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

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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

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Crisis or Incident? the leadership challenge

• On 25 July 2002, penny stocks (defined as those
  under HK0.50 (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?

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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

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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.

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Objective of Case Study

• Identify and discuss leadership challenges during
  the Penny Stock Incident
• Part 1 Background
• Part 2 Leadership challenges

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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.

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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

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The Drive for Market Reform

• Raising market quality was part of three-pronged
  strategy in 1999 to consolidate and enhance Hong
  Kongs 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

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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 lt
  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 Kongs market
  integrity and credibility
• Major markets dealt with poor quality companies
  through delisting. E.g. NASDAQ delists shares
  that drop below US1

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Clear need for market reform

• Top 30 companies account for 70 of market
  capitalization and 50 of turnover
• Shares priced under HK1 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

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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 proposalCompanies falling below a minimum
  price threshold must consolidate their shares
• Second proposalDelisting a necessary
  disciplinary backstop to force non-compliant
  companies to consolidate
• Plan to introduce revised delisting criteria
  widely reported in media since 2001

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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

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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.

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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

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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 brokers financial status
  suffered from market fall

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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

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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)

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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.

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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

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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

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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

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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.

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Kotewall Reports 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

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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

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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)

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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?

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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 SFCs position?

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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?

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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 planto 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.

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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

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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

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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

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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

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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

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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

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Reaching out to Stakeholders

• Articulate SFCs position and views
• Listen to and get feedback from stakeholders
  through media
• Working with informed and influential market
  opinion leaders

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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

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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)

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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

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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

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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

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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

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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

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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

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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

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Leadership challenges

• Note Dynamic forces, rapid changes
• critical to understand the forces at work at the
  time as a basis to make decisions

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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

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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