Financial watchdogs are supposed to protect investors, but Hong Kong’s securities regulator is pushing for sanctions that would likely hinder price discovery and hurt the reputation of Chinese equity markets when they are fast opening up to foreign capital.
Moody's was this month given leave to go to Hong Kong's Court of Final Appeal against being penalised for a 2011 report in which it raised concerns about Chinese companies, many of which are listed in Hong Kong. The US rating agency had been reprimanded and fined HK$11 million ($1.4 million as of February 17) by Hong Kong’s Securities and Futures Commission (SFC) for failures in the preparation and publication of the research.*
The report, Red Flags for Emerging-Market Companies: A Focus on China, sought to highlight possible governance or accounting risks for non-financial corporate issuers in China. Its publication on July 11, 2011 sparked steep share price falls for many of the companies cited.
The research, which analysed 61 rated Chinese entities, seemed to have decent predictive accuracy. The five companies garnering the highest number of red flags—which Moody's labelled as 'negative outliers'—saw their share prices drop heavily**. It seems likely the valuations would have rebounded if the research had been inaccurate, but none have neared their former share prices since.
Ultimately, the SFC’s sanctions—if upheld—would set an unhealthy precedent and could lead to a different outcome from the one the regulator may have envisaged. The case also raises a number of issues that should worry investors, not least because it might make firms think twice before releasing research that is critical of companies listed in Hong Kong.
When explaining its decision to sanction Moody’s, the SFC pointed to the fact that there was “limited correlation in China between lower credit ratings and larger numbers of red flags” and concluded from this that the report should not have been issued by a rating agency. It also argued that Moody’s work had been sub-standard and imprudent in making its allegations about the companies in question.
But it appears SFC may have targeted the paper more because of its short bias, given positive research is not subject to the same criticism or scrutiny by the regulator, even if badly researched.
Both Moody's and the SFC declined to comment for this article. But several fund managers said the Moody’s report was well researched, with more robust due diligence than many other research pieces, whether negative or positive in their findings.
What's more, many positive reports that are less well researched than the 'red flags' document have not attracted such sanctions, noted investment experts.
“The Moody’s report was good and thought-provoking,” one Hong Kong-based corporate governance specialist at a fund manager said. “You definitely see far shoddier work on the long side.”
"This is not a short-seller doing a hatchet job," he added. "Moody’s is not an investor taking a short position in these stocks before putting the report out.”
If anything, the fund manager said, the rating agency has a disincentive to put a negative report out on names it would typically be competing to rate.
Additionally, activist investor David Webb's Webb-site pointed out in April 2016 that Moody’s was highlighting “accounting and governance warning signs”. These are relevant in that they could have a negative future impact on the company’s capital levels and thus its creditworthiness.
“A badly run, well-capitalised company may eventually burn through its capital and find it harder to raise more equity to refill the coffers,” Webb-site said in its comment.
It should also be noted that companies can take action themselves if they feel a report’s findings are inaccurate or misleading. They can rebut, clarify, ask for corrections or even sue for libel or defamation.
SFC chief executive Ashley Alder did say in a statement in June last year that the regulator “has no intention to suppress legitimate commentaries on listed companies, whether positive or negative”.
But if the penalty against Moody’s is upheld, companies will surely think twice before publishing critical research of Hong Kong-listed or other Chinese companies—and even if it is not, perhaps some of the damage is already done. Either way, it looks to be bad news for investors.
All in all, if this is how Hong Kong's SFC is going to react to such research, it does not bode well for how mainland Chinese authorities might respond. If they are seeking to encourage greater foreign investment in local stock markets, they should bear that in mind.
*The Securities and Futures Appeals Tribunal had issued its initial determination in April 2016, partially upholding the SFC’s decision but reducing the fine to HK$11 million from HK$23 million.
**West China Cement's share price more than halved from HK$2.92 to HK$1.24 between July 8 and October 7, 2011, and closed on February 15, 2018 at HK$1.33. Winsway Coking Coal, now called E-Commodities Holdings, fell from HK$38.12 to HK$23.00 between July 1 and September 1, 2011; it now stands at HK$0.83. Hidili Industry International fell from HK$6.66 to HK$2.29 between July 1 and September 30, 2011; it stood at HK$0.27 as of February 15, 2018. Shares in China Lumena New Materials were suspended from trading in March 2014, as it was unable to produce its 2013 results on time and to answer criticisms in two research reports.