Market Structure, Disclosure and Governance Issues in Asia
The 'bezzle', our corporate governance feedback to the State Securities Commission of Vietnam, and other corporate governance challenges in Japan and HK-China
This Insight is not investment advice and should not be construed as such. Past performance is not predictive of future results. Fund(s) managed by Seraya Investment may be long or short securities mentioned in this Insight. Any resemblance of people or companies mentioned in this Insight to real entities is purely coincidental. Our full Disclaimer can be found here.
This Insight is an extract adapted from the Panah Fund letter to investors for Q1 2017.1
In his famous book ‘The Great Crash 1929’, John Kenneth Galbraith introduced the concept of the ‘bezzle’. This is equivalent to the undiscovered inventory of money that has been embezzled at any point in time, which fluctuates in size along with the business cycle.
In the good times – when money is loose and trust is high – the size of the bezzle increases: there is an increase in psychic wealth as the embezzler has scored a gain but the person who has been swindled does not yet feel the loss. Of course, all of this changes when the cycle turns. With the inevitable revelations of malfeasance and fraud, the public then becomes more suspicious of money and ‘money-men’, leading to a renewal in the standards of commercial morality.2
How big is the bezzle now? After nine years of loose monetary policy and lukewarm global economic expansion, we are wary of the shenanigans which seem to be coming to light on a monthly basis.3 We would hazard a guess that the current size of the global bezzle is not insignificant. Even among certain ‘blue chip’ stocks within the region, we have noticed a tendency towards the adoption of more aggressive accounting techniques. As and when global liquidity tightens, we would not be surprised to see further problems come to light.
In that vein, we will share some of our recent experiences of corporate governance challenges and issues in Asia.
TABLE OF CONTENTS
Market Structure & Governance in Vietnam
A recent request for foreign investor comments on various issues by the State Securities Commission (‘SSC’) of Vietnam has prompted us to reflect on market structure and governance issues in Vietnam and elsewhere in the region. The Panah Fund and Apollo Asia Fund made a joint submission to the SSC,4 and the brief summary is as follows:
Block placements of government stakes should be professionally handled with a transparent book-building process. This is to avert avoidable failures such as the recent Vinamilk placement; such incidents damage investor perceptions of the whole market.5
Proposals, resolutions, and announcements for private placements should all be clearly expressed, in Vietnamese and English, with a single version only. Companies should work with sub-custodians rather than sending different sets of documents to different entities.
Proxy voting through normal intermediaries is essential; we have heard frequent complaints from other fund managers that they never receive the forms in time for official voting. (We try to vote every time, though this has been challenging on occasions.)
Full notes should accompany financials.
All public disclosures made to stock exchanges and/or the SSC (i.e., financials, company announcements, dealing disclosures, etc.) should be made available on an official website which is always accessible from outside Vietnam.
Announcements should be stamped with date and time, with no substitution of the ‘same’ document allowed. The details of any correction should be clearly set out, with any discrepancy highlighted and explained.
Appropriations to funds (e.g., for Bonus and Welfare) should be clearly set out on a timely basis, and reconciled with drawdowns and balances.
Selective disclosure to favoured investors should be banned, and sanctions enforced for infringement! Simultaneous reporting in Vietnamese and English should be encouraged, especially for larger companies and those with a large proportion of foreign shareholders.
Poll results should be published (total votes cast, with the number for and against each resolution) and signed off by a named official from a reputable organisation.
Annual General Meetings require a longer notice period. We would recommend three weeks after the publication of the annual report and agenda (which is typical elsewhere).
Enforcement of rules on front-running and insider-trading.
Restricted sectors for Foreign Ownership Limits (‘FOLs’) to be clarified and updated. For companies where FOLs remain in place, we would like to see the introduction of Non-Voting Depository Receipts (or similar instruments).
This ‘wish list’ is not comprehensive, but rather reflects some of our experiences during the slightly more than two years since we started to invest in the country.
While there are clearly challenges to investing in Vietnam, we nevertheless see it as positive that the SSC is asking for feedback from investors. We very much hope that the SSC follows through by introducing constructive measures based on the feedback they have received, though only time will tell.
Sceptics might argue that the drive for improvement is driven by necessity, given the government’s wish to see the Vietnamese stock market upgraded from Frontier to Emerging status by MSCI in the coming years, and because of the need to sell down national stakes in various enterprises to foreign investors to plug the fiscal deficit.
That may be true, but even if the motives for progress appear to be born of self-interest rather than immaculately-conceived, and although the starting point for Vietnam might be lower than for other more developed Asian countries, the direction of travel is important nonetheless.
Japanese Earnings Previews Finally Banned
In Japan, it has now been roughly a year since several of the major brokerages, including Nomura Holdings and Daiwa Securities Group, banned ‘earnings preview meetings’ between their analysts and the companies they cover.
There are no rules banning selective information disclosure in Japan, which had meant that company earnings preview meetings just before quarter-end had been a valuable opportunity for company representatives to guide sell-side analysts (and newspapers such as the Nikkei) towards accurate quarterly earnings numbers. It was also an open secret that the brokerages’ best clients would receive the accurate earnings estimates first, giving them an unfair advantage.
While it might have been legal to receive non-public material information, it was in fact illegal for brokers to induce clients to trade based on such inside information. The regulators started to clarify the uncertainty in this grey area by censuring two foreign brokerages in late 2015 and early 2016, as they had allegedly solicited trades from clients based on non-public material information. It was this development which prompted major sell-side firms to prohibit their analysts from participating in earnings preview meetings around one year ago.
Since then, many more companies than usual have missed analysts’ earnings estimates, with increased volatility following earnings numbers. We understand that the regulator is also considering a general review of the fair disclosure rules, which would likely bring Japan more in line with other markets where the selective disclosure of material non-public information is banned (we think a new rule similar to the US’s Regulation FD would be appropriate).
While such a tightening of the rules is long overdue, this and other developments (such as the trend towards passive investment, and the introduction of MiFID II)6 will likely make the Japanese market – already notable in Asia for a lack of comprehensive stock coverage – more inefficient. While this might lead to lower liquidity, it will also arguably make Japan an even better hunting ground for active investors.
Issues in Hong Kong & China
Of the markets in Asia in which Panah invests, we have found recent market developments in Hong Kong to be the most disappointing.
Hong Kong has historically been a market dominated by institutional investors. Since the introduction of the Shanghai-Hong Kong Connect (in November 2014) and the Shenzhen-Hong Kong Stock Connect (in December 2016), however, the new marginal buyer of Hong Kong-listed stocks now comes from north of the border.
‘Southbound flows’ were slow to pick up at first, but it seems that a combination of factors such as rapid domestic credit growth in China and stricter capital controls (since the Renminbi depreciation panic of early 2016) have pushed more liquidity southwards to Hong Kong’s stock market.
China’s A-Share market is well-known for its somewhat capricious nature, with occasionally outrageously high valuations, and stock movements driven by rumour rather than fundamentals. Such market dynamics are probably best explained by reference to the ratio of broad money to total stock market capitalisation; while in many more developed economies these figures are roughly in balance, in the case of China (and many frontier markets), broad money aggregates are many multiples of stock market capitalisation. This means that a small change in liquidity has the potential to have a big impact on stock market valuations.
Since the start of 2017, we have noticed unusual volatility and instances of extreme share price movements in various Hong Kong-listed stocks. A recent trip to Hong Kong suggested that other fund managers had also started to notice the impact of this new source of liquidity from the north, favouring momentum over fundamentals.
The new capital is pouring into a market which – according to our ‘red flags’ metrics – is second only to Mainland China in Asia for creative accounting and poor earnings quality.7 Indeed, in recent years we have witnessed a steady march of corporate scandals concerning listed companies in Hong Kong. For those with interest in specific cases, two of the more high-profile cases of recent alleged malfeasance – still ongoing – are Hanergy Thin Film Power Group and China Huishan Dairy.
These scandals did not happen in a vacuum. There seems to have been a reasonably high awareness of these companies’ problems among the institutional investment community in Hong Kong for quite some time before the inevitable denouements. Even with credible reports of malfeasance circulating widely, it is notable that the regulator has once again been left to play a role cleaning up after the fact rather than addressing potential problems proactively.
This might be somewhat understandable given the sheer volume of companies alleged to be acting with impropriety. Critics also claim, however, that in certain cases the regulator appears to be holding the authors of ‘short reports’ and critical independent research (i.e., reports seeking to uncover accounting malfeasance and fraud) to higher standards than the companies which are playing fast and loose with their accounts.
We would like to see more done by the regulator to address investor concerns about fraudulent companies listed in Hong Kong, although we acknowledge that this is difficult in practice. It is encouraging to see that the number of enforcement staff have increased in recent years, but suggest that it would be sensible to encourage more critical independent research to help police the market. Given recent political developments in the SAR, however, we fear that the pendulum is swinging in the other direction.8
Nevertheless, there are various measures which could be adopted in Hong Kong to improve the current situation. Present rules dictate that once any issue with a Hong Kong-listed stock emerges, then the shares of the company are almost always suspended fairly swiftly, in some cases for many years.9 It would make more sense for shares in suspended stocks to automatically return to trading after a shorter pre-determined time period (to allow the market to find a clearing level), or else for the stocks to be delisted more promptly.
We believe that there should also be higher penalties and punitive bans imposed for those investment banks and investment bankers who bring fraudulent companies to market. Since 2013 in Hong Kong, senior bankers on IPO deals can be held accountable if offer documents contain untrue statements. We welcome recent news that the regulator is investigating or has sanctioned certain investment banks over their IPO work.
Finally, we are always disappointed to see ‘reputable’ audit firms sign off on questionable numbers; we would like to see more auditors pursued by regulators (in Hong Kong and elsewhere) for their role as enablers of aggressive accounting and corporate fraud.
Thank you for reading.
Andrew Limond
The original source material has been edited for spelling, punctuation, grammar and clarity. Photographs, illustrations, diagrams and references have been updated to ensure relevance. Copies of the original quarterly letter source material are available to investors on request.
For the full quote, see Chapter 8 of ‘The Great Crash 1929’ (1954) by John Kenneth Galbraith.
Two more examples of recent alleged impropriety from last month, are: Thailand-listed Group Lease and HK-listed China Hongqiao. In the former case, it is encouraging that the auditor clearly flagged his concerns, although he did not give a qualified opinion on the company’s accounts.
Our proposals are provided in more detail by Claire Barnes on the Apollo Investment Management website.
Vinamilk is a Vietnamese dairy products company and the largest listed company in the country (with a market cap of US ~$9.2bn). Panah has never directly invested in the company. The government’s recent attempt to sell down a stake in Vinamilk hit various avoidable obstacles.
This EU directive calls for the unbundling of research payments from execution (for more details. Foreign brokerage firms which provide services to European asset managers will reportedly also have to comply.
Panah’s ‘red flags’ quantitative screening process compares all companies in the region versus peers in the same sub-industry using numerous metrics. As of March 2017, of the ~14,600 companies in the ‘Red Flags’ universe, 745 companies had a score of 70% or more, of which 297 were China-listed and 85 HK-listed – collectively accounting for more than 50% of the ‘problem companies’ with a score of 70% or more.
We note with dismay that David Webb, a long-term supporter of corporate governance and freedom of speech in Hong Kong, has decided to play a less active role in advocating for reform for the time being. We very much hope that his absence from the fray will be only temporary.
A revision of the suspension rules is apparently under consideration, but we understand that this has been the case for some time. The Hong Kong Exchange publishes an up-to-date list of Hong Kong-listed stocks which have been suspended for more than three months. The record for the longest trading suspension without delisting apparently goes to Mandarin Resources, which was reportedly suspended from trading for as long as 14 years!
