Clients of Bernard Madoff found to their sorrow that information has value and is not disclosed without sufficient compensation - or because it is required by law, enforced by a competent regulator. Despite regular prodding, the SEC failed to force the disclosure of information in this case.
The SEC’s failure was definitely due to incompetence and possibly inherent economic flaws. Any referee of any game is supposed to be independent and free from political and economic influence. The value of any central bank and its ability to successfully manage any monetary system must be based on its degree of independence from politics. The same is true of any market regulator.
In a letter published in the Financial Times on December 7th, 2005, I pointed out that the Hong Kong Stock Exchange (HKEx) could not meet international standards of investor protection. I cited three reasons. The first was an inherent conflict of interest. One of the watchdogs for the HKEx is owned by the Hong Kong Exchanges and Clearing Company. So one of the regulators has an economic incentive to protect its listed parent’s shareholders more than other investors. Further, there are no civil or criminal penalties. The powers are defined by contract and not statute. This severely limits the type of penalties that can be imposed. It also means that the rules can changed at any time, possibly as a result of direct or indirect influence from the State Council in Beijing.
The second reason had to with jurisdiction. Although there are many mainland based securities listed on the HKEx, there is no legal jurisdiction to enforce an order for information from any Chinese company. Any investigation can only rely on voluntary compliance.
The third reason has to do with free speech. Markets are about choice. To make an informed choice you need information. To get that information you need free speech. A free press with large economic incentives to find and disseminate the truth is a necessity for providing accurate, timely and complete information to markets.
Not surprisingly the HKEx responded to my letter with a denial. They felt that
Section 63 of the Securities and Futures Ordinance requiring HKEx to act in the interests of the public, having particular regard to the interest of the investing public, and to give precedence to those interests if they conflict with HKEx's own commercial interest while discharging its obligations.
In addition to the management of HKEx, my thesis was challenged by an economics professor at Johns Hopkins University who insisted that another economist, “Simeon Djankov and his colleagues at the World Bank's investment climate department. In the bank's "Doing Business in 2006" report, Hong Kong ties for third among the 145 countries included in the "investor protection index".
The next year proved my point. The Hong Kong's financial watchdog conceded in an article published in the Financial Times on May 11 2006 admitted that it lacked the teeth to pursue fraud in Hong Kong and its capacity to take action against local-listed Chinese companies was "seriously impaired".
Recently we had an excellent example that not much has changed. In the US, financial results for publicly listed companies are reported quarterly and must be disclosed within 40 days of a quarter-end and 60 days of a year-end. In Hong Kong, listed companies need to report results twice a year and have three months after the end of the period for the half-year report, and four months for the year-end to disclose the results. Not only is this delay a problem for most investors, it also works to the benefit of directors and managers of Hong Kong-listed companies who are allowed to trade shares until a month before results are announced. So they have months of proprietary access to very valuable information. In the US such trading would be banned under the SEC rule 10b5-1 which prohibits insider trading.
To prevent this type of insider trading, last year the Hong Kong Stock Exchange wanted to change the rule which would prevent insiders from trading in their own shares until the results are disclosed. The rule was supposed to go into effect on January 1st, but the howls from the richest members of the Hong Kong community became intense. They placed a full page advertisement in local newspapers on December 29th from hundreds of listed companies run by prominent local families including Li Ka-shing, who is Hong Kong’s richest man. The protest worked. The Hong Stock Exchange decided to delay the rule change until April 1st. Finally on February 12th the watchdog caved and will no longer implement the rule and, of course, the stock market fell.
When the regulator is subject to the wishes of the regulated, then, as predicted by the game theory and the free rider problem, it will be the markets that suffer. The Wall Street Journal reported this morning that hopes of China’s rebound were beginning to fade as I predicted in my last article and in my letter published in the Financial Times last November. With such a poor global economic environment HKEx should try to increase transparency to help its market. Unfortunately, it is and remains what is referred to in game theory as a relationship based system. It is controlled by a few powerful distributional coalitions who have access to information not available to the general market. In this situation, any reliance on either fundamental or quantitative analysis will be misplaced. Further since these coalitions have no legal or economic incentives to change the rules, they won’t change. In time, investors understand that poor information increases their risks, so they seek safer investments elsewhere.
Disclosure: No positions
