Hong Kong heading for crisis of credibility over IPO frauds

Leo Goodstadt is a smart chap. He was deputy editor of the Far Eastern Economic Review in the old magazine's glory days, and he headed the Hong Kong government's Central Policy Unit in the run-up to the handover.

But although he's worked for government on the inside, he's no establishment poodle. In the past he's been scathing about Hong Kong's remote officials and their overly cosy relationships with big business. And what he has to say about how the government should deploy its vast fiscal reserves makes a lot of sense.

So no doubt Hong Kong's financial regulators are feeling pretty pleased with themselves after Goodstadt gave them top marks in a new book published earlier this month.

In Reluctant Regulators, Goodstadt praises the hands-on prudential approach of Hong Kong's regulators. He credits it with preserving the stability of the city's banking system during the 2008 financial crisis, and contrasts it to the disastrous light-touch policies adopted by regulators in London and Washington.

When it comes to financial regulation and financial services supervision, Hong Kong has a record of excellence, Goodstadt told a lunchtime audience last week.

But although there is some merit in what Goodstadt says, there is a gaping hole in his argument. His analysis focuses exclusively on financial system stability. But preserving systemic stability is only one element of good regulation. Regulators must also be responsible for protecting investors' interests.

Unfortunately Goodstadt ignores this aspect of regulation. The phrase Lehman minibonds gets just one mention in his entire book.

If he'd given more thought to the duty of regulators to protect ordinary investors, it is unlikely Goodstadt would have given Hong Kong such high marks. True, the minibond investors kicked up such an almighty fuss that they eventually won a refund and the rules governing the sale of similarly complex structured products have been toughened, but little has really changed. Despite the minibond scandal, the city's financial institutions continue to make vast profits peddling toxic trash to hapless investors.

Customer protection simply isn't the regulators' priority. The Securities and Futures Commission is responsible for supervising conduct in the securities market, but under existing regulations it lacks the teeth needed to safeguard investors.

Meanwhile, the Hong Kong Monetary Authority is ultimately responsible for overseeing the securities arms of the city's banks, and the HKMA doesn't consider investor protection to be part of its job at all. As a result, Hong Kong's banks have a free hand to neglect even basic due diligence, promoting share offerings on the stock exchange for companies whose prospectuses are little more than works of imaginative fiction.

The regulatory failure is scandalous. A prospectus is intended to be a legal document containing all the information an investor needs to decide whether to buy into an offering or not. It's accuracy should be beyond doubt.

Yet over the last year the SFC has queried more than 80 per cent of the prospectuses filed by deal sponsors, complaining repeatedly about significant errors and obvious inaccuracies in draft copies. Infamously last week, China Forestry, which floated late in 2009, was forced to admit that almost all the key information in its regulatory filings, including its financial statements, had simply been made up.

So far the SFC has been unwilling to hit the sponsors of these dodgy deals with massive fines, and unfortunate investors have found themselves unable to take legal action on their own behalf.

Company directors are typically based on the mainland, beyond the reach of Hong Kong law. And under Hong Kong regulations, deal sponsors and auditors have no direct obligation to shareholders and so cannot be sued.

And even if they could sue, as shareholder rights activist David Webb has repeatedly argued, the lack of provisions in Hong Kong for class action lawsuits means that the cost of taking legal action is prohibitive for the vast majority of investors.

The result is a culture of impunity that threatens fatally to undermine Hong Kong's credibility as a well-regulated financial centre.

If you can't trust a company's financial statements, then you can no longer value its shares with any confidence. And if you can no longer value a company's shares, what you end up with is casino capitalism. You no longer have investors, just speculators who only buy securities in the hope of flipping them back to the market in the hope of making a quick capital gain.

So although Hong Kong's regulators may have done a fine job of preserving the financial system's stability, their neglect of investor protection is creating not a world class international financial centre, but a giant casino. That is hardly a record of excellence.