governance. It is now generally realized that corporate malfeasance can have serious economic and political consequences, causing loss of confidence and upheaval in financial markets. Good corporate governance is in the interest not only of investors, but of the good of the company itself. The perceived quality of a company's corporate governance can influence its share prices as well as the cost of raising capital. It can even affect the competitive position of whole financial centres. International investors prefer to use markets whose standards of corporate governance are seen to be high. Quality issuers are drawn to markets with good reputations.
What is corporate governance? Put simply, it is mainly about how accountability towards shareholders is exercised. First and foremost, this means systems to ensure that shareholders are kept well-informed in a balanced way about a company's financial performance and prospects, and that prompt and full voluntary disclosure is made of events and factors which materially affect the interests of shareholders. Corporate governance is also about checks and balances to prevent abuse of power. Such power may reside in a chief executive, if ownership of a company is widely dispersed (as tends to be the case in North America); or it may rest in the hands of an individual or family with a controlling shareholding, as more often happens in Asia. That is why much of the debate about corporate governance in HK tends to revolve around protection of minority shareholders.
Role of the Stock Exchange
The Stock Exchange plays an important role in HK's system for maintaining standards of corporate governance. The Listing Rules are currently the main instrument which prescribes many of the disclosure requirements of listed companies and their directors, as well as procedures for ensuring that all shareholders are treated equally and fairly - notably in relation to so-called "connected transactions". However, the Stock Exchange and its Listing Rules are only one element in a larger structure. The top of this structure is the statutory framework, which I will say more about later.
Over the years, the Stock Exchange has taken a series of initiatives to up-grade standards of corporate governance among HK-listed companies. These include a complete re-vamp of the Listing Rules in 1991, introduction of the Code of Best Practice for directors and the requirement for independent non-executive directors in 1993. The Stock Exchange also set up its own ad hoc corporate governance working group. The disclosure requirements in financial statements were expanded in 1997 and 2000.
Our most recent initiative was a Consultation Paper issued in January this year containing a number of proposals for amending the Listing Rules as they relate to corporate governance issues. We received many submissions and comments from the market, some of them quite strongly expressed. The results of the review are due to be published shortly. K.C. Kwong has already given the market a preview of the conclusions reached by the Executive of HKEx on some of the more controversial points - issue of shares under general mandates, definition of "associates", transactions between connected persons and associated companies, minimum number of independent directors, disclosure of directors' remuneration on an individual basis, and quarterly reporting. The proposals are now being considered by the two Listing Committees. After that, they will go before the SFC, without whose approval (as you know) no listing rule amendments can become effective.
Government's Review of the "Three-tier" Regulatory Structure for Listing Matters
While all this has been happening, other events took place which could have a much more momentous effect on HK's listing regime and our laws on matters related to corporate governance. I refer, of course, to the Government's appointment (following the penny stock incident) of an Expert Group of three experts to review the so-called "three-tier" structure for handling listing regulation. Since this review could affect both HKEx and the market profoundly, I would like to devote my main comments today to the issues under discussion in this context.
Let me say, first, that I welcome the review. The effectiveness of our listing regime is crucial both because of the major role which the equity market plays in HK's economy, and the importance to HK's prosperity of maintaining our position as an international centre for capital formation. The attractiveness of HK as a listing venue is also a key factor influencing the profitability of HKEx, which (as you all know) is now itself a listed company with public shareholders.
Perceived Conflicts of Interest
This brings me to a key point I would like to make. Few readers of the HK press will have failed to notice the views expressed recently by some suggesting that there is an irreconcilable conflict of interest inherent in HKEx's being a profit-making company and at the same time administering the Listing Rules, which is a delegated regulatory function.
This is an issue of principle which has been faced in a number of markets in recent years, as more and more stock exchanges around the world have demutualised - i.e. have ceased to be owned by stockbrokers and have been turned into public companies. This happened in HK in 1999 (under government initiative), largely because conflicts between the interests of the brokers and those of the market in general were hampering market development and creating regulatory friction. One of the main purposes of demutualising and listing the exchanges was to align the interests of the exchanges' shareholders more closely with those of the public.
It was recognised by Government, however, that giving the exchanges an ability to distribute dividends would create a new kind of potential conflict between their pursuit of profit and their important public interest functions. These functions extend, by the way, far beyond administering the Listing Rules; they include risk management in the clearing and settlement system, market surveillance and disseminating corporate disclosure material.
The issues raised by this new type of possible conflict were of course considered by securities regulators world-wide in bodies such as the International Organisation of Securities Commissions (IOSCO). A number of different solutions were recommended. The model adopted by HK falls well within IOSCO's range of suggestions.
One course of action considered by Government and the SFC in 1999 was to transfer responsibility for listing matters from the stock exchange to the SFC. After considering this route, both Government and the SFC decided against it, and their decision was endorsed by Legco when the Exchanges and Clearing Houses (Merger) Ordinance was passed.
However, to protect against the new type of potential conflict, and in recognition of the strong public interest involved in many of HKEx's operations, a variety of safeguards were incorporated into the new legislation. These include:
- A statutory duty for HKEx to act in the interest of the public and give precedence to the public interest over any of its other interests; the public interest must therefore be paramount in the minds of Board members when making any decisions;
- A majority of the Board of HKEx consists of "public interest" directors, appointed by the Financial Secretary;
- The Chairman of HKEx is appointed by the Chief Executive of the SAR;
- SFC Approval is required for the appointments of the Chief Executives of HKEx, SEHK and HKFE;
- All fees and charges levied by HKEx relating to its regulated business are subject to approval by the SFC;
- The SFC has power to give directions to HKEx if it considers a conflict of interest has arisen;
- HKEx, as a listed company, is regulated by the SFC, not by the SEHK.
These provisions in the law were reinforced by several further measures designed to eliminate or control potential conflicts. A new Memorandum of Understanding Governing Listing Matters was concluded between the SFC and SEHK which provides, among other things, for a clear separation between the decision-making process in relation to listing matters and HKEx's main business unit. The functions and powers of the Stock Exchange Board in respect of all listing matters were delegated to the Listing Committee, whose members are appointed through a process which gives a large measure of control to the SFC. The members of the Listing Committee are independent persons drawn from cross-sectors of the market including market practitioners and users (such as brokers, investment bankers, lawyers, accountants and fund managers) who have no interest of any kind in HKEx's bottom line. The idea that they could bend the Rules out of a desire to boost HKEx's revenues would be far fetched.
In addition to these numerous safeguards, the Listing Rules (and any amendments to them) are, of course, subject to approval by the SFC, and there is constant statutory oversight by SFC of Stock Exchange's performance of its listing responsibilities. This could reasonably be expected to identify any problems which might arise due to conflicts of interest. If any rule-bending were detected, the SFC has extensive powers to deal with it. No such problems have, in fact, arisen.
Finally, as I said at the outset, the new type of conflict is in my view more theoretical than real, because it is overwhelmingly in HKEx's commercial interest to maintain the integrity and fairness of the market; that is our main selling point in attracting investors and issuers, which is what ultimately drives our revenues.
I believe this array of safeguards, combined with a natural congruence between the interests of HKEx and those of the public, ought to be more than sufficient to convince any observer who is aware of the facts that HKEx's commercial interest could never in practice lead to a distortion of the listing criteria or rules.
Why HKEx Should Retain Listing Responsibility
Why, you may ask, did Government decide in 1999 that administration of the listing rules should remain with the Stock Exchange? And why does HKEx say that this is still the right formula for HK? There are many reasons. I have time to day only for one. But it is an important one.
This is that transferring the listing function to the SFC would not be a mere switch of administrative duties from one body to another. It would be a profound change in HK's regulatory system with far-reaching effects, because it would automatically cause the Listing Rules to become statutory. At present, as you know, the Listing Rules (although approved by a statutory body) form part of a contract between the exchange and each listed company. If making and administering the Listing Rules were transferred to the SFC, such Listing Rules would need to take the form of statutory rules issued under the new Securities and Futures Ordinance (SFO) -- that is to say, the Listing Rules would become subsidiary legislation requiring the vetting of the Legco. This would make the process of setting and amending the Listing Rules very lengthy.
Furthermore, there is a profound difference between the way statutory and contractually based rules operate. Statutory rules are "black letter law". Their application necessarily becomes more rigid and legalistic and generates more frequent recourse to the courts, particularly when parties dislike the decisions they receive. The handling of cases would almost certainly be slower and more expensive. HK's capital formation system would become less efficient.
Preventing Abuse of Minority Shareholders
Hong Kong's investor protection regime is built on a combination of common law, statutory law (including the Companies Ordinance and the SFO), non-statutory rules such as the Listing Rules and codes of practices, for example, the Codes on Takeovers and Mergers and Share Purchases. Advocates of transferring the listing function to the SFC are, I believe, largely motivated by a desire to improve HK's investor protection regime, particularly as it affects minority shareholders. Their hope is that, if the Listing Rules were made statutory instead of contractual, they would acquire more "teeth" to deter abuse of minorities.
While I share the desire to strengthen HK's regime for protecting minority shareholders, I believe profoundly that trying to do this by making the Listing Rules statutory is the wrong approach and would create a great deal more problems than it solved. The correct way to address this problem, in my view, is to enhance basic rights of shareholders by carefully- targeted amendments or additions to primary legislation.
In relation to abuse of minority shareholders, one of the effective ways to help minority shareholders is to give them the power to defend themselves by bringing actions against directors or company controllers who indulge in abusive practices. Fear of such actions can have a powerful effect on corporate conduct. Such provisions exist in the legislation of most countries with well-developed financial markets.
Generally speaking, the statutory remedies under the Hong Kong laws that are available to shareholders are the "unfair prejudice" remedy and winding up on just and equitable grounds under sections 168A and 177 of the Companies Ordinance respectively. The Securities and Futures Commission Ordinance is also empowered to take such action for the public interest under section 37A of the Securities and Futures Commission Ordinance. However, these appear to have proved difficult to use and are therefore very seldom invoked. I shall refer later to a number of proposals made by the Standing Committee on Company Law Reform (SCCLR) aiming at enhancing protection of minorities.
There have been some recent and relevant changes in primary legislation which will come into effect next year. These include the inclusion in section 391 of the SFO of an explicit right of action for an investor, or group of investors, who become victims of false or misleading statements in corporate disclosure material.
In addition, it is provided for in the new SFO the so-called "dual filing" system. This will give statutory "teeth" to corporate disclosure rules. Under the new system, the SFC will issue rules for the statutory filing (although this may still be done via the Stock Exchange) of corporate disclosure material such as listing documents, financial reports, circulars to shareholders (for example, about connected transactions) and company announcements (for example, explaining unusual share price movements). It will be a criminal offence to knowingly file any false or misleading information.
It should be noted that introducing this dual filing system required no change in the status of the Listing Rules, nor in HKEx's role as front-line regulator in relation to listing matters.
As I mentioned earlier, the SCCLR 18 months ago also put forward a number of proposals which relate to protection of minorities, in a Consultation Paper which formed part of its Corporate Governance Review. These include the following new provisions to be added to the Companies Ordinance:
1. A derivative right of action should be introduced allowing shareholders or directors (without leave of the court) to bring an action on behalf of the company for a wrong done to the company where the company is unwilling or unable to do so; the grounds for such action would include fraud, negligence, default in relation to any laws and breach of duty; this remedy would apply to companies listed in HK, whether registered here or not.
2. The "unfair prejudice" remedy under section 168A of the Companies Ordinance should be extended in various ways, including a power for the court to award damages and compensation of costs to shareholders, and to require controlling shareholders to buy out the minority shareholders; this remedy would also be extended to members of overseas companies listed in HK (unfair prejudice would, incidentally, include the payment of excessive remuneration to directors, diversion of assets, and the use of corporate assets to subsidise the business of related persons).
3. The SFC would be able without court approval to bring derivative actions against wrongdoers in relation to a listed company (including an overseas company) for breaches of duty, including fraud, negligence, default in relation to any laws, breach of duty and any other misconduct in relation to an investigation or the recovery of property.
4. Transactions in which any director or connected person of a HK-registered company has an interest should be disclosed to shareholders; where such transactions are significant, they should be referred to disinterested shareholders for their approval.
5. Approval of disinterested shareholders in HK companies should be obtained in relation to transactions (including the acquisition or disposal of assets) above a specified size involving directors, or persons connected with directors, or potentially benefitting such persons.
6. Connected transactions involving controlling shareholders of HK companies must also be disclosed and subject to a disinterested shareholders' vote.
  If the SCCLR's eventual recommendations resemble the proposals in its Consultation Paper, and are accepted by Legco, a considerable amount will have been done to address the problem of minority shareholder abuse.
One additional point which perhaps needs to be addressed is the cost to an individual shareholder of bringing unfair prejudice or derivative actions. As we all know, this is very high in HK. Our legal system does not permit class actions and contingency fees. Institutional investors in HK have not so far shown the kind of shareholder activism which exists in the UK, for example. If the SFC had the ability to assist in funding such actions, in cases where it considered this would serve the public interest, that could have a powerful effect on the conduct of listed company directors.
To sum up, I believe the focus in recent public debate on making the Listing Rules statutory is aimed at the wrong target. The Listing Rules are only one plank in a much larger structure which should deal with abusive corporate practices of all kinds. Unfortunately, the Listing Rules are a plank upon which advocates of stronger investor protection have tended to place excessive weight, because some of the statutory planks are weak or missing. Getting the right provisions into the law is where the focus of debate should be.
I shall be happy to answer any question you may have.