Vocational Training Council 20 th Anniversary Distinguished Lecture - - PowerPoint PPT Presentation

Vocational Training Council 20th Anniversary Distinguished Lecture Series “Post-Enron impact on regulation of financial markets”

by Andrew Sheng Chairman Securities and Futures Commission 23 September 2002

2

Post-Enron Impact

 Corporate governance failure is global issue  Total market cap loss for Enron and

WorldCom was US$80 billion (HK$624 billion), roughly equivalent to the drop in the whole Hong Kong market capitalization

3

Summary of Lecture



An overview of what went wrong and what the major markets are doing to fix it



The current structure of regulation of listed companies in Hong Kong



The role of the SFC in tackling corporate misconduct



Views are totally personal, and not necessarily the views of the Commission, including non- Executive Directors

What went wrong and what are major markets doing to fix it?

5

Major Market Changes in Regulatory Framework



Post-tech bubble, US and European regulators realized that the bubble may have been partly fuelled by bad accounting and corporate misconduct



Corporate governance has failed because the various checks and balances within the system have been weakened by the conflicts of interest that exist at different levels



Corporate governance is steeped in each jurisdiction’s financial, legal and market history

6

US Regulatory Structure



1929 Wall Street crash, led to the 1933 and 1934 securities legislation that founded the SEC



US system premised on statutory disclosure, with companies seeking public funding being required to file statutory information with the SEC, now under the famous EDGAR[1] system.



Rules-based system is based on “caveat emptor”,

• r buyer beware, with a set of rules that specify the

disclosure that issuers must make to investors and the public, and which is presumptively material

[1] Electronic Data Gathering, Analysis, and Retrieval system.

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Lines of Defence in Corporate Misconduct

US system has four lines of defence



First, the management or Board of Directors itself, including the independent non-executive directors, who should represent the public interest



Failure of fiduciary duty:

 “The Enron Board of Directors failed to safeguard Enron shareholders and contributed to the collapse of the seventh largest public company in the United States, by allowing Enron to engage in high risk accounting, inappropriate conflict of interest transactions, extensive undisclosed off-the-books activities, and excessive executive compensation” (Senate Report)



Can underpaid non-executive directors stop important corporate misconduct? Still being debated

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Second Line of Defence



Second line of defence lies with the corporate advisers, (auditors, lawyers, professional valuers, sponsors, investment bankers, bankers and rating agencies) who provide independent and professional advice on corporate performance, including compliance with the relevant codes of conduct, rules and laws



Question of independence of opinion calls for regulatory oversight



US and some parts of Europe, auditing profession has public oversight



UK, other parts of Europe and Hong Kong, professions by and large are still self-regulatory

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Third Line of Defence



NYSE and NASDAQ assess eligibility according to their rules and quantitative criteria, but all the issuers must file statutory information with the SEC



SEC sanctions range from fines to jail sentences, on the provision of false or misleading information. Willful violation of securities regulations is a criminal offence



Delist companies that do not perform. e.g. NASDAQ delisted 770 companies last year, of which 390 were delisted for non-compliance with listing requirement



US state and federal prosecutors’ offices can take severe action against corporate theft or fraud

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Fourth Line of Defence



Class action-contingency fee system, whereby shareholders can jointly undertake direct legal action against management or majority shareholders where they feel that they have been disadvantaged



Such a powerful weapon in the hands of minority shareholders ensures that directors, controlling shareholders and their advisers are more careful to act without provoking costly class action suits



Such system is not available in the UK, Australian and Hong Kong legal systems, because of different legal tradition and risks of a litigious society.



Despite these checks and balances, Enron and WorldCom happened

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US Sarbanes-Oxley Act

Strengthen corporate governance and auditing oversight:



Independent Public Company Accounting Oversight Board to enforce professional standards, ethics and competence for the accounting profession



Prohibit the provision of consulting services to audit clients, when these services create conflicts of interest



CEOs and CFOs to vouch for the veracity of their financial statements and much stiffer penalties for fraud



Strengthen disclosure requirements for public companies, notably off-balance sheet transactions and insider trading



Review rules to protect independence and objectivity of securities analysts;



Reviews of corporate governance, the separation of audit and non-audit work, and the role of rating agencies



Increasing the resources available to the SEC

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European & UK Reforms

 EU has issued various directives on disclosure & listings:

 Prospectus Directive, the Transparency Obligations Directive, the Investment Services Directive, the Market Abuse Directive and the amendment of the Admissions to Listing Directive

UK has upgraded company law and securities regulatory

framework:

 Competent Authority for Listing transferred from LSE to FSA in May 2000. Authority makes and ensures compliance with Listing Rules, and admits securities to the UK’s Official List  White Paper issued in July this year indicating that companies law would be simplified and modernised  On 31 July, FSA issued consultation paper on the review

• f the listing regime

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Reforms in Australia and China

 In Australia, the Corporate Law Economic Reform Program

(CLERP) Act came into force in March 2000:

 Introduced statutory derivative action against corporate wrongdoing, which modified the common law action and circumstances under which shareholders can enforce their rights  Clarified directors’ duties of care and diligence  Established new institutional arrangements for the Australian accounting standard setting process

CSRC made impressive corporate governance reforms

 Appointment of independent non-executive directors  Quarterly reporting  Delisting of poorly performing companies  Strengthening enforcement by closer cooperation with the police

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Hong Kong’s Initiatives



HKEx consultation paper on Listing Rules relating to corporate governance, completed in May, but awaiting results.



SCCLR review of corporate governance in 2000, widespread support for its proposals issued in July 2001.



Phase II of SCCLR’s review due by end 2002.



New SFO will enhance transparency, establish MMT, augment SFC investigatory powers, and provide investors with private cause of action for false/misleading public communication



Subsidiary legislation on dual filing to make SFC statutory regulator of information disclosure, closer to US SEC model



SFC co-chairs IOSCO Task Force on Transparency and Disclosure with CONSOB to develop a set of International Ongoing Disclosure Standards (IODS)

The Current Structure of Regulation

• f Listed Companies in Hong Kong

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Regulation of Listed Companies



Recent spate of minority shareholder activism is healthy sign



Suspicious transactions less obvious during bull market, because all investors hope that asset prices would rise



In a bear market, minority investors concerned majority shareholders may enter into transactions that may dilute their interests or be prejudicial to their rights.



Need to regulate listed companies as they have a duty to the public to be honest and fair in their dealings.



Listed companies are normally regulated through entry requirements, their conduct in transactions and the enforcement of applicable legislation, such as the Companies Ordinance and the SFO

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• Fig. 1 – Corporate Governance:

Entry, Conduct & Exit

HKEX Official Receiver ICAC CCB, Police FS Registrar of Companies SFC SFC HKEx HKEx

Regulator

LR – Non- statutory Companies Ordinance – statutory Statutory Statutory Statutory Statutory Non- statutory Non- statutory Non- statutory

Legal Status

Delisting

• Listing

Rules

• Insolvency

Anti- Corruption Laws

• Corruption

Criminal Law

• Stealing
• Fraud

Companies Law

• Special

Investigation

• Prospectus

law Securities and Futures Ordinance

• Investigation
• Insider

dealing

• Market

manipulation

• Protection of

share- holders’ rights Takeovers & Mergers Code

• Regulation
• f

acquisitions & mergers Listing Rules

• Corporate

Disclosure

• Director &

Board Practices

• Protection
• f share-

holders’ rights Listing Rules

Code, Rules and Law

EXIT CONDUCT & TRANSACTIONS ENTRY

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Regulatory Regime in Hong Kong



Regulation of listed companies cuts across various regulators



Exchange in charge of entry requirements for listed companies



Oversight of the conduct of business:

 the Stock Exchange under Listing Rules  SFC in Takeovers Code, insider dealing and market manipulation  ICAC in corruption  CCB in fraud and theft



The FS can appoint special inspectors under Section 143

• f the Companies Ordinance.



The exit of companies depends upon the Listing Rules and also on the liquidation process.



Corporate misconduct has different levels of seriousness, ranging from incompetence, and unfair transactions to outright stealing

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Regulation of Corporate Conduct



Most listed companies in Hong Kong obey the law:-

 S&P’s review of Hong Kong Corporate Governance*: “compared with other Asian countries, Hong Kong is a leader in the corporate governance domain.”



Fundamental principle of full and fair disclosure is to provide all information material or relevant to an investor’s investment decision as to its financial condition and future prospects. Enforcement against false and misleading information.



Several regulators involved in “middle ground” of transactions to ensure that rules are complied with before the transaction happens.



“After-the-transaction” enforcement actions, which require investigation and prosecution of wrongdoing, involve SFC Enforcement Division, the Police and sometimes the ICAC

*Standard & Poor’s, “Corporate Governance in Hong Kong”, 15 February, 2002

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Changes in Regulatory Perception



SEHK (part of HKEx) is the frontline regulator of listed companies, administers the Listing Rules which govern entry, large part of conduct of listed companies and exit or delisting



Merit-based regulatory system for the Main Board, and disclosure-based regulatory system for GEM



After demutualization and listing of HKEx in 2000 perception

• f its regulatory role changed:

 A for-profit exchange could not be given statutory enforcement powers. Relationship with other listed companies is contractual  Tackling corporate misconduct involves cost and risk, and

• ften no commercial gain. Tough enforcement cases can

lead to lawsuits that hurt corporate value  A widely held view that a listed company should not regulate

• ther listed companies

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Defences in “Middle Ground”



First and second lines of defence against corporate misgovernance lie in integrity and conduct of management, Board committees and corporate advisers, which fall under the purview of the Listing Rules which carry no statutory sanctions



Third line of defence depends on regulators in the Listing Rules, administered by the Exchange, and the Takeovers Code, administered by the SFC



Thousands of commercial transactions daily do not involve regulators as corporate governance framework good



Courts are fourth line of defence. They are, quite properly, entrusted with deciding whether a transaction is legitimate.



As litigation is expensive with no class action/contingency fee system, not surprising that shareholders call for the regulators to intervene in

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Regulation of “Middle Ground”



Under Listing Rules or Takeovers Code, SEHK or SFC respectively conducts due diligence on compliance, with requirements for greater disclosure, requests for clarification and independent valuation as needed



In appropriate circumstances, voting by independent shareholders



At the controversial end of the spectrum of transactions are those that appear unfair but comply with the non-statutory rules.



These would require rule changes, which should then go through the appropriate market consultation and due process

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Are Sanctions under Code Adequate?



Can corporate behaviour be effectively regulated through non-statutory rules or codes, where private/public reprimands or censures are seen at best as slaps on the wrist?

 They can work where breaches results in exit, or where non- compliance can result in exclusion from the market. In the case of listed companies, delisting has not so far been used as a disciplinary tool



SFC identified this issue and we consulted the market in May on “dual filing”, which would make the Commission the statutory regulator of listed company disclosure



Dual Filing powers will come into effect early 2003

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Dual Filing Powers



If disclosure is materially false or misleading, SFC can investigate and has a range of enforcement actions:

 Suspend trading in listed securities  Apply for court orders to remedy oppression, inadequate disclosure, unfair prejudice or crime or misconduct  Injunctions to restrain breaches of the SFO  Recommend to the FS civil actions before the Market Misconduct Tribunal  Criminal prosecution  Winding up applications  Disciplinary action (including fines up to $10 million, reprimands, revocation and suspension of licences) against a listed company's SFC licensed corporate finance advisers

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Dual regulator model adds complexity and costs in defending “Middle Ground”



Dual or split regulator framework in “middle ground” results in lack of clarity and adds complexity and costs to the whole process. No one regulator has the total picture

• f what the perpetrator is up to.



Regulatory arbitrage can occur, as a transaction that fails the regulatory test under one set of rules could be modified with a similar motive under another set of rules



Hence, Hong Kong model different from US model, but closer to UK model, except FSA can impose fines for breach of Rules.



Like SFC, FSA can be checked by administrative appeals, and judicial review.

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Two Key Policy Issues



First, should we move to a statutory regime to improve corporate governance to protect shareholders’ rights?



Second, should the present “middle ground” regulatory structure and processes be simplified so as to avoid duplication and delays in regulatory response to corporate misconduct?



These questions require wide public consultation and only the government and legislature can answer. Ample international experience and debate on these issues



We welcome proposal by FS for Expert Group to study these issues.

The Role of SFC in Combating Corporate Misconduct

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Role of the SFC Enforcement



We have seen that there is no single designated corporate regulator in Hong Kong.



SFC shares regulation of the conduct of the listed company sector in the policing of insider dealing, statutory disclosure of interests in securities and inspecting the books and records of listed companies if impropriety is suspected.



In areas such as corruption, fraud and theft, and cases

• utside the jurisdiction of Hong Kong, the SFC

cooperates with other regulators, such as the Stock Exchange Enforcement Division, the CCB and ICAC, as well as overseas regulators to investigate and pursue enquiries

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Hong Kong Corporate Features



Three factors that govern approach to combating corporate misconduct



Nearly three quarters of the companies listed in Hong Kong are incorporated outside Hong Kong



Many of the listed companies in Hong Kong also have substantial operations outside Hong Kong



SFC must cooperate closely with both Hong Kong and

• verseas regulators to investigate companies listed in

Hong Kong

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Why the Secrecy?



Section 59 of the SFC Ordinance imposes an obligation of secrecy on SFC personnel in conducting investigations



First, any announcement of investigation can lead to a sharp drop in the share price of the company being investigated, causing potential losses to the shareholders



Second, any information leakage may tip off those under investigation, leading to the destruction of evidence or abscondment



Third, such leaks may prejudice subsequent criminal trials



SFC is currently investigating a number of cases that have received high media profile in recent months

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Enforcement of Corporate Governance Top Priority



Initiated 4 s29A investigations and 3 s33 investigations since March into listed companies



19 active cases under discussion with the CCB - 7 cases involve listed companies



One of the best records in insider dealing prosecutions

• utside the US. Last year, 3 major successes, disgorging

$22.8 m in profits and $23.2 m in penalties. 12 more cases pending



4 people convicted in 3 cases last year for market manipulation



4 more persons convicted in 2 cases, with full cooperation with the CCB in Q1 ’02. The CCB has charged 2 more persons

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Increasing Successful Prosecution Record

 14 persons and 8 companies successfully

prosecuted and fined for SDIO prosecutions, 72 warning letters issued up to March. 4 persons and 2 companies have been prosecuted under SDIO, and 16 warning letters were issued Q1 ’02

 Last 12 months, 2 “cold shoulders” under the

Takeovers Code, and 4 active investigations involving serious breaches of the Code

33

Derivative Action



The Government has taken advice of the SCCLR and asked SFC to look into possibility of developing a statutory derivative action. SCCLR pointed out that the common law derivative actions for shareholders are complicated. SFC actively studying the matter



SFC successful in suit under 37A of SFCO in the case of Mandarin Resources for unfair prejudice. Investigation and case took 6 years, but we persevered to successful settlement



For those engaged in corporate misconduct, we will not hesitate to use our powers under the [SFCO] to pursue them to court. Enforcement colleagues are already actively looking.

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Strengthening our Enforcement



15 staff being added to beef up enforcement and corporate finance area to undertake dual filing as a matter

• f priority



Strengthening cooperation with both the CCB and the CSRC in the investigation of corporate misconduct in Hong Kong and also the activities of Hong Kong listed companies in the Mainland



Increasing vigilance and strive to complete investigations as fast as we can work together with our regulatory counterparts



In short, those who break the securities law are now

• warned. We will pursue them without fear or favour.

Those who break the law will be investigated and prosecuted in accordance with the law

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Final Notes



If Hong Kong is to maintain international financial centre and Mainland fund-raising role, must press ahead with reforms in regulatory and infrastructure areas.



“Regulation is like frying small fish – it must not be

• verdone”. 治 大 國 如 烹 小 鲜



If we over-regulate, we stifle entrepreneurship and add costs.



If we under-regulate, Enron and WorldCom demonstrate the huge costs imposed on biggest and best regulated of markets.



No easy solution to find right balance.

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Final Notes II



The Commission is committed to defending the integrity of

• ur markets.



There are clearly structural issues in the Hong Kong regulatory framework that need to be addressed.



Irrespective of these factors, the Commission will work closely with the Stock Exchange and all the other regulators in Hong Kong and abroad to tackle corporate misconduct as a matter of top priority.



We all share the same objective to protect the integrity of

• ur markets and the rights of shareholders.

Thank you very much

SFC Website : www.hksfc.org.hk