A straw man proposal is intended to generate discussion of an intended course of action and Hong Kong Exchanges and Clearing’s ‘straw man’ weighted voting rights proposals have certainly succeeded in doing that. The question remains however – what comes next?

In 2013, when Chinese e-commerce giant Alibaba sought to list in Hong Kong with a control structure which would have allowed the company’s founder and selected partners to retain control of the majority of board nominations irrespective of their equity stake, Hong Kong was faced with a dilemma. Alibaba would have been a prize IPO for Hong Kong, representing a major coup for the local market – the Alibaba Group has sales that exceed those of eBay and Amazon combined. However, the company’s founder and partners were not prepared to relinquish their ability to nominate the majority of the board after being listed and this would have had the effect of concentrating power in a manner that diverges from Hong Kong’s ‘oneshare, one-vote’ market rules.

The denouement of this dilemma was, as is well known, that Hong Kong stuck firm to its weighted voting rights (WVR) restrictions and Alibaba listed on the New York Exchange. But the debate has not gone away.

Those in favour of allowing WVR structures in Hong Kong argue that Hong Kong’s competitiveness is at stake. Hong Kong is in a good position to become the premier ‘overseas’ market for largescale PRC tech companies like Alibaba since it combines the attractions of an open international financial centre with the familiarity of a jurisdiction within the Chinese geographical and cultural sphere. Hong Kong Exchanges and Clearing Ltd (the Exchange) continues to capture the lion’s share of listings by Mainland Chinese companies, but there can be little doubt that some IPOs have been lost to the US because of its restrictions on WVR structures. Of the over 100 Mainland Chinese companies that have chosen to list on US exchanges, almost one third have a WVR structure. This third represents 70% of the market capitalisation of all New York listed Mainland Chinese companies.

Those opposed to WVR structures in Hong Kong argue that the current restrictions on such structures are there for a very good reason. The consequences of permitting exceptions to the ‘one-share, one-vote’ principle – which prevents a shareholder from having greater voting power than other shareholders with the same amount of equity in the company – would be highly damaging to Hong Kong’s competitiveness, they argue. High standards of corporate governance preserves Hong Kong’s deep investor base. In a speech at the Securities and Futures Commission (SFC) media luncheon on 9 March 2015, Ashley Alder, SFC Chief Executive Officer, warned that permitting WVR structures might result in fund managers applying a ‘governance discount’ to stock prices, or adjusting portfolio weightings away from Hong Kong.

The Exchange’s proposals

In August 2014, the Exchange issued a concept paper seeking views on whether WVR structures should be permissible in Hong Kong. The Exchange emphasised that it has not formed any view for or against WVR, but it believes that the issue needs to be debated. Interviewed by CSj in December 2014, the Exchange’s Chief Executive Charles Li said: ‘we believe that there is sufficient merit in WVR structures being the subject of review and a comprehensive public debate’.

The concept paper was subject to a public consultation which concluded in November 2014. The Exchange concluded from the responses to the consultation that there is support for a second stage consultation on proposed changes to the current rules on WVR structures. ‘It is clear from the responses that this remains a subject on which there are strong and divided views,’ the Exchange’s consultation conclusions, published on 19 June 2015, stated. But the Exchange is in the process of finalising a draft proposal for discussion with stakeholders with a view to refining the proposal and then publishing a second stage formal consultation on proposed changes to the current rules for companies seeking a listing with a WVR structure.

‘We are considering proposing that, generally, “one-share, one-vote” should prevail but that WVR structures should be allowed for certain companies in certain circumstances and with certain safeguards. We seek to define those circumstances and safeguards. These proposals will, in essence, develop the “exceptional circumstances” concept that already exists in the rules (but which, in practice, has never been used successfully to bring a company to listingon the Exchange) and extend them to “limited circumstances” in which certain companies with WVR structures could be listed with enhanced investor protection safeguards,’ the Exchange’s consultation conclusions state.

The SFC response

The debate on the admissibility of WVR structures in Hong Kong clearly raises important questions for the HKSAR. Many of these have already been aired by the Exchange and respondents to the Exchange’s first consultation on WVRs. However on 25 June 2015, the SFC issued a formal statement on the Exchange’s draft proposal on WVR which stated that: ‘The board of the SFC has unanimously concluded that it does not support the draft proposal for primary listings with WVR structures’.

The SFC statement raised doubts about the measures so far discussed to limit the availability of WVRs. For example, the Exchange expects that any second stage proposal will limit WVR structures to new companies seeking to list on the Exchange for the first time, but the SFC questions whether it would be possible to prevent circumvention of this restriction. The Exchange has proposed bringing in ‘appropriate anti-avoidance measures’, but the SFC has ‘significant concerns’ regarding the effectiveness of these measures. ‘For this feature to work, there must be effective measures to prevent ineligible issuers from bypassing the limitation through arrangements such as spin-offs, asset transfers or other forms of corporate restructuring,’ the SFC states.

‘The SFC is of the view that Hong Kong’s securities markets and reputation would be harmed if WVR structures became commonplace,’ the SFC statement comments. ‘It is insufficient to look only at controlling the number of WVR issuers. The SFC is concerned, for example, about the potential impact of acquisitions of existing listed assets by WVR issuers. Unrestricted, post-listing transactions could over time result in the transfer of a significant proportion of existing listed businesses and assets to WVR structures. In the SFC’s view, such a development would be detrimental to our markets and the interests of the investing public generally.’

The Exchange is also considering imposing a very high expected market capitalisation test, in addition to existing eligibility criteria for WVR listings on the main board. The SFC, however, is sceptical as to the effectiveness of this measure. ‘Size offers no assurance that a company would treat its shareholders fairly,’ the SFC statement comments. ‘Any corporate misconduct by an issuer with a large market capitalisation will likely affect more investors and have a greater impact on our markets. For example, these issuers are more likely to become index components which will compel index funds and other types of “passive” institutional investors (which invest public money) to buy and hold their stocks even if fund managers disagree with their WVR structures.’

The SFC also has concerns about the draft proposals that would require regulators to assess compliance with the criteria for companies to be eligible for WVR. For example, the Exchange is considering imposing ‘enhanced suitability’ criteria which could include the contribution of the founder or founders of the company. ‘Such criteria can only be applied subjectively and are therefore inherently vague. A regime that relies on the subjective judgement of regulators to determine which listing applicants are eligible for WVR would give rise to regulatory uncertainty and could result in inconsistent and unfair decisionmaking. The SFC is opposed to proceeding on this basis,’ the SFC states.

What comes next?

The SFC has not categorically ruled out taking the WVR proposals any further, but the statement released on 25 June 2015 is clearly a significant set back for the draft proposals. After all, the SFC would need to approve any changes to the rules to permit WVR in Hong Kong.

The statement makes it very clear that the SFC does not support the draft proposal for primary listings with WVR structures – will the debate now refocus on enabling WVR for secondary listings? If the Exchange still intends to proceed to a second draft proposal, it would have to identify viable safeguards to ensure that any changes to the current restrictions on WVRs do not result in negative consequences for investors and the market as a whole. In addition to the objections described above, the SFC’s statement expresses concern that the current proposals do not explain how the safeguards currently on the drawing board can be monitored on an ongoing basis and what actions can be taken either by regulators or by public shareholders if they are not complied with.

Beyond these specific objections to the draft proposals, the SFC has also questioned the rationale for relaxing the current restrictions on WVRs. ‘A focus of the discussion to date on WVR has been competition from the US for the listing of Mainland China businesses. Hong Kong’s business and competitive environment is affected by many factors and can change significantly within a relatively short period. In carrying out its regulatory functions, the SFC considers both long term and short term objectives and seeks to uphold the core principles of fairness and transparency which underpin Hong Kong’s reputation as an international financial centre,’ the SFC statement comments.

Some of these doubts had already been raised by Ashley Alder, SFC Chief Executive Officer in his speech at the SFC’s media luncheon on 9 March 2015. He prefaced his remarks by emphasising that the SFC was keeping an open mind to the WVR proposals. ‘We should always look carefully at proposals that could result in Hong Kong enhancing its success as a truly international financial centre in the years ahead,’ he said. He questioned, however, whether allowing WVR will in fact increase Hong Kong’s competitiveness. He pointed out that the US is a very different environment for listed companies. It has higher levels of securities litigation, for example.

This point was also made in an article in this journal by Joseph Lee and David Neuville of Cadwalader, Wickersham & Taft (see CSj January 2014 edition). ‘There is a long history of shareholder derivative and minority shareholder litigation in the US in which US courts have acted to protect public company shareholders, a litigation history largely absent in Hong Kong. Without these protections for shareholders, Hong Kong regulators clearly have felt, and continue to feel, strong pressure to protect those parties.’

Given the divided views revealed by the Exchange’s first consultation on WVR and the objections raised by the SFC, it will be interesting to see if the proposal will ever forge enough market consensus to move forward in respect of primary listings.

Kieran Colvert Editor, CSj

More information on the draft proposals on weighted voting rights is available on the websites of Hong Kong Exchanges and Clearing: www.hkex.com.hk, and the Securities and Futures Commission: www.sfc.hk.

The previous CSj articles on weighted voting rights can be found online via the CSj link on the HKICS website (www.hkics.org.hk – see the January 2014 and January 2015 editions).