SEC Halts Short Selling of Financial Stocks

We all experienced the US financial turmoil last week. Finally the US government has made the rescue plan to recover investor confidence. Prohibition of short selling is probably a consideration for bailing out those financial entities suffering from subprime mortgages.

On 19 Sep 2008, US SEC, acting in concert with the UK FSA, took temporary emergency action to prohibit short selling in financial companies. SEC's action applies to the securities of 799 financial companies. As explained by SEC's chairman, the temporary emergency order is expected to restore equilibrium to markets and would not be necessary in a well-functioning market.

Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets. At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation. Financial institutions are particularly vulnerable to this crisis of confidence and panic selling because they depend on the confidence of their trading counterparties in the conduct of their core business.

The emergency order will terminate on 2 Oct 2008 but SEC may extend it beyond 10 days if it deems an extension necessary in the public interest and for the protection of investors, but will not extend the order for more than 30 calendar days in total duration.

SEC has also taken the following steps to address the recent market conditions:

• Temporarily requiring that institutional money managers report their new short sales of certain publicly traded securities. These money managers are already required to report their long positions in these securities.
• Temporarily easing restrictions on the ability of securities issuers to re-purchase their securities. This change will give issuers more flexibility to buy back their securities, and help restore liquidity during this period of unusual and extraordinary market volatility.

Of course SEC intervenes the markets (by prohibiting short selling of financial companies and taking up their bad debts) only in a very special circumstance, I am concerned about the abuse of such measures which could create more moral hazard. In 1998 Milton Friedman heavily criticized the HK government's intervention of stock markets. Ten years from 1998 the US government is doing the same. What would Milton Friedman think if he was still alive?

SFC v Styland

SFC challenges the senior management of another listed company by commencing proceedings in the High Court against the former chairman, a former executive director, and two current executive directors of Styland Holdings Ltd. Styland, well-known to many retail investors, was listed in 1991. The group's business includes securities dealing, property investment, general trading and infrastructure development. SFC ordered suspension of trading in Styland's shares on 23 Dec 2002. Trading resumed in Jun 2003 but was suspended again at Styland's request on 21 Apr 2004 pending an announcement of a possible rights issue. Trading remains suspended.

SFC alleges the four directors breached their duties to the company resulting in Styland incurring substantial losses in a number of transactions. SFC is seeking orders that the four directors (or any of them):

• be disqualified as company directors; and
• pay compensation to Styland for losses allegedly caused by their misconduct.

The four directors are former chairman, Mr Kenneth Cheung Chi Shing, current executive directors, Ms Yvonne Yeung Han Yi and Ms Miranda Chan Chi Mei and former executive director Mr Steven Li Wang Tai (the four directors).

SFC also alleges that Cheung breached his duty to the company in a number of transactions in which he is alleged to have received (directly or indirectly) financial benefits totaling $79m. These transactions should have been disclosed to shareholders (and the market) and required shareholder approval which was not sought or given. SFC also alleges Yeung breached her duty through connected transactions not authorised by the company's shareholders (which should have been authorised by shareholders), receiving financial benefits totaling $6.95m.

This is the first time SFC has commenced action seeking compensation for a listed company or sought orders for the commencement of compensation proceedings by the listed company against company directors for alleged misconduct. This action is concerned with three important issues:

1. The obligations of listed company directors to ensure shareholders are given a proper opportunity to scrutinise transactions that require their authorisation;
2. The extent to which Hong Kong law recognises the special responsibilities entrusted to a chairman of a listed company; and
3. The ambit of the court's jurisdiction under S.214 of SFO to order compensation to be paid to a listed company.

If SFC could win this case, then the perceived protection of investors in HK listed companies would be better.

Court Order Against Ex-CEO of Wah Sang

Last week SFC commenced proceedings in the High Court against Mr Shum Ka Sang, the former chairman, CEO and executive director of Wah Sang Gas Holdings Limited (Wah Sang Gas), and one other former company director seeking an order to disqualify them from acting as company directors or being involved, directly or indirectly, in the management of any corporation for a period to be specified by the court. Listed in GEM since March 2000, the company is engaged principally in providing gas connection service through its subsidiaries on the Mainland.

Under S.214 of SFO ("Remedies in case of unfair prejudice, etc. to interests of members of listed corporations, etc."), the court may make such orders for up to 15 years if it finds those persons are wholly or partly responsible for the company's affairs being conducted in a manner involving defalcation, fraud or other misconduct.

These proceedings follow an SFC investigation of the company into suspicions that the company's accounts had been falsified and asset values were overstated for the financial year ended 31 Mar 2004. On SFC's order, the company's shares were suspended from trading on 6 Apr 2004.

SFC alleges that Shum, who resigned as a director of the company on 22 Oct 2007, knew or was involved in falsifying the accounts or was otherwise responsible by failing to exercise reasonable skill, care and diligence and to act in the company's best interests. The same allegations are also made against another former director, who is named in the proceedings but who has not yet been located and notified of these proceedings.

An independent audit led to the reconstruction of the company's accounts. In new financial results finally filed with SEHK on 11 Jul 2007 (following new management being appointed to run the company), the company reported a reduction in the value of net assets as at 31 Mar 2004 of approximately $720m.

Trading in Wah Sang Gas shares remains suspended and resumption of trading is subject to SFC's approval. The company announced to the market on 29 May 2008 a Restructuring Proposal, which will be the subject of a Circular that it must issue to shareholders no later than 30 Sep 2008.

Once again SFC has demonstrated that it has more teeth to bite the wrongdoers of listed companies than SEHK.

SFC Quarterly Report (2Q/2008)

Last week SFC released the first Quarterly Report for the second quarter of 2008 to enhance its transparency and accountability of its operation. The following activities of SFC during this quarter highlighted in the Report are remarkable:

• SFC is concentrating on completing investigations within 7 months and it did so in 76% of all completed investigations. It seems that Enforcement has become more efficient now.
• SFC has sent a strong message to deter market misconduct. It used all the tools available to tackle insider dealing (e.g. sought an interim worldwide injunction to freeze assets of suspected insider dealers in one case).
• SFC has encouraged good compliance and deterred wrongdoing by reaching agreements with ICEA and Core Pacific-Yamaichi such that repeated material breaches of the same kind would trigger an accelerated enforcement response.
• SFC received 329 complaints, compared with 258 in the same period of last year. I wonder whether the significant increase in complaint figure was caused by "accumulators".
• SFC issued a joint consultation paper with HKEx to seek public feedback on allowing paper application forms to be handed out for public offers of shares, debentures and authorized CISs, without also having to hand out paper offer documents if electronic offer documents are available from websites. Comments are being reviewed by SFC. Given that most of the HK people have regular access to the internet, this proposal seems highly feasible.
• Companies can now list in HK by way of depository receipt after SFC approved proposed changes to the main board listing rules. SFC has also approved the re-positioning of the GEM board as a secondary board and a stepping stone to the main board. I doubt if this could "rescue" the GEM board if it is labelled as a platform for "inferior" companies.
• SFC approved HKEx's proposal to introduce gold futures in HK. Trading of gold futures is expected to start in Oct 2008. Would one more "gambling" tool be made available to the retail investors?
• SFC also approved HKEx's proposed amendments to relax the tick rule. It is said the current stock market has suffered from substantial short selling activities. Would relaxation of the tick rule worsen the situation?
• Two teams have been assigned to handle licensing applications by Mainland fund managers. Would SFC offer any "special treatment" to them?

The staff length of SFC has not increased when compared with one year ago. It seems that the workloads of SFC staff have become heavier.