Hong Kong's New Bourse Knows How To Bend Rules

Is Hong Kong's new market sacrificing discipline for size?

Leave it to Hong Kong to get a new stock market going at Internet speed. Since opening in November with a mandate to funnel cash into startups, Hong Kong's Growth Enterprise Market (GEM) has raised $1.3 billion. It has a roster of 23 companies and a market capitalization of $8 billion. The exchange is bigger now than officials had expected it to be at the end of this year. And it has surpassed Singapore's Sesdaq, which has a market cap of $5.1 billion. Now, K.S. Lo, the property magnate who set up GEM, has set his sights even higher: He wants 100 companies and a $13 billion market cap by yearend. "You become a financial center by becoming big," he says.

True enough. But size isn't worth much if it comes at the expense of discipline. Rules governing everything from stock options to the length of time companies must be in business before getting listed have been routinely bent to entice executives to list on GEM instead of Nasdaq. Some analysts believe that lax standards and dubious dealing may jeopardize the exchange's ability to attract global capital. Besides, the companies that dominate GEM aren't little startups; most are spin-offs from Hong Kong's biggest conglomerates. "It's too early to call it a failure, but [GEM officials] have, partly through their own actions, tarnished the image of the exchange," contends David Webb, a former investment banker in Hong Kong whose webb-site.com analyzes GEM companies.

Examples of rule-bending are legion. Companies were supposed to be in business for two years before listing; in March, GEM officials cut the waiting period to just one year. Either way, getting around the restriction has proved simple. Tom.com, an Internet portal controlled by tycoon Li Ka-shing, barely had a Web site when it went public in March. Executives had injected tom.com into an unrelated but established business handling electronic customs documentation. Sunevision, a Net company controlled by the Kwoks, prominent real estate moguls, bought and revamped a satellite-dish company so it could be peddled as a hot startup. Tom.com CEO Carl Chang says the company played by the book. "This was not a maneuver," he says. "We submitted our rationale to GEM's board and they approved it. There's no controversy." Sunevision did not respond to requests for comments.

To boost the number of new issues, GEM has permitted bigger stock options than the 30% its rules allow. Tom.com, for example, was able to grant stock options of up to 50% of issued shares, thus potentially diluting outside investors' stakes. And GEM has given execs permission to sell their shares before waiting the required two years. Managers at tom.com, for example, can unload stock just six months after the IPO. "We applied for a waiver because we want flexibility to use our currency," says Chang.

WAY TO COMPETE. Lo, who heads GEM's listing committee, concedes that the waivers may look excessive. But he defends them as a way for the exchange to compete, especially against Nasdaq. "Overly restrictive rules on such issues only block out good companies," he says.

Lo's flexibility doesn't sit well with everyone in Hong Kong. "There should be certainty in the rules," says Andrew Sheng, chairman of Hong Kong's Securities & Futures Commission and a former World Bank official. "Waivers should not be seen to be given to such an extent that the rules themselves do not appear to apply."

Despite his title, though, Sheng doesn't have primary regulatory responsibility. That lies with the Stock Exchange of Hong Kong, which is part of the soon-to-be-privatized Hong Kong Exchange & Clearing Ltd., a for-profit body. Critics have long accused the stock exchange of lax enforcement. And Hong Kong's legal community doesn't often go after this kind of offender. "You have no natural checks and balances," says a prominent industry executive. "I don't like the litigious U.S. system, but because the lawyers will hunt wrongdoers to the ends of the earth, people are scared."

There is also a worrying amount of privileged positioning in these new companies. Executives from Goldman Sachs, Merrill Lynch, and Morgan Stanley Dean Witter were among those who bought shares in Internet incubator Techpacific.com Ltd. shortly before it went public in April at steep discounts. Ilyas Khan, Techpacific's managing director, says: "The timetable for our funding is a matter of public record. There's a difference between when the investors committed and paid on one hand and when they received share certificates on the other." Meanwhile, key investors in iSteelAsia.com, including a former head of Goldman, Sachs & Co. in Asia, paid less than a penny on the dollar for 18% of the company's stock. A senior official at iSteelAsia says there was no wrongdoing.

Lo himself is nonexecutive chairman of Pandaplanet.com, an Internet recruiting company that plans to list on GEM later this year. He says that his investment is "peanuts," that he is not involved in day-to-day management, and that he recused himself from all listing-committee meetings about the company. "If I take up this job, I can't be wealthy?" he asks.

Then there's the issue of whether GEM is fulfilling its mission to raise finance for startups with limited resources. Tom.com, Sunevision, and hongkong.com, a spin-off of Nasdaq-listed chinadotcom Corp., alone account for some 70% of GEM 's market cap. There are even questions about how much of the money is really going to build up technology companies. Timeless Software, for example, raised $37 million on GEM in November and then spent much of it on a fancy office building in Hong Kong's pricey business district, according to company records. As it is, most GEM companies are now trading below their IPO prices.

Lo is undaunted by the criticisms--which don't seem to be scaring away many of the startups, either. Indeed, he says that another three dozen companies have already filed applications for listing on GEM. And the exchange's surveys indicate that 70 to 100 more are already doing the preliminary work necessary for a GEM offering.

NO LEEWAY. He also pledges that there won't be any leeway for rulebreakers on the new exchange. Lo says he strongly supports a securities bill that is expected to be presented in Hong Kong's Legislative Council by October. The bill includes provisions to make insider trading and market manipulation criminal offenses--as they are in the U.S. Still, Lo says: "I do not think we should set rules that shut out 999 good people just so we can prevent one thief."

GEM's backers say that the exchange is far from tarnished. "What's important is that the integrity of the market and the sponsors must remain high," says Timothy D. Dattels, head of investment banking in Asia for Goldman Sachs and a member of the listing committee. "If there is abuse it will hurt Hong Kong."

Questionable behavior among the ranks of GEM companies may be the exception rather than the rule, as Lo contends. Even so, the exceptions are too glaring to overlook. Investors may put up with these shenanigans for a while--these companies are supposed to be high-risk endeavors, after all. But if Hong Kong is serious about building an enduring market for startups, not to mention a competitive global financial center, it has to start exercising more discipline. A new law is a step in the right direction. But a new attitude among Hong Kong's close-knit financial community would be an even more welcome change.

    Before it's here, it's on the Bloomberg Terminal.