Debating merits of cornerstone investments

As with all regulatory reforms, Hong Kong Exchanges and Clearing's proposal to restrict cornerstone investments is drawing support as well as opposition, even within the bourse.

Industry participants clearly have two views in play.

In one camp, a legislator representing brokerage constituents, an academic who sits on the listing committee and a listed company executive uphold the proposed curbs. In the other, an investment banker, Hong Kong's best-known shareholder advocate, and another listing committee member do not see much wrong with such investments.

Hong Kong is one of a few developed markets that set aside a portion of new shares for individual investors. Only institutional investors are solicited in some western markets.

In a consultation paper issued last Friday to invite comments until April 7, the HKEx tabled a range of suggestions to change the listing rules. Among them is a proposal to restrict cornerstone investors.

In many initial public offerings in recent years, sponsors and issuers guarantee investors such as Li Ka-shing, Lee Shau-kee and Cheng Yu-tung or other corporations, substantial share allotments provided they agree not to sell their holdings from six months to three years.

The HKEx's biggest concern is that the lock-up period will affect the post-listing liquidity of the public float, which is required to be at least 25 per cent of a company's capitalisation.

Saying the investments 'may also increase the potential risk of market manipulation as a result of the limited liquidity', the exchange proposes not counting the stakes held by cornerstone investors in the public float.

The local bourse did not make any reference to overseas regulatory regimes for comparison.

'The concern over cornerstone investors of new offerings is rather unique to Hong Kong because of the way the initial public offerings are brought to the market and the considerable interest retail investors express in the IPO market, compared to the UK and the US,' said Patrick Wong, a partner of law firm Johnson Stokes & Master.

Brokers agreed with Mr Wong. They noted that in key markets such as the United States, retail investors are not given the same opportunity in an open process as in Hong Kong to subscribe to new shares.

Underwriters there give institutional investors first choice. The only way individual investors get allocated shares is if they have a trading account of considerable value at one of the underwriting investment banks.

Locally, it has become popular for listing candidates to invite substantial individual or corporate investors as a marketing strategy. With Mr Lee turning out to be such a 'Midas of stocks' last year, lining up cornerstone investors is like getting a vote of confidence in a new listing.

Cornerstone investors are allocated shares from the retail tranche and here lies the problem. Although the retail portion is usually smaller than the institutional tranche of the public float, locking up shares held by these substantial investors for up to three years will raise a stock's price by reducing its liquidity, the consultative paper argued.

Chim Pui-chung, the legislator representing the stock broking industry, agreed with the HKEx's proposal.

'Of course, the cornerstone investors will boost public confidence in the IPOs but it also means these tycoons - but not other retail investors - are guaranteed to get the new shares. It's unfair to other retail investors,' Mr Chim said.

'I do not think we should go so far as to ban the practice but at least there should be a cap on the amount of shares given to these tycoons to ensure it won't hurt the chances of other retail investors during a popular IPO,' the legislator added.

Kelvin Wong Tin-yau, the executive director and deputy managing director of Cosco Pacific, agrees. His firm was listed in 1994 - without a cornerstone investor.

'There should be a cap on the amount of shares guaranteed to cornerstone investors,' Mr Wong said. 'It's good for the exchange to propose not counting cornerstone stakes in the public float. This will encourage issuers to allot more shares to fund managers and retail investors.'

Listing committee member Low Chee Keong, an academic and corporate governance expert from the Chinese University of Hong Kong, has been advocating more regulation of cornerstone investors.

He said that in 2006, seven of the eight new share offerings featuring cornerstone investors - all H shares - were hugely oversubscribed by institutional and retail investors who viewed positively the mainland's strong economic growth.

Meanwhile, not all listings with cornerstone investors needed big names to boost retail investor confidence as many simply could not get any shares.

Alibaba.com - the hottest listing last year - collected HK$450 billion from retail investors and was oversubscribed 250 times. Although priced at the top, the stock gained 192.59 per cent on its trading debut in November.

Aliliba had a roster of cornerstone investors, including Yahoo, Industrial and Commercial Bank of China, Cisco Systems and the Kwok brothers of Sun Hung Kai Properties.

Another hot deal, China Railway Group, whose retail tranche was oversubscribed 208 times last month, included nine cornerstone investors including China Life Insurance, Kerry Holdings, SHKP, Henderson Land Development and Wharf (Holdings).

Mr Low said these investors appeared to have received preferential treatment in these offerings.

'One must ask whether such arrangements are intended to benefit the company or the cornerstone investors. Although cornerstone investors do not breach the listing rules - as there are no such provisions to begin with - there is nonetheless a legitimate concern as to the fairness of such arrangements,' he said.

The academic questioned whether the practice had 'outlived its purpose', given that the 'mainland has metamorphosed into an economic powerhouse'.

On the other hand, HKEx non-executive director David Webb and well-known champion of the cause of minority shareholders, does not believe cornerstone investors are unfair to individual investors.

'This is not unfair. The general public is not entitled to IPO allotments. They are entitled to free speech, freedom of assembly and freedom of movement but IPOs are not a form of social welfare nor civil right. It should be up to an issuer and its advisers to structure the issue to achieve the best proceeds for the company or vendors,' Mr Webb said.

Carlson Tong Ka-shing, the chairman of the listing committee, said cornerstone investors would boost confidence in a downturn.

'When the market for mainland shares is 'hot', as it has been recently, one may question the value and fairness of having these cornerstone investors,' Mr Tong said. 'But market sentiment can change, so I believe there is no straightforward answer.'

Mr Kelvin Wong said substantial investors would be of little help when sentiment is poor, as they would be reluctant to agree to a lock-up period or 'would demand the shares at a low price or in small amounts', he said.

'[Cornerstone investors'] contribution to the success of an IPO is no different from other investors,' he said as he argued for a rule 'to ensure all investors get equal treatment'.

Not surprisingly, deal arrangers are trying to fend off any curbs.

'The arrangement of cornerstone investment should be decided among the issuer, sponsors, underwriters and the cornerstone investors,' said Joseph Tong Tang, Sun Hung Kai Financial's executive director. 'Cornerstone investors are longer-term investors, partly due to the lock-up, which benefits the issuer as well as other investors.'

Mr Tong also said even without the cornerstone allocations, retail investors are not guaranteed to receive more new shares. Most shares are placed with institutional investors.

Cornerstone investments are a two-edged sword. Since these investors spend large sums but are banned from selling the shares for a period 'they are also taking substantial market risk, especially in an uncertain market environment', Mr Tong said.

'The stock market ... has been volatile and this is proof that there is no guarantee that cornerstone investors definitely will make a profit when the lock-up period is over.'