Financial crisis provokes tougher regulation

With angry taxpayers baying for blood and politicians eager to pass the buck, the ritual humiliation of banking executives by legislative committees has become a common sight on both sides of the Atlantic.

These public dressings-down have left American and British bankers, who are used to a system in which regulatory issues are generally discussed and settled behind closed doors, looking rather shell-shocked. Yet such displays could merely be a taste of what is to come as government officials and regulators work out tough new rules to limit the risk-taking capacity of financial institutions and listed companies.

Stock markets and regulators in the US and Europe have typically preferred to punish companies that break their rules in secret, arguing that this ‘light touch’ approach is more likely to win the cooperation of the errant issuer and produce a better outcome for investors. As Adair Turner, the new chairman of the UK’s Financial Services Authority (FSA), insists that light-touch regulation is dead, however, there are growing expectations that the naming and shaming of firms will become more commonplace.

In the less-developed markets of Asia, regulators are much more willing to publicly censure companies that have breached listing rules, and several exchanges also publish watch lists of stocks with bad financial records or poor governance. Many of the firms on these blacklists claim such action is counter-productive, however, as the intense reputational damage caused makes it very difficult for even well-meaning directors to turn the situation around.

There is also evidence naming and shaming can have other undesirable outcomes, such as a spike in highly speculative trading as investors gamble on the chances of recovery at blacklisted firms.

Varied approaches
While most regulatory authorities have the power to publicly censure miscreants, there is no clear consensus on how frequently such action should be taken. Although the US regulatory system is generally perceived to be tougher than those of other western markets, the NYSE and NASDAQ have issued just a handful of public censures in recent years.

Likewise, in London, both the FSA, which regulates the London Stock Exchange’s (LSE) main market, and the LSE itself, which oversees the niche Alternative Investment Market, very rarely name companies that break the rules. The LSE says it is not always appropriate to out errant companies and believes it can act more swiftly and nimbly when it avoids the legal complications inherent in naming rule-breakers.

But in Asia, where breaches of the listing rules are much more frequent, it is a different picture. The stock exchanges in Singapore and Hong Kong often issue public censures against companies for a variety of offenses, from failure to disclose information in a timely manner to concealing details of related party transactions. While disciplinary action in London and New York usually takes years, justice is much swifter in Hong Kong and Singapore. In March, for example, Singapore Exchange (SGX) took just days to issue a public reprimand against shipping group Neptune Orient Lines for failing to address market rumors of a possible rights issue in a timely fashion.

In addition, SGX, like China’s Shanghai Stock Exchange and Vietnam’s Hochiminh Stock Exchange (HOSE), publishes a watch list to alert investors to under-performing companies. Firms are placed on the list if they record three consecutive years of losses and their market capitalization falls below a set limit. They then have to take steps to improve their financial position and have two years to sort out their problems before their shares are forcibly de-listed.

The nascent HOSE employs a similar system, while in Shanghai under-performing companies are put under ‘special treatment’, whereby they have the prefix ‘ST’ added to their stock ticker and have a 5 percent daily price band trading limit imposed.

Blacklist backlash
Although many investors appreciate this transparent approach to market discipline, some of the affected issuers argue that naming and shaming is unhelpful for all concerned.

‘We are only a small company, and being put on the watch list has done a lot of harm to our reputation with investors and customers,’ says an executive from one Singapore-listed company, who asked not to be named. ‘Evidently, we need to improve our financial performance – but we knew that already. Being put on this list only creates more paperwork for us and makes it harder to turn things around.’

In Vietnam, where capital markets are a very recent invention and breaches of the rules are frequent, there has been a backlash against HOSE’s policy of putting companies that report losses on a watch list. Critics believe it unfairly penalizes companies in an undeveloped market and will put off new companies from listing at a time when there is already a distinct lack of IPOs.

Do Van Trac, general director of Saigon-based Cables and Telecommunication Materials, is one of several Vietnamese executives who spoke out after his firm was added to HOSE’s watch list. He told state media: ‘Our market is very sensitive to such news, especially coming at the toughest possible time’.

Vietnam’s State Securities Commission appears to be listening and is currently working on proposals to make it easier for companies to be removed from the watch list. At the same time, the Vietnamese regulator insists its main priority this year is to improve the quality of disclosure in order to boost investor confidence, which was badly bruised by the stock market bubble of 2007-2008.

In China the special treatment system also has its opponents, who argue that it actually makes for a less orderly and fair market, as ST-prefixed stocks often attract highly speculative and poorly informed investors, and trading can become extremely volatile.

Unhelpful attention
‘Some people think all regulatory action and censures should be disclosed to the public so investors are fully aware, but I’m not sure exchanges need to disclose everything,’ says David Smith, co-head of Asia-Pacific corporate governance research at proxy adviser RiskMetrics. ‘They must strike a balance between the need to inform the public and the need to not focus too much attention on what they’re doing.’

While public censures may seem unfair in the case of individual firms that have slipped up unintentionally, there is a wider benefit to be gained from naming those who breach the rules: it acts as a deterrent for more negligent issuers while educating the whole market about possible regulatory issues.

When Wolfson Microelectronics, a London-listed microchip manufacturer, was fined £140,000 ($229,000) by the FSA earlier this year for failing to disclose price-sensitive information in a timely fashion, the regulator gave investors a rare and fascinating insight into how markets actually work, as opposed to how they are meant to work.

The FSA noted that Wolfson had been wrongly advised by its IR consultants, Makinson Cowell, and chose not to seek counsel from its corporate brokers, JPMorgan and Citi, because it was concerned they would leak information to the market given the ‘inherent conflicts that exist in such businesses’.

‘The financial crisis came about, in part, because of the cozy consensus that had built up between issuers, investors and brokers,’ comments one former FSA official, who now works for a large financial institution.

‘Naming those who break the rules helps investors to sort the wheat from the chaff and get a better understanding of what is really happening. Whether firms like it or not, one consequence of this crisis will be that more of them will have to face the music in full view of the investing public.’

Recently named and shamed firms

HKEx
China Vanguard Group (February 2009)
Pearl Oriental Innovation (March 2009)

HOSE
Bien Hoa Sugar (February 2009)
General Forwarding & Agency (February 2009)
MT Gas (February 2009)
Refrigeration Electrical Engineering (February 2009)
Cables and Telecommunication Materials Corporation (February 2009)

NASDAQ
Onstream Media (December 2008)
Cell Therapeutics (January 2009)
Energy West (March 2009)

SGX
Netelusion (June 2009)
Rotol Singapore (June 2009)