Are we putting corporate governance at risk — again?
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 (WVRs), also referred to as dual-class shares. Owners of shares carrying WVRs have enhanced voting rights that 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 shareowners, who are typically founders of, and the brains behind, “innovative” companies. HKEX is now proposing to broaden the rules to permit not only individuals but also corporate entities 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 issuers from the People’s Republic of China opted to list in the United States rather than Hong Kong SAR, and the availability of WVRs often was cited as a major factor in their choice of listing venue. The 2018 rule change in Hong Kong SAR leveled the playing field somewhat and helped HKEX secure the listings of Alibaba, Xiaomi, and Meituan Dianping, which together raised more than US$20 billion in new funds.
HKEX has set 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 cement HKEX’s position as the listing venue of choice in this context. WVRs, however, represents a departure from the one-share-one-vote principle that CFA Institute and many others believe is the cornerstone of good corporate governance. HKEX seeks to allay these concerns by striking a balance between making the rules attractive to issuers, on one hand, and providing adequate safeguards to minority shareholders, on the other. These safeguards include, among others, setting stringent eligibility requirements, placing a limit on the 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 through super-voting rights even after successive rounds of fundraising and dilution. How does this argument extend into the corporate WVR framework, when super-voting rights are no longer held by individuals but by corporations? This is where the eligibility criteria come in. Some are straightforward 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 capitalization (not less than HK$200 billion). Others are more vague — for example, the consultation paper describes an “ecosystem” of companies within which 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 judgment must be made about the ecosystem and about the value the ecosystem and the corporate parent contribute to the issuer.
The lack of objective measures of what makes one ecosystem qualify is suboptimal 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. Furthermore, parent-subsidiary listings tend to entrench management and reduce accountability, a problem that will be further exacerbated if the parent enjoys super-voting rights.
In the CFA Institute 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 rather should 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 life span, HKEX proposed a time-based sunset of no 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 in which the issuer actively operates in an ecosystem that consists of its parent and other associated companies, with outsize 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 the one-share-one-vote principle 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 SAR 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 maximize short-term IPO businesses without regard for long-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 SAR’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. This is exactly the message we should convey.
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