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Toronto Leadership Centre Case Study: The Hong Kong Penny Stock Incident

Toronto Leadership Centre Case Study: The Hong Kong Penny Stock Incident By Andrew Sheng Former Chairman, Securities and Futures Commission of Hong Kong Professor, Graduate School of Economic Management, Tsinghua University, Beijing 28 July 2006 1

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Toronto Leadership Centre Case Study: The Hong Kong Penny Stock Incident

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  1. Toronto Leadership Centre Case Study:The Hong Kong Penny Stock Incident By Andrew Sheng Former Chairman, Securities and Futures Commission of Hong Kong Professor, Graduate School of Economic Management, Tsinghua University, Beijing 28 July 2006 1

  2. Crisis or Incident? the leadership challenge • On 25 July 2002, penny stocks (defined as those under HK$0.50 (6.4 US cents) per share) declined in 1 day by 10% of the market capitalization of that sector, equivalent to about 0.3% of the total market capitalization of the Hong Kong Main Board (US$ billion). • This arose allegedly from the issue of a HKEx (stock exchange) consultation paper seeking market views to raise overall market quality. • Was this a regulatory or political crisis? 2

  3. Leadership challenges • Harvard Professor Malcolm Sparrow: “Pick Important Problems, Fix Them and Tell Everyone.” • What was the Important Problem? • Bad Communications? • Misreading the Market? • Misreading the Political Environment? • Regulatory issue? • How to Manage the Incident 3

  4. Dealing with Crisis • Crisis is an Event • Crisis Resolution is a Process • Process to Deal with Crisis: • Diagnosis • Damage Control • Loss Allocation • Restoring Market Credibility and Changing Incentives to prevent repeat of crisis Reference: Sheng (ed): Bank Restructuring: Lessons from the 1980s, World Bank/Oxford University Press, 1996. 4

  5. Objective of Case Study • Identify and discuss leadership challenges during the Penny Stock Incident • Part 1: Background • Part 2: Leadership challenges 5

  6. Economic and Political Background • Hong Kong transited smoothly on 1 July 1997, but faced the Asian crisis from 1997-1999, recovered with the Tech Bubble, which peaked in March 2000. The market then declined continuously in line with global markets • On July 1, 2002, the Hong Kong Government changed the senior officials from former senior civil servants to a politically accountable system of Principal Officials (Ministers) appointed by the Chief Executive. • The Legislative Council and the Media decided to test the limits of political accountability. 6

  7. Background • The slowing economy and political uncertainty led to a “feel bad” factor. - Daily turnover kept on declining - SFC decided to address market quality by publishing Quality of Market Paper [date] • BBC headlines • 01 Jul 02 | Business - “Regional rival threatens Hong Kong” • 02 Jul 02 | Business - “Hong Kong loses its financial glitter” • 11 Jul 02 | Business - “Hong Kong battles with recession” 7

  8. The Drive for Market Reform Raising market quality was part of three-pronged strategy in 1999 to consolidate and enhance Hong Kong’s position as Premier Financial Centre in Asian Time Zone, meeting the challenges from Shanghai, Singapore and Sydney • Demutualize and Merge Stock Exchange of Hong Kong, Hong Kong Futures Exchange, Hong Kong Securities Clearing Corporation and list the merged Hong Kong Exchanges Ltd (HKEx) • Improve Market Infrastructure by Scripless Trading and Settlement • Consolidate 11 pieces of securities legislation into new Securities and Futures Ordinance 2001 to world standard 8

  9. Market Quality Issues • Hong Kong Stock Market was 10th by global market cap, with strong blue chips, such as HSBC, Hutchison, China Telecom etc • However, at end May 2002, 14% of all companies < HK$ 0.1 • Small cap stocks had low liquidity, poor performance, weak corporate governance and were easily manipulated • Retail investors which were in this sector suffered and clearly market quality issues needed to be addressed to protect Hong Kong’s market integrity and credibility • Major markets dealt with poor quality companies through delisting. E.g. NASDAQ delists shares that drop below US$1 9

  10. Clear need for market reform • Top 30 companies account for 70 % of market capitalization and 50% of turnover • Shares priced under HK$1 accounted for 58% by number, but only 2.8% by market capitalization and 3.9% by turnover • However, Hong Kong stock market clearly demarcated into two tiers - the blue chip market, comprising top 100 companies, which the large foreign investment banks, fund managers and leading local brokers were interested in; and • A retail dominated Penny Stock Market, where many of the smaller 500+ local brokers derive market income from trading penny stocks 10

  11. Events Leading to Incident After months of deliberation and informally consulting market experts, HKEx as front-line regulator of the stock market, issued the Consultation Paper • First proposal–Companies falling below a minimum price threshold must consolidate their shares • Second proposal–Delisting: a necessary disciplinary backstop to force non-compliant companies to consolidate • Plan to introduce revised delisting criteria widely reported in media since 2001 11

  12. The Consultation Paper (CP) • 25 July 2002, HKEx issued CP with proposals for reform of listing rules • HKEx proposed: • prices of listed companies’ shares quoted at below $0.5 should be consolidated, • if not consolidated, after certain procedures and appeals, delisting may follow. • Consultation till end August 2002 12

  13. Regulatory Split • Prior to Demutualization in 2000, HKEx, as front-line regulator of market, were in charge of the Listing Rules, supervised its member stock brokers, and maintained the trading and clearing and settlement functions.\ • SFC, as statutory regulator, undertook insider dealing, market manipulation investigations and oversight of predecessors of HKEx. Market consultations on Listing Rule changes required agreement of SFC. • After Demutualization in 2000, HKEx self-listed, but retained front-line responsibility over listed companies • SFC took over regulation of brokers in Mar 2000. 13

  14. Three Tier Structure: Rationale “The essence of this structure is that the operation of the market should rest with the market operator close to the market under the watchful eyes of an independent regulator. Government maintains a broad policy interest...” [2002 Kotewall Report, paraphrasing the philosophy outlined in 1988 Hay Davison Report that recommended the establishment of SFC] 14

  15. Crisis Breaks • HKEx Consultation Paper was issued to press lunch-time Thursday, 25 July 2002 • No immediate market reaction Thursday afternoon • On Friday, 26 July 2002, overall decline of $10.91 billion representing 0.3% of the total market cap. Large brokers did not pay any attention, but headlines in local Chinese papers • Immediate focus of SFC was on soundness of small brokers. Found that no broker’s financial status suffered from market fall 15

  16. The Political Storm Begins • On Saturday, media reported that small investors suffered from the crash and some reports demanded compensation • Some legislators called for political accountability, testing new Principal Officials Accountability system • On Sunday, 28 July 2002, new Secretary for Financial Services, former banker, called for press conference with SFC Chairman, HKEx Chairman, HKEx CEO and himself • HKEx Chairman stated that he was not involved in Listing Rules due to Chinese wall 16

  17. Managing the Storm • On 31 July, Special meeting of Legislative Council called to determine who is to blame. • Although the meeting was to discuss the incident, the underlying motive was to clarify political accountability to see how the new Ministerial System worked • The Financial Secretary, with overall policy responsibility for the financial system, appointed an independent Panel of Inquiry into the Incident, comprising a leading QC and a Chartered Accountant who was former Chair of the Listing Committee • Panel reported in September 2002 (Kotewall Report) 17

  18. Lead up to 26 July 2002 • Sell-off not anticipated • 26 June -23 July – $0.50 consolidation proposal already covered extensively in HK media • 28 June –Listing Committee approved CP • Noon Thursday, 25 July 2002 –CP issued - No market reaction in the afternoon trading session • Friday, 26 July: Penny Stock sell-off • Preliminary view – sell-off was triggered by market reaction to fear that micro-cap stocks would be delisted and untradeable. 18

  19. Getting Message Across • On 26 July, SFC and HKex highlighted that the process was only consultative and not a policy decision, and that formulating rules would take a few months, and if adopted, there would be a 12-month transitional period • Secretary appealed to the public not to panic • Market continued to be volatile till 29 July

  20. Pressures to withdraw proposal “Over the weekend, the exchange withdrew its plan and said they would reconsider it before presenting a new one in October. Shares in Hong Kong subsequently bounced back from Friday's falls.” BBC News 31 July 2002 20

  21. Responding to Pressure • On 27 July, HKEx announced decision to extend consultation period till October, yielding to “public opinion”. • On 28 July, the Administration gave its support for a delisting mechanism “which commands market consensus” • On 28 July, HKEx announced decision to withdraw the proposals for separate discussion • 29 July, market stabilized

  22. Kotewall Report – 9 September 2002 Key Findings: • Unclear whether the Consultation was the only factor triggering the sell-off on 26 July. • Consultation would have been better managed if more pre-consultation market soundings had been carried out. • For controversial proposals regulators should adopt a 2-stage consultation process: concept release/detailed proposals. 22

  23. Kotewall Report’s key recommendation: • Government should review 3-tier regulatory structure (Govt, SFC and HKEx) over listing matters in particular the structure, role and operations of the Listing Committee. • Financial Secretary appointed 3 member expert group, chaired by former ASIC Chairman Alan Cameron on 26 September 2002 23

  24. Cameron Report Recommendation • The Expert Group Report (March 2003) • Conflicts of interest at the Exchange between regulatory function and for-profit business answerable to public shareholders, • Overlaps/gaps between role of Exchange and role of SFC: lack of clear public accountability for listing regulation. Insufficient enforcement “teeth” to sanction Listing Rule breaches. • Recommendation –“HKLA”, based on UK model, with Listing Rules backed by law 24

  25. Post-Mortem Could the “crisis” could have been anticipated? “… errors of judgement …a few mishaps … examples of miscommunications and some systemic wrinkles .. none.. In themselves major… combination of circumstances, however, led to unanticipated events … and less than favourable response to how the matter was later dealt with by the authorities thereafer…” (Kotewall Report, para. 10.30) 25

  26. Leadership challenges: Communications Question 1: How do you communicate your plans and ensure there is sufficient feedback on market reaction, given the complexity of the three-tier regulatory structure? • Crisis is the result of “fragilities” + “mistaken assumptions”, which together with “trigger”, leads to loss avoidance or flight to quality. • Under situation of confusion, how do you communicate complex messages simply and clearly? 26

  27. 2. Diagnosis • What was the size of damage and scale of problem? • Was it a political issue arising from change in Ministerial System? • Was it vested interests taking the opportunity to weaken political and regulatory authority? • What was scale of pressures to have proposal withdrawn? • What was SFC’s position? 27

  28. Political and Legal Clarity • Legislators (there was no party whip system in Hong Kong) demanded clarity of political and legal accountability. Many wanted to test the extent which the new Ministerial system assumed responsibility for problems under their watch. • New Secretary for Financial Services was only appointed on 1 July 2002 • Market watchers also wanted clarity on who was responsible for incident. • If HKEx was front-line regulator responsible for stock market, should HKEx bear responsibility? • If HKEx was supervised by SFC, should SFC also bear responsibility? 28

  29. Vested Interests Some speculators control “shell” companies which are sold for backdoor listings. Delisting of penny stocks would remove the value of such shells. “ The South China Morning Post described a meeting of brokers who on Thursday night apparently agreed to start selling penny stocks in order to cause a panic sell-off by small investors. .. brokers had reportedly wanted to put a stop to a plan…to delist penny stocks that fall below 50 Hong Kong cents for 30 days in a row.” … BBC News 31 July 2002 An Association of Listed Companies was formed after the Incident to represent some listed company interests. 29

  30. Priorities within SFC • Legal Status - market sell-off was on market consultation and not on policy decision. Given fundamental principle of caveat emptor, no legal basis for “blame” nor compensation. • Investigate whether there was any market manipulation in market that day • Examine whether any brokers had material financial exposure and were unsound • Internal due diligence • Did Corporate Finance Division, in discussing Consultation Paper with HKEx, undertake all required and reasonable due diligence in its work? • Managing the stakeholders - politicians, exchange, brokers, media 30

  31. Consultation with Market perhaps insufficient The Kotewall Report • Unclear whether the Consultation was the only factor triggering the sell-off • Apparent failure to utilize available channels for market feedback before Paper was issued. Suggested: • Pre-consultation market soundings • For controversial matters, 2 stage consultative process 31

  32. Managing the Market Pulse • HKex was front-line regulator, in charge of listing rules and Paper was solely issued by HKEx, which handled consultation through its own channels and through press briefing • SFC was directly in charge of prudential and conduct of brokers, not listing matters • Pre-consultation market soundings would require front-line soundings of vested interests • Difficult to assess depth and strength of market views, as media reports before issue of Paper did not forewarn market reaction

  33. Kotewell Report: Conclusion 7 • “The SFC and HKEx have worked diligently, and have adhered to well established practices in the processing of similar consultation papers. With the benefit of hindsight, HKEx could have improved the arrangements had there not been certain structural obstacles, including the lack of engagement of its consultation network, the somewhat unclear role and expectation of the Listing Committee, the occasionally tense relationship with the SFC, all of which prevented HKEx from making full and complete use of the knowledge, expertise and experience which could have been available to it.” • Improvements – Kotewall Report, pages VI and VII, paragraph 25

  34. 2. Damage Control: Maintaining Market Integrity • Intermediaries Division found no brokers materially hurt by market adjustment • Enforcement Division investigation revealed no obvious market manipulation, but shallow liquidity meant penny stock volatilities huge and prices easily moved • Dah Hwa International lost 54% of value on 26 July • Represented drop from HK$ 0.11 to 0.051 cents on a turnover of a mere HK$ 50,000 • Need to reassure market that overall market was sound, however illiquid penny stocks market, with poor corporate governance, low liquidity and high volatility posed risks to investors 34

  35. Holding the Ground • New Ministerial System meant that Ministers are willing to be seen upfront in managing crisis rather than leaving to SFC and HKEx • Uncertain political environment meant postponement of decision easier to manage than standing firm that Consultation Paper was only consultation and not policy decision • But, early withdrawal of proposal shifted media focus to blame

  36. Reaching out to Stakeholders • Articulate SFC’s position and views • Listen to and get feedback from stakeholders through media • Working with informed and influential market opinion leaders

  37. Key Messages Articulating viewpoint: • SFC view: “sell-off ... was primarily an over-reaction by investors to a set of proposals for market consultation that were unfortunately misunderstood by some as policy changes” (Kotewall Report, para. 10.25) • Market maintained soundness as no broker was materially hurt by incident

  38. Investigation into possible market manipulation(Kotewall Report, para. 9.12(b)) In context, most declining stocks had recorded heavy price declines prior to 26 July: “....many penny stocks had been losing value for some time. … wrong to suggest that investors in penny stocks lost all their money overnight. ... While the percentage drops in the value of penny stocks that day looked dramatic, the actual losses represented by those percentages were quite small when compared with the actual losses suffered in the previous six months.” (Kotewall Report, para. 10.21)

  39. Turning the Tide • Listen to stakeholders and get feedback through media • Shift media focus from blame to solutions: • Transparency – since the 3-tier regulatory structure was in question, independent analysis was necessary • Engage the public in debate • Discussion with constituents e.g. brokers • Consider if reforms need to be made to regulatory structure, given public opinion

  40. From Crisis to Opportunity • Use opportunity to clarify roles and responsibilties between SFC and HKEx • As a self-regulator, exchange responsible for maintaining integrity of market and ensuring that risks are managed properly • Getting support to move HK to international standards of governance

  41. HKEx challenges • Failure and vacuum in collecting market views (Kotewall Report, para. 11.42-43) • No consideration of alternatives (para. 11.38(e)) • Consultation with internal network (para. 11.55) • Lack of communication with market (para. 11.58) • Timing of release of CP (para. 11.66) • Relationship with constituents (para. 11.68) • Exit of significant senior management and CEO of HKEx

  42. How to Prevent Repeat • Incident was a catalyst for: • Considering whether regulatory arrangements were adequate to deal with the pressures that emerged during that period. (Kotewall Report) • Policy and regulatory reform

  43. Pick Important Problems, Fix Them and Tell Everyone • Need for clear evaluation of risks, vested interests, with strategies to address all options • Fortunate that SFC had strong team in corporate finance, legal analysis and deep relationship with major stakeholder • Need to address weaknesses identified from independent analysis and feedback • Investor education about inherently volatile stocks • Manage public expectations

  44. Conclusions • Incident signified need for renewal of trust and confidence in market regulatory regime • Need clarity about who is in charge and expectations: but regulators and market and opinion leaders need to work together

  45. Conclusions • Must recognize and be sensitive to important trends and identify risks e.g. develop a stakeholder intelligence system • Must be effective: i.e. decide on course of action after pros and cons are weighed • Must be able to provide a sense of direction i.e. communicate clearly

  46. Leadership challenges Note: Dynamic forces, rapid changes – • critical to understand the forces at work at the time as a basis to make decisions

  47. Conclusion • What type of leadership is needed to suit time and circumstances – depends on many factors e.g. in this case: • Need for continual renewal of credibility (accountability) • Need to recognize societal and political barriers e.g. unrealistic expectations, too many stakeholders

  48. Conclusion 2 key messages: • Leaders must always maintain and renew constituents’ support through accountable leadership • Leaders, media and constituents share responsibility for the development of their market

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