In the preceding article of this month’s Viewpoint column, Gilles Hilary, Professor of Accounting and Control, INSEAD, warns against the dangers of overregulation. CSj invited Michael Duignan, Senior Director, Corporate Finance at the Securities and Futures Commission, to share his views on the issues raised in Professor Hilary’s article.
Professor Hilary’s article warns against the dangers of overregulation globally – do you think this is a problem in Hong Kong?
‘When people are talking about overregulation, it is important to ask what areas they are thinking of. If you are a bank, then clearly you will worry about the outcome of Basel III, but as a trading company making auto parts, quite frankly, that might be interesting to read about in the financial papers but it won’t really impact your working life.
In terms of listed companies, there has been a shift in our approach to regulation towards behavioural concerns – we have been looking at how companies should behave and how individuals in those companies should behave. This has been partly in response to the fact that a lot of people, particularly in financial services, have been thinking of compliance solely in terms of their legal obligations. They spend a lot of time talking with their lawyers about what they are legally obliged to do, rather than thinking about what is the right thing to do in the circumstances.
So, for example, they might ask whether or not they are legally obliged to make a disclosure about a particular activity or transaction when maybe they should be thinking more in terms of what their investors would expect to be told.’
Do you think greater reliance on principles-based regulation in Hong Kong would help change this mentality?
‘One has to get the appropriate balance between trying to write the rules in a way that results in desirable behaviour, while avoiding something so high level that companies don’t know whether they have complied. This is not an easy balance to achieve.
I think the listing rules and the Takeovers Code are good examples of rules that deal with a wide variety of circumstances but not necessarily in a prescriptive way. In the majority of circumstances the rules indicate the right thing to do and if companies encounter a different scenario they can talk to us or the stock exchange. In circumstances where a rule will not achieve what it sets out to do, then a waiver might be appropriate.
To give you an example, there was a European case a few years ago where a company involved in animal experiments started having problems obtaining finance. One of the major shareholders was prepared to lend the company money in order for it to survive as the bank had withdrawn funding and no other bank was prepared to take the company on as a client. Under normal circumstances, as a connected-party transaction, this would have been subject to a shareholder vote and full disclosure, but the shareholder didn’t want their name to be disclosed. The loan was to be on ordinary commercial terms but they wanted the transaction to remain anonymous.
The regulator therefore had a decision to make. The connected-party transaction rule was designed to protect investors but, if the rule was applied rigidly, the company would have lost its financing and would have gone bust. In many respects, the decision was a no brainer – applying the rule would have led to the liquidation of the company and the investors would have got nothing. On the other hand, a strict regulator might take the view that there should be no deviation from a rule designed to protect investors. One thing that always concerns regulators when you turn a rule off for a particular set circumstances is how do you ring-fence that decision? ‘
What’s your personal view?
‘I think you need to look at what the rules are designed to do rather than viewing them as a set of commandments that have to be followed in all circumstances, whatever the cost. This goes back to the focus on behaviour I mentioned earlier. If a rule is designed to achieve something but a company can achieve that outcome in a slightly different way which technically might not be in compliance with the rule – then you can have a conversation. The question is whether or not the reasons for not applying the rule are sufficiently good and whether the overall objective will still be achieved.
Principles-based regulation was the mantra used by the Financial Services Authority (FSA) in the UK, and now of course many people are saying that it has been a total failure and a flaw in the regulatory architecture. I’d like to make a couple of points on that. Firstly, if you actually printed out the FSA handbook, you probably wouldn’t be able to get it on an average-sized table. So, for principles-based regulation, there still seems to be an awful lot of rules. Secondly, the US has a much more rules-based approach and did those rules actually stop corporate failures? Clearly not, partly because people were gaming the rules. If you try to set out rules for every conceivable set of circumstances that might occur, you are going to have a very large rule book and people will still find ways around it. I’ve been told that Enron was setting up companies three years in advance of using them solely in order to get around one of the SEC’s accounting rules. They were planning that far ahead.’
Do you think Hong Kong is ready for the principles-based approach, or do you think companies here are still very much in a prescriptive rules-based mentality?
‘I think that people tend to involve their lawyers extremely readily now, partly because of the risks, and therefore there is a greater desire than ever to have a rules-based approach. But I am not sure I buy the big distinction that tends to be made between rules-based and principles-based regulation. In reality, it’s always a balance between the two. You can have principles that underlie, or overarch, a rules-based approach.’
Do you get feedback from companies that indicates that there is an appetite for a less prescriptive approach?
‘I think companies are still getting used to the changed regulatory framework within which they are now operating and I think that the better run companies are aware of what else is going on. But one of the things that I don’t think has really been achieved here is enlightened selfinterest. A lot of companies still regard disclosure rules as a regulatory burden, whereas there are surely a lot of reasons why you should want to be engaged with investors – that way investors will be prepared to invest in you because they won’t be subject to nasty surprises. As a result, the market might apply a slightly lower discount in relation to your valuation than they do in relation to other companies.
As I have said publicly before, one message passed to me from a number of fund managers I have had discussions with, is that the discount they apply to Hong Kong listed stocks can be as much as 50%. I find that astonishing. What they are saying is that, on a purely fundamentals-based valuation, the company would be worth twice as much. The discount is due to the risk of not getting the right information at the right time and not understanding fully what the company is doing.’
Professor Hilary warns that the regulatory process that started in the aftermath of the last financial crisis may be sowing the seeds of the next one. Do you think there is truth in that?
‘It’s not really my area, but we don’t operate a zero-failure regime in terms of supervising firms. People will cheat. They will lose money and you will get rogue traders. What you have to do is try to put in place controls that prevent this as much as possible and identify those problems as early as possible.’
On the other hand, there is the opposite view – that it was the ‘light touch’ regulation that led to the crisis in the first place.
‘Yes, I thought that one of the best points the article makes is that “the development of compliance-centric procedures is not conducive of good risk management”. This is not a box-ticking exercise. If you don’t understand what you are actually doing it doesn’t matter if you tick all of the boxes or not – the chances are you will eventually go down. Any company that unthinkingly says “we make sure we comply with everything”, is probably abdicating responsibility because that in effect says “we’ll leave it up to the regulators to decide what we need to do in order to keep ourselves safe”.’
Another issue raised in Professor Hilary’s article is the fact that regulators are not working in a globally integrated framework –would you like to see better integration of the regulatory framework globally?
‘Yes. The SEC is doing its thing and the EU is doing its thing, and both of them are doing so in an increasingly extraterritorial way. In effect there are times when they have said: “whatever the circumstances in your home jurisdiction, if you are engaged in our market at all you have to comply with our rules”. The Asia Pacific countries are now starting to work together on this and the SFC is one of the leaders in this space. We are kicking back and saying: “We have something that works just as well, it just doesn’t do it in exactly the same way, but there should be an acknowledgement that it works”.
Now, the interesting thing is that Europe has developed the concept of “equivalence” – this means accepting that another jurisdiction has standards equivalent to your own. Most jurisdictions don’t have that hard wired into their legislation. In fact there has been a shift to a more domestic outlook because, when international companies go bust, they become a problem in their home states so politicians are seeking tougher controls domestically.’
Do you think the equivalence principle is the solution to this?
‘In the absence of a global regulator, I think equivalence or regulatory deference is the only way you can achieve better integration of the global regulatory architecture.’
Do you think there will ever be a global regulator?
‘No – partly because markets are at different stages of evolution. There are huge differences across jurisdictions. For example, at one time warrants were immensely popular in Italy but virtually unknown in France, as they are neighbouring countries. So when you have that kind of difference in mentality, you can’t possibly have a single set of rules that applies to everybody across the globe – it just wouldn’t work.’
Is the SFC promoting the equivalence approach?
‘Yes. Ashley Alder [Chief Executive of the SFC] is the Chairman of the IOSCO Task Force on Cross-Border Regulation which is looking at cross-border regulatory cooperation. One of the biggest barriers to that is the fact that national legislative regimes are domestic in outlook and do not have a concept of equivalence. It is also the case that there are few universal principles that guide the way regulators coordinate on cross-border regulation and resolve disputes arising from potential or apparent conflicts of interest and laws among jurisdictions. That makes it harder for regulators to deal with the challenges posed by an increasingly connected and interdependent world.’