The Regulatory Framework for the Second Board

Attached for your reference is a speech given today by Mr Andrew Sheng, Chairman of the Securities and Futures Commission, at Beijing Hi-Tech International Week Finance Forum.

1. I am very honoured to speak to you today on the subject of financing growth in the hi-tech industry. As you may be aware, the Stock Exchange has been working on a second board model for Hong Kong since last May. This initiative arose out of concerns from the Government and industries bodies about the lack of capital for small and medium sized companies (especially hi-tech companies) to finance their business development. I would like to thank the China International Capital Corporation for giving me this opportunity to share with you some of our thoughts in developing the regulatory framework for Hong Kong's Growth Enterprise Market.

Overseas Experience

2. Let me start by looking around the globe for experiences on second boards. Clearly, we have many examples by which we can be guided – In Europe, we have the Alternative Investment Market (AIM) of the U.K.; Nouveau Marche of France; Easdaq¹ of Belgium and the Neuer Markt of Germany. Within this region, we also have much experience – the Second Board of the Kuala Lumpur Stock Exchange, Mesdaq² of Malaysia, Sesdaq³of Singapore and ROSE⁴ of Taiwan.

Note

¹  EASDAQ - European Association of Securities Dealers Automated Quotations.

²  MESDAQ - Malaysian Exchange of Securities Dealing and Automated Quotation Bhd.

³  SESDAQ - Stock Exchange of Singapore Dealing and Automated Quotation System.

⁴  ROSE - Republic of China Over-the-Counter Securities Exchange.

3. Although the success rate of second boards around the world has been mixed, the success of a focussed second board, such as the recently-established Neuer Markt, has proved that it is viable for exchanges to provide an alternative source of funding for growing corporates.

4. Before going any further, let me also lay to rest a common misconception regarding Nasdaq⁵. Although often referred to as a "second board", Nasdaq is not and never has been a "second board" in the true sense. It was established originally as a means of formalising the substantial OTC market in the US and has always been effectively a parallel stock market to the New York Stock Exchange. It commenced operation in 1971 with median quotes for more than 2,500 OTC securities. Since then Nasdaq has steadily outpaced the other major markets to become the fastest-growing stock market in the U.S.. By 1994, the annual share volume of Nasdaq surpassed that of the New York Stock Exchange. Nasdaq now has more than 5,000 companies listed and is itself divided into two tiers, namely the National Market (for larger companies with higher capitalisation) and the SmallCap Market (for medium-sized companies). It also regulates the OTC market and the Bulletin Board quotation system.

Note

⁵  NASDAQ - National Association of Securities Dealers Automated Quotations.

5. The "hottest" second board in major markets is currently the Neuer Markt. This shows how a focussed and specialised board can succeed in the right conditions. The Neuer Markt was launched in March 1997 and has prospered in the current "bull market" throughout Europe over the period. Since its start, the Neuer Markt has been among the best-performing stock exchanges in the world. In 1998, the Neuer Markt Index jumped 175%, compared with a gain of 17.4% by the DAX Index of the first board of Deutsche Borse. By April 1999, it had a total of 80 issuers and a market capitalisation of above US$40 billion.

6. However, not all second boards tell stories of success. Before AIM was established in 1995, for example, the U.K. had three attempts to establish an alternative market for small, emerging companies with high risk profiles⁶ All these markets suffered from insufficient liquidity and were closed. AIM itself also has not had anything like the success of the Neuer Markt and has not achieved the liquidity which had been hoped for.

Note

⁶  The Unlisted Securities Market was created in 1980 as a market for small firms, that did not meet the listing requirements of the Official List.  In spite of early successes, the market eventually suffered from insufficient liquidity, insufficient market marker capital commitment, and systematically underperformed the Official List.  It was closed in 1996.  Rule 4.2 was an off-market facility, with trading done on a matched bargain basis through brokers.   Trading was closed in 1995.  The Third Market existed from 1987 to 1990, and was meant to attract small, start-up companies with high risk profile, that did not meet the USM requirements.  All three markets proved unsuccessful in establishing or maintaining a liquid trading environment.

7. Many factors contribute to the success of a market. There is no doubt in our mind that a market which aims to achieve investor confidence and embraces quality, integrity and transparency is one that is more likely to succeed.

8. The Neuer Markt also shows the benefit of focus in its listed companies. It is not just an alternative board to the main market. Companies listed on the Neuer Markt are based in industries with a strong future and above-average sales and earnings prospects, such as telecoms, biotechnology, multimedia or environmental technology. However, companies from traditional sectors can also seek a quotation on the Neuer Markt if they offer new products or services or take an innovative approach to business processes. The Neuer Markt has also been fortunate in the market and economic conditions in which it has operated. Typically, high-growth and emerging companies prosper, and the attractiveness of investment in their shares increases, in surging economic and market conditions such as have been experienced in Europe in the period during which the Neuer Markt has operated.

Regulatory Framework for The Growth Enterprise Market ("GEM")

Fundamental principles of regulation

9. One of the first questions we asked when developing the regulatory framework for GEM is this – should the principles of regulation for GEM be different from those for the Main Board?

10. Our response, as confirmed by experiences of major markets around the world, is that there should be no difference – the fundamental principles of regulation for the Main Board should also apply to GEM. There may be a lowering of the initial listing requirements in order to allow emerging growth companies access into the new market, for example, by setting a lower market capitalisation requirement or reducing the profit record requirement. However, the quality of information to be given to investors, the extent of compliance by issuers and their advisers and the quality of supervision of the market by the regulator must not be lowered or watered down. In other words, any risks associated with the new market should only derive from the young and emerging nature of the companies and their businesses; and not from compromises on market and regulatory integrity.

11. The ultimate aim of any regulatory system, whether it is for the Main Board or for the Second Board, must be to ensure that market users, investors, issuers, intermediaries and other participants alike, have a high level of confidence that the market is a clean and fair place in which to do business. Markets that command such confidence will naturally attract the liquidity that will serve the best interests of all participants. To achieve and retain public confidence and trust, the basic principles apply - my own philosophy is market integrity and fairness, level playing field in competition and transparency and disclosure. Like markets across the world, we are concerned with the quality, integrity and transparency of the Second Board. It is also important to note that for the regulation of listed issuers, IOSCO laid down three broad principles:

12. Accordingly, our basic regulatory approach with respect to the Second Board is that the fundamental principles of investor protection and market integrity apply. This means that in developing the relevant rules and related infrastructure for GEM, we seek to ensure that :

13. Further, I wish to emphasise our standpoint in two very important respects:

The Disclosure-based System

14. Since the issue of the Stock Exchange Consultation Paper in May 1998, GEM has been characterised as an "enhanced disclosure-based" market. It is important to clarify at the outset what a "disclosure-based" market really means.

15. A typical disclosure-based market is one which delivers investor protection by imposing on the issuer an obligation to disclose all necessary and relevant information to enable investors to make informed decisions. In a disclosure-based system, in contrast with the "merit-based" system, the regulator does not comment on the merits of the investment, or pass any judgement on the securities or the investment opportunities being offered, be it good or bad. It only seeks to ensure that the relevant documentation provides all material information about the company and its securities so that investors could judge for themselves whether the securities being offered are worthy of investment. A disclosure-based system assumes a certain degree of sophistication of its investors – to a great extent, it depends on investors taking the initiative to read and understand what has been disclosed before they make an investment decision. The success of a disclosure-based system also depends on:

16. A disclosure-based system does not, contrary to the belief of a number of market participants, mean a system with no vetting or quality control by the exchange or the regulator. In reality, the role of the regulator to ensure that the market adheres to the relevant rules of disclosure is of pivotal importance.

17. So far as the Hong Kong Main Board is concerned, it operates on a hybrid, partly disclosure-based and partly merit-based, system. Under the current regime, the Stock Exchange does not pass judgement on the commercial viability of a business or company or the commercial aspects of a transaction to be undertaken by a listed issuer. The Listing Rules and the Companies Ordinance require that disclosures be made on the company or the transaction involved so that investors could make their own investment decisions. Thus, as in any sophisticated market, proper disclosure is a prerequisite. However, the Listing Rules also reserve for the Listing Committee the discretion to decide on whether a company is "suitable for listing". When the Listing Committee is asked to make such a decision, it necessarily passes judgement on the "merits" or "quality" of the particular issuer concerned, its management or the nature of its business, albeit that the commercial aspects of the deal are not the focus of such a decision.

18.  With respect to GEM, the question is whether Hong Kong is ready for the establishment of a purely disclosure-based market. In our view, the disclosure-based direction is one which all international markets, including Hong Kong, should and will move towards. Investment in companies listed on the GEM may carry greater risks than investment in companies listed on the Main Board, because of the nature of the businesses carried on by GEM listed companies. This means that the quality of the disclosure and market integrity are all the more important. For these reasons, the Exchange and the SFC will be focussed on ensuring that the standards of performance by the sponsors meet the requirements of the market. This will mean tougher and more onerous duties on the sponsors accompanied by a more onerous disclosure regime.

19.  What then is the role of the Exchange and the SFC? The Exchange is the front-line regulator in this area and, as the manager of the listing process, we envisage that the minimum duty of the Exchange is to check that the sponsor has adequately performed its duties. In the event that proper disclosure has not been made or the sponsor has not complied with its obligations, we would expect that adequate sanctions are imposed on the company management or the sponsor.

20.  Moreover, because GEM companies are likely to be small in size, and their share prices and volumes prone to be more volatile, we expect that the Exchange and the SFC would cooperate closely to conduct market surveillance to ensure that trading in the GEM is not subject to market manipulation or market misconduct.

21.  I repeat, investors in the GEM must know the high risks of the businesses that they invest in, but they should not expect that they could be cheated in the GEM. The risks of investment should be in the companies in which they invest, not in the quality or integrity of the market. This imposes a greater burden of supervision on the part of the sponsors, the Exchange and the SFC to crack down hard on all misconduct that threatens market integrity. The pursuit of a disclosure-based system without appropriate checks and balances would be detrimental to investors and damaging to the market. Therefore, with respect to GEM, we envisage that:

"Caveat Emptor"

22. The second board is a high risk market. Its high risk profile is principally posed by the small, start-up nature of the companies to be listed; the emerging nature of their businesses, the lack of a profitability record of operations and hence, the higher likelihood of business failures and insolvencies.

23. Neither the Exchange nor SFC possess the necessary expertise to review or comment on the commercial aspects of a business venture. Sponsors and financial advisers have the professional knowledge and experience to assess the growth potential and marketability of a company, and are therefore better placed to judge the strength and weaknesses of a company and its business. Accordingly, in regulating GEM, we are not concerned with, and do not seek to pass any judgement on, the commercial viability of any company. This is an area where the regulator should not be involved. It is a fact of life that emerging companies have a higher risk profile and that there are a greater proportion of failures among emerging companies than among well-established ones.

24. The principle of "caveat emptor" applies. The market should make its own judgement on whether a company is commercially viable. No regulatory system can, and should, relieve the investor of the responsibility for exercising judgement and care in deciding how to invest his money. If he makes a foolish decision on the basis of inadequate understanding of the risks involved in the investment, he cannot look to the regulator to make good the losses arising from his own misjudgement.

Summing Up

25. To sum up, we will adopt three basic principles in regulating Hong Kong's Second Board:

26. Whether GEM will be successful depends on many factors, not least the quality of the companies themselves and the appetite of investors. For our part, we will work closely with the Stock Exchange and the CSRC to uphold and maintain the integrity of the market.

Thank you.