Are we putting corporate governance at risk - again?

April 29, 2020 09:25
Photo: Reuters

In January, the Stock Exchange of Hong Kong Limited (HKEX) published a consultation paper seeking feedback on a proposal to allow corporate entities to be holders of weighted voting rights (WVR), also referred to as dual-class shares. Owners of shares carrying WVRs have enhanced voting rights which allow them to maintain control over the listed company even if their shareholding is below the threshold normally needed to maintain control. This proposal follows HKEX’s introduction in April 2018 of WVR for individual share owners, who are typically founders of, and the brains behind, “innovative” companies. HKEX is now proposing to broaden the rules to permit not just individuals, but also corporates, to hold WVR shares.

It is easy to understand why HKEX wants to relax its rules further. The business of landing high profile cross-border initial public offerings (IPOs) is a competitive one. In the past, many PRC issuers have opted to list in the United States rather than Hong Kong and the availability of WVRs there was often cited as a major factor in their choice of listing venue. The 2018 rule change in Hong Kong levelled the playing field somewhat, and helped HKEX secure the listings of Alibaba, Xiaomi and Meituan Dianping, which together raised over US$20 billion in new funds.

HKEX has its sights firmly on the future with its latest proposal: behemoths such as Alibaba and Tencent have made significant investments in the tech sector, acting as incubators and venture capital providers, and some of these businesses are ready to be spun-off and listed. Allowing corporate entities to hold WVRs would help cement HKEX’s position as the listing venue of choice in this context. However, WVRs represent a departure from the one-share, one-vote principle that CFA Institute and many others believe is a cornerstone of good corporate governance. HKEX seeks to allay these concerns by striking a balance between making the rules attractive to issuers on the one hand and providing adequate safeguards to minority shareholders on the other. This includes, among others, setting stringent eligibility requirements , placing a limit on maximum number of voting rights to five per share and mandating a time-based sunset provision of not more than 10 years.

Proponents of WVRs believe that founders of innovative companies are key to their successes, and these founders should be allowed to maintain control via super voting rights even after successive rounds of fund raising and dilution. How does this argument extend into the corporate WVR framework, when super voting rights are no longer held by individuals but by corporates? This is where the eligibility criteria come in. Some are straight forward and rely on the status of the corporate parent as a listed company in one of the major exchanges (Hong Kong, London or New York) and its market capitalisation (not less HK$200 billion). Others are more vague: for example, the consultation paper describes an “ecosystem” of companies with the same parent and synergistic benefits can be derived from the wider group. For HKEX to consider granting WVRs to the corporate parent, a subjective judgement must be made about the ecosystem, and the value the ecosystem and the corporate parent contribute to the issuer.

The lack of objective measures of what makes one ecosystem qualify is sub-optimal and may encourage a rise in cross-shareholdings, ultimately leading to more corporate WVR holders. Ecosystem is a fancy label but it is nothing new – conglomerates with parent-subsidiary listings have existed for decades, as have cross shareholdings. Further, parent-subsidiary listings tend to entrench management and reduce accountability, a problem which will be further exacerbated if the parent enjoys super voting rights.

In CFA Institute’s report “Dual-class shares, the good, the bad and the ugly” we noted that even when a founding shareholder is given super voting rights, such rights should not be perpetual but expire after a period of time, say, seven years – a concept called “time-based sunset”. Acknowledging that, unlike individuals, corporate entities do not have a natural lifespan, HKEX proposed a time-based sunset of not more than 10 years for corporate WVRs. In our view 10 years is too long, and it is disappointing to see that instead of providing a hard stop, under the current proposals, the sunset provisions can be renewed indefinitely, rendering the safeguard ineffectual.

Another issue is connected party transactions. When parties to a transaction are related, the underlying conflict of interest may lead to potential abuse. In a situation where the issuer actively operates in an “ecosystem” that consists of its parent and other associated companies, with outsized control by its parent, the scope for abuse is much increased. What are the additional considerations for the approval process and disclosures for connected party transactions in WVR situations? What should be the roles of the board, independent directors and independent shareholders? The consultation is completely silent on these important issues, which does not bode well for shareholder protection.

CFA Institute believes strong board independence must be in place to address the issue of under-represented, minority shareholders. Ensuring that the board has a majority of independent directors is a starting point. We also recommend that all WVR listings should be subject to mandatory, time-based sunset provisions without the option of renewal. Such provisions would limit super voting rights to a defined period, and in turn, relieve minority shareholders of permanent exposure to moral hazard. We believe that one-share-one-vote provides for the effective function of corporate governance and the protection of minority shareholders’ rights. Investors value growth but not at all costs. For the long term, sustainable development of the market, the proposed safeguards can, and should, go further.

Ensuring the long term competitiveness of Hong Kong is often cited as a reason for opening the door to WVRs. Given the economic headwinds we are facing, it may be tempting to set rules that maximise short term IPO businesses without regard to longer term costs in the form of erosion in corporate governance standards. But that would be misguided. In fact, now is the time to demand higher governance standards and to demonstrate Hong Kong’s leadership in doing the right thing. If we learn anything from the recent market volatility, it is that in unprecedented times like this, companies with superior governance, risk management and accountability will have a higher chance of survival and outperformance, and this is the message we should convey.

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CFA, Head of Advocacy, APAC, CFA Institute