A year on since the introduction of weighted voting rights in Hong Kong, experts debate whether the stock structure really makes the city a more attractive listing hub, Nicky Burridge reports.
Illustrations by Gianfranco Bonadies
Smartphone maker Xiaomi Corporation raised HK$42.6 billion through an initial public offering (IPO) on the Hong Kong Stock Exchange (HKEX) in July last year. It was not only the size of the listing that made it headline news, with Beijing-headquartered Xiaomi raising more than double the amount of the largest IPO in 2017, but also the fact that it was the first company to take advantage of a new listing regime allowing weighted voting rights shares to be issued in Hong Kong.
Unlike conventional share structures, where each share counts for one vote, under weighted voting rights – also known as dual-class shares – different classes of shares have different voting rights. The structure is not new, but is now often favoured by technology companies as it enables the companies to raise funds without the founder losing overall control.
The new listing rules, which came to effect in Hong Kong on 30 April 2018 also included measures to allow pre-revenue bio-technology companies to list and a new concessionary listing route for Mainland and international companies. The aim is to encourage more new economy companies to list in the city, after a spate of Mainland technology companies had chosen to list in New York, where dual-class shares have long been allowed. The change was billed as the biggest shake up to listing rules since 1993 when Mainland companies were allowed to raise capital in Hong Kong through H shares.
HKEX Chief Executive Charles Li previously predicted the new regime would lead to dozens of companies listing in the city, and would “make the Hong Kong market more relevant and even more competitive as we make Hong Kong a welcoming home for innovative companies.” But while the change has been welcomed by some as ushering in a new era for Hong Kong, others have warned it weakens corporate governance standards.
Paving the way for innovation
The new rules are limited to what the exchange terms “innovative” companies. These companies must also have a market capitalization of at least HK$10 billion at the time of listing and revenue of HK$1 billion in the most recent financial year, unless the market capitalization exceeds HK$40 billion.
So far, only two companies have listed under the new regime, Xiaomi and Mainland food delivery and retail platform company Meituan-Dianping, which raised HK$33.1 billion in September last year.
Edward Au, Co-Leader of Deloitte China’s National Public Offering Group, Council member of the Hong Kong Institute of CPAs, and Deputy Chairman of the Institute’s Corporate Finance Advisory Panel, welcomes the revised listing rules as marking “a new milestone” for Hong Kong.
Paul Lau, Partner and Head of Capital Markets at KPMG China and an Institute member, also views them as a positive development, saying: “The rule changes signify the HKEX’s willingness to improve and adapt to an ever-changing market.” He adds that although last year should be viewed as a transition period, two of the top 10 global IPOs by funds raised in 2018 were weighted voting rights companies listed in Hong Kong.
The new listing regime also signals a shift in focus in Hong Kong towards being a global hub for new economy companies. It is also in line with the government’s objective of assisting the development of innovation and technology companies, with a particular focus on the areas of fintech, artificial intelligence, biotechnology and smart city. Wilson Chow, Global Technology, Media and Telecommunications Leader at PwC, points out that in the past Hong Kong did not have an ecosystem for technology, media and telecom companies, but the new listing regime is helping to create one. “Previously, these companies might not be able to generate enough interest from potential investors and would not be able to attract good valuations for IPOs,” he says.
But others are less enthusiastic. Mary Leung, Head of Advocacy, APAC at the CFA Institute, warns that if every stock exchange in the world starts to offer dual-class shares it will simply become a race to the bottom. “Offering something like dual-class shares is not a silver bullet to competitiveness,” she says.
Jamie Allen, Founding Secretary General of the Asian Corporate Governance Association, also questions whether dual-class shares are actually necessary in Hong Kong. “The primary reason for dual-class shares is to protect the founder against hostile takeovers. That argument makes some sense in the United States, where there is a strong market for corporate control. But we don’t have a strong market for corporate control in Asia and very few hostile takeovers.”
A number of investor safeguards have been introduced for weighted voting rights shares, including a process to determine the suitability of companies wanting to issue them, higher market capitalization requirements and enhanced disclosure requirements. Au points out that the rules also stipulate that the company must create a corporate governance committee, composed entirely of independent non-executive directors (INEDs). He says that while New York does not have all these additional requirements, they are necessary in Hong Kong due to the higher level of retail investors, which account for nearly 25 percent of the market, compared with only about 5 percent in the U.S. “This is a balanced set of safeguards at this point and these safeguards are already more stringent than those in the U.S.,” he says.
Chow does not consider the new listing rules to have weakened corporate governance, pointing out that Hong Kong has well established regulatory systems governing listing applications and ongoing monitoring of listed companies.
But not everyone thinks the new rules have successfully balanced the need for innovation with the need for strong corporate governance. “From our standpoint, we have always been one share, one vote champions. We think it is best if shareholders of companies are treated equally. The notion of dual-class shares is inherently unfair, and we do not think it is conducive to good corporate governance,” Leung says.
Allen puts it more strongly, saying: “We have had long-standing concerns about dual-class shares. They introduce a new element of governance risk into the system which we think compounds existing problems and raises investment risk. We are concerned that over time this will damage the Hong Kong market.”
He explains that from a governance point of view, dual-class shares are deeply unfair because they allow someone who has limited ownership rights in a company to have outright voting rights. “The basic tenant of good corporate governance is fair treatment of all shareholders. Fundamentally, dual-class shares do not meet this test.”
A second issue, he says, is that investors tend to discount companies they do not trust. “If dual-class shares become the norm in Hong Kong and you have not just IPOs, but a lot of listed companies starting to use them, such as through new spin-off listings, then that could have quite a negative impact on the valuation of the Hong Kong market.”
Leung says the CFA Institute’s main concerns focus on the entrenchment risk and the lack of accountability that arises when there are weighted voting rights. She points out that under “one share, one vote” structures, if management is underperforming, shareholders can potentially come together and get rid of them, but if you have weighted voting rights, there is no avenue to do this.
Hong Kong has capped the number of votes allowed per share at 10, which is a significant difference to the U.S., where there is no limit, with some founders having 500 or even 1,000 votes for every share they hold.
“It looks like a great win for investor protection, but in order to have 51 percent of control under the rules, founders only need 9.1 percent of the equity,” Leung says. She adds that another issue with weighted voting rights is that if the founding shareholder makes a bad decision, they do not get punished in the same way as other shareholders because their equity stake is so small. “With this 9.1 percent stake you have control and can direct the company to do whatever you want, and if you mess up, the 91 percent of others will be picking up the bill,” she says.
Improving shareholder protection
In order to improve safeguards for shareholders, Leung would like to see the introduction of a time-based sunset provision, under which the “super voting rights” of the founding shareholder of a company with dual-class shares would lapse after a certain period.
Hong Kong has implemented event-based sunset provisions, so if the founding shareholder sells their shares, dies or leaves the company their higher voting rights will lapse.
But Leung points out it is difficult to know how the policy will be enforced, as it may not be clear if the founding shareholder is no longer actively involved in the company. “In our view, you should have an agreed time after which these super voting rights will collapse back into one share, one vote,” she says.
Stephen Law, Managing Director at ANS Capital and an Institute member, thinks shareholder protection could be enhanced by having more INEDs appointed to the boards of companies with weighted voting rights shares. He points out that the U.S. requires companies with dual-class shares to have a majority of INEDs on the board, but Hong Kong only requires a third of directors to be INEDs, so they are in a minority. “If you increase the number of INEDs at board level, there would be more protection in terms of corporate governance and protecting minority shareholders,” he says.
He adds that although Hong Kong requires there to be a corporate governance committee comprised of INEDs that reports to the board, the board does not have to follow its recommendations.
Au agrees, adding that INEDs could also be required to have minimum qualifications. He would also like to see weighted voting rights companies have to report on the work of the corporate governance committee on a quarterly basis to enhance the effectiveness of corporate governance and increase transparency for investors.
Another issue with the new regime is that the term “innovative” has only been loosely defined as a company whose success is attributable to the application of new technology or an innovative business model, or one where research and development, intellectual property or intangible assets make a significant contribution to its success or value. “The criteria could be clearer,” says Law. “Xiaomi makes the majority of its revenue through selling mobile phones, but does that make it a new economy company?”
He also questions why only innovative companies can benefit from weighted voting rights, pointing out that many types of companies rely on their founders to lead them and generate growth. “If you allow weighted voting rights for one group why not allow it for another group?”
Allen also questions what is meant by an innovative company: “We were always sceptical, and we are still sceptical about the way in which the concept of innovative is linked to new economy companies. The idea that you can draw a clear distinction between an innovative and a non-innovative company is unrealistic. Many old economy companies are highly innovative, while some new economy companies are merely copying existing business models.”
Au points out that the definition of what constitutes an innovative company will also need to evolve over time, as what is considered to be innovative now may not be in two years’ time. “I think the market will expect there to be more published guidance from time-to-time, so that people can formulate a judgment on whether a potential candidate can really fulfil the criteria of being an innovative company,” he says.
However, others think the current criteria are appropriate. Chow believes that if the criteria were too strict, it may prohibit companies from gaining access to the capital market. He adds that the IPO vetting process imposed by the HKEX and the Securities and Futures Commission is robust enough to assess the suitability of companies during the application process, with the Listing Committee, which is made up of professionals from banking, legal, accounting and other relevant fields, making an independent final assessment.
“The guidance letters issued alongside the new listing rules have helped improve clarity on the criteria for determining the suitability of companies, though leaving room for interpretation,” Lau adds. “The criteria of being an ‘innovative’ company are based on a non-exhaustive list of characteristics relevant for consideration, whose interpretation may evolve over time to catch up with market trends and developments.”
“The guidance letters issued alongside the new listing rules have helped improve clarity on the criteria for determining the suitability of companies, though leaving room for interpretation.”
Improving Hong Kong as a listing venue
Chow views the changes favourably. “It allows the Hong Kong stock market to embrace a wider diversity of companies in the new economy, believed to be the growth engine of our future economy,” he says.
Accountants will benefit from the change, notes Law, pointing out that the new regime will generate more work for accountants if a higher number of companies list in Hong Kong. “All listings require auditors and financial reporting. Companies also employ chief financial officers and financial controllers. The more companies that list, the more opportunities there are for accountants,” he says.
But Leung points out that despite the new rules, a number of Mainland technology companies still opted to do IPOs in the U.S. last year, including Tencent Music, even though Tencent itself is listed in Hong Kong. Au also points out that to make Hong Kong an attractive place for listing, there needs to be other changes made alongside the new listing rules to build up its ecosystem for innovative companies.
Allen is unconvinced by the changes. “This was sold to Hong Kong as a necessity to compete with the U.S. We were told there would be dozens of dual-class listings.”
But Anthony Leung, EY’s Assurance Leader for Hong Kong and Macau, and an Institute member, points out that the launch of the new listing regime, while being a big step forward, was not meant to open a floodgate of innovative companies listing in Hong Kong.
“It is important to build the infrastructure to facilitate innovation. It is equally important to uphold corporate governance standards. The art of balance is not easy to achieve, and we are still on the tightrope, but so far so good,” he says.
Lau is also upbeat: “We consider the changes to have been widely positive and expect the new listing regime to help create a vibrant and diversified financial market with sustainable growth for the future.”
As part of the reforms to Hong Kong’s listing regime, the Hong Kong Stock Exchange added three new chapters in the Main Board Listing Rules and made consequential changes to the rules to: (a) permit listings of biotech issuers that do not meet any of the Main Board financial eligibility tests; (b) permit listings of companies with weighted voting right structures; and (c) establish a new concessionary secondary listing route for Greater China and international companies that wish to secondary list in Hong Kong.