Tighten, not ease, governance rules to promote Hong Kong's market

Higher standards will boost valuations of listed firms, attracting both issuers and investors to the city and enhancing its financial hub status

PUBLISHED : Tuesday, 10 December, 2013, 2:51am
UPDATED : Tuesday, 10 December, 2013, 8:55am

A couple of months ago, mainland internet giant Alibaba cancelled its proposed stock offering in Hong Kong.

It pulled the deal after being told plans that would have allowed holders of 10 per cent of the company's stock to stuff the board with their own directors failed to meet the Hong Kong stock exchange's governance standards.

Inevitably, the decision prompted a chorus of complaints. By insisting on such onerous standards, the city was deterring listings from high-profile companies, grumbled local financiers. If Hong Kong is to compete successfully as an international financial centre, it must take a more flexible approach.

Even exchange chief executive Charles Li Xiaojia was swayed. In his blog, he described the existing rules as "extreme" and argued that "innovative companies" deserved special consideration when it came to governance.

If Hong Kong was not prepared to modify its stance, the city "could lose the chance to embrace the future and all the benefits it would bring", he warned.

This prevalence of controlling shareholders erodes internal controls [and destroys] value

In other words, Hong Kong should consider relaxing its governance rules to promote the city as an international financial centre.

Whether that approach would work is doubtful. On the contrary, there is strong evidence that Hong Kong's position as a financial centre would be enhanced by tightening its governance rules, not by loosening them.

The city likes to congratulate itself as a paragon of good governance. But although it performs well on some scores, like the governance components of the Global Competitiveness Report published by the World Economic Forum, specialist researchers question the city's reputation.

For example, the 2010 league table compiled by New York-based governance consultancy GMI Ratings ranked Hong Kong a lowly 26th out of 39 markets for corporate governance with a score of just four out of 10.

That placed Hong Kong only slightly above the average for emerging markets and far behind Britain, with a score of 7.6, and the United States, on 7.16 (see the first chart).

Other studies come to similar conclusions. The Asian Corporate Governance Association ranks Hong Kong-listed companies poorly for their governance rules and practices, while this year the Hong Kong Institute of Directors warned that standards of transparency and directors' responsibility were deteriorating.

These dismal ratings should be worrying because poor corporate governance means poor price performance.

According to GMI, between 2005 and 2012, shares in Asian companies that rank among the best 10 per cent in the region for accounting and governance risk outperformed those of the worst-governed by 94 per cent (see the second chart).

Bryan Michael and Say Goo at the University of Hong Kong believe many of the city's governance problems can be pinned on the abnormally high proportion of listed companies - 70 per cent - tightly controlled by dominant, often family, shareholders.

This prevalence of controlling shareholders, they argue, erodes internal controls, undermines the effectiveness of independent directors, weakens the integrity of earnings reports, suppresses innovation and leads to poor capital allocation, ultimately destroying value.

As a remedy, they propose an 18-point list of recommendations to shift the relative balance of power away from controlling interests and towards minority shareholders. That, they argue, would improve Hong Kong's corporate governance and so boost valuations.

And rising valuations will attract both issuers and investors to the city, enhancing Hong Kong as a financial centre far more effectively than racing to the bottom with looser governance standards.

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