Market Views: do dual-class shares dilute investor protection?
After four years of deliberations, Hong Kong Exchanges and Clearing (HKEx), the operator of the city’s exchange, announced the addition of three new chapters to the main board listing rules on April 24.
The new rules, which went into effect on April 30, include allowing the listing of biotech issuers that don’t otherwise meet financial eligibility tests, creating a secondary listing route for Greater China and international companies, and more controversially, permitting companies with weighted voting right structures (WVRs), or dual-class shares, to list.
The issue of WVRs has been under consideration by the HKEx ever since Alibaba chose to list in New York rather than Hong Kong in 2014. The exchange operator has said attracting initial public offerings (IPOs) from large mainland Chinese technology firms was one of the major drivers for permitting dual-class share listings in a June 2017 concept paper.
However, there are concerns about corporate governance and the rights of minority shareholders when it comes to dual-class share structures. The HKEx rules state that the voting power of shares with WVRs are to be capped at 10 times that of ordinary shares, and non-WVR shareholders must hold at least 10% of eligible votes to be cast at general meetings, but questions remain over whether these regulations are enough.
We asked a fund manager, a diversified financial firm, a consultant and a lawyer what the new rules mean for Hong Kong's image as a regional IPO hub as well as for investors.
Mary Leung, head of advocacy for Asia Pacific
CFA Institute
We firmly support one-share-one-vote and we remain steadfast in the belief that there should not be any unequal voting rights. A structure that provides one shareholder group with disproportionate votes creates the potential for a minority shareowner to override the wishes of the majority of owners for personal interest. Unequal voting rights would weaken the checks and balances between shareholders and management, and immunise management against criticism, leading to entrenchment issues.
Going back to the rationale of dual class shares (DCS) in the first place – it is to allow owners that were instrumental in the success of startups to maintain control, even though their stakes in the company would have been heavily diluted after successive rounds of financing. As the contribution of these founders fades, such preferential treatment (in the form of super voting rights) should be reduced and eliminated. Neither HKEx nor the Singapore Exchange (SGX) has proposed time-based sunsets as a safeguard, but we believe this should be encouraged as a best practice even if not formally in the rules.
We note that stock exchanges in the region are seeking to compete in the global IPO business by allowing companies with DCS structures. This competitive strategy is easily replicable and we question if this is the right one. While HKEx has established certain safeguards, we would argue that they don’t go far enough – from a commercial and business development perspective, the fewer the safeguards, the easier it is to attract new IPOs.
Domestically, the misalignment of economic stakes and voting rights gives rise to managerial entrenchment and may induce beneficiaries of super voting rights to make decisions that are in conflict with other shareholders. As a result, this could hurt Hong Kong’s high corporate governance standing, which may be shown by the decline in international rankings.
Regionally, given the status of HKEx as a leading exchange, its decision to permit dual class shares to be listed is encouraging other exchanges to follow. For instance, SGX is currently consulting the market on DCS safeguards. Their proposed safeguards include, for example, automatic conversion of multiple voting shares (which we agree with); establishing independent audit, nominating and remuneration committees (again, we agree with); and limiting maximum voting differential to 10:1 (we believe this is too high, 3:1 may be more appropriate). It is expected that SGX will closely follow HKEx and will allow DCS listings soon.
Robert Cleaver, partner
Linklaters
My personal view is that on balance it's positive, but it's very finely balanced. It's very noticeable that in the consultation carried out by the exchange on this, the people they spoke to were quite divided, and as a general rule, the sell-side was very much in favour of the reform, and the buy-side was against it. The sell-side are clearly the ones who are interested in bringing more companies to listing, and the buy-side are the ones who are very interested in corporate governance, so they weren't so keen about it. I'd probably describe it as a necessary evil, something that Hong Kong had to do to ensure these companies could come and list here.
The positive is that it opens the door to potentially some very attractive companies. It is generally thought that quite a lot of tech companies, especially Chinese tech companies, prefer the weighted voting rights structure that Alibaba has. Among that large group of companies with weighted voting rights structures, there may be another Alibaba and it would be unfortunate for Hong Kong if it missed out on those kinds of company listings.
Clearly allowing a company with weighted voting rights to list - where the founders can remain in control even though they don't own a majority of the shares - does create an opportunity for them to do what they want. It's very difficult for minority shareholders to get rid of the founders if they don't like what they're doing, and that means there could potentially be abuses. But Hong Kong has to make a decision as to what is best for it. I think on balance it's better to ensure these companies can list in Hong Kong.
It's so imperative for Hong Kong to remain competitive internationally. Hong Kong is competing against not only the likes of New York and London and Singapore, but also against the Chinese exchanges. So it's in a really tough position competitively, and I think it just has to do something to remain competitive.
Tan Jenn-hui, head of capital markets & corporate governance for Asia Pacific
Fidelity International
Undoubtedly, the decision by the HKEx to allow dual class share listings will attract more technology and biotech companies to Hong Kong in the short term. There will be many who will say that the reality is that most listed companies in Hong Kong are controlled anyway and that dual class shares are nothing new, especially for those familiar with US and some European markets.
As long term investors though, we are more circumspect. The truth is that we simply don’t know what are the long-term implications of this grand experiment. The Hong Kong market is different in many ways from Western markets and will only become more so as the weight and influence of mainland Chinese companies and investors grows.
Fidelity International has long believed in the principle that owning one share should entitle its holder to exercise one vote. The principle aligns the influence of shareholders to the size of their investment and empowers minority shareholders to engage fairly and effectively on environment, social and governance (ESG) issues.
The decision to dilute this principle to attract new listings carries risk. Concentrating power in the hands of a founder to run the business for the long-term sounds like a good idea, but what happens if, one day many years from now, the interests of the founder and the interests of the company they founded diverge? Public shareholders may have no alternative but to sell, exacerbating volatility at a time when the company needs stability. The system of checks and balances which underpin our system of corporate governance will have been undermined.
These decisions do not exist in a vacuum. Other market operators can, and already have, responded by offering similar flexibility to attract the best companies to list. This collective action problem can easily result in a regulatory race to the bottom, eroding regional governance standards and ensuring that any benefit from the initial change is at best short-lived.
Globally, great progress is being made on improving ESG standards at companies. Longer term, the implications of dual class share structures may be far outweighed by other positive developments.
Michelle Li, head of research
AMTD Group
We view this as a positive development for the overall competitiveness of Hong Kong’s capital market. The weighted voting right (WVR) structure not only increases the attractiveness of HKEx as the listing destination for high-tech and innovative companies, but also puts HKEx’s rules more in line with other major stock exchanges in the world. However, this does not mean a weakened emphasis on corporate governance or on investor protection.
Voting is the key right enjoyed by shareholders and it is a tool for them to express views on important matters of the invested companies. However, in the world of high-tech high-growth companies, founders are often diluted by multiple rounds of fundraising due to rapid expansion and significant investments into research and development. The eventual success of a start-up however is highly dependent on the founders’ vision, passion and consistent execution capability. It is important to allow the founders and management to continue maintaining control over the strategic direction of the company. Thus, the introduction of WVRs.
The existing listing rules provide a very high level of protection against abuse of position by major shareholders and management. HKEx introduced new listing rules specifically for issuers that have the WVR structure. These include WVR voting power being capped at no more than 10 times the voting power of ordinary shares, and non-WVR shareholders must have 10% of voting power.
Currently HKEx sets a high standard for companies that are eligible for WVR structure. The market cap must be at least HK$10 billion ($1 billion), and annual revenue must be HK$1 billion if market cap is less thanHK$40 billion. We believe this is HKEx’s approach to first apply WVRs on more matured high-tech companies with strong corporate governance in place.
Together with the new listing standards for biotech firms and secondary listing, we believe HKEx’s new rules have significantly strengthened Hong Kong’s overall competitiveness as a global financial centre. We expect to see an increasing number of tech or biotech-focused funds based in Hong Kong, due to proximity to the huge China market.