good intention, bad execution
New bookkeeping rules for equity and debt markets transactions by the Hong Kong Securities and Futures Commission came into effect on August 5. Nearly two months later, the general standards seem a little toothless.
With no significant deal flow since early August, it may be difficult to test the effectiveness of the rules, but a consensus quickly emerged among market participants – the regime added to the workload, but had little impact on the pain points they were meant to tackle.
The transparency of the bookbuilding process is at the heart of the changes at the SFC. The standards ban so-called X orders – the practice of inflating the books with anonymous investors – and introduced measures to improve investor confidence and introduce a fair price discovery process.
The rules require bookrunners to identify bond investors to the issuer and appoint a general coordinator to manage the transaction; the latter requirement is more critical for Hong Kong IPOs. The SFC further discourages exclusive orders or offers placed by different entities under the same parent company.
The intention of the regulator is good: to improve the transparency of the bookbuilding process and to strengthen market standards.
But the opposite appears to have happened, further distancing Hong Kong’s capital markets from international best practice.
In its attempt to clarify the situation, the SFC has proactively published numerous FAQs since concluding an initial consultation on the matter last year and then publishing the rules. But the details are now biting investment banks operating in the industry.
For instance, GlobalCapital Asia understands that X orders can still find their way into trades by being placed on an “omnibus” basis.
This means that even though the standards require the identity of investors to be disclosed, this requirement is significantly diluted for mixed syndicates made up of Hong Kong and overseas bookrunners.
In such situations, the order pool, or omnibus, does not require detailed identification of end investors. This loophole benefits private banks who demand anonymity and bookkeepers who have long placed orders with several entities of the same group.
Fee and retainer letters are other areas where abuse is emerging.
SFC’s rules were meant to end the era of zero fees, curbing unhealthy competition between bookrunners. The new rules urge that fee details be broken down into a fixed part and a variable part to maintain the somewhat controversial standard of rewarding bookkeepers who bring in more orders.
But the transmitters have found a loophole. They push the full bookkeeping fees under the variable component and withhold no fees for the fixed part. This gives companies the discretion to allocate banks based on their role in transactions and the number of orders they bring.
Some companies are also reluctant to issue formal mandate letters, so they can sneak in a deal at the last minute. This usually occurs when banks that were not originally involved in the transaction are able to place orders for the transaction, allowing them to play a role in the transaction.
For its part, the SFC has shown pragmatism by leaving leeway to bookkeepers so that the rules do not end up strangling them.
Bookkeepers were asked to show that “reasonable efforts” were made to obtain retainer letters or negotiate fees. Such a concession is necessary, but it can also make situations more murky.
Another issue was also only partially resolved. The rules encourage bookrunners to deprioritize orders placed by a single group. Chinese transactions, for example, are traditionally backed by bookrunners with several group entities placing orders. This practice prevents genuine investors from getting their fair share of allocations, while preventing a market-driven price discovery process.
The rules now allow deprioritization, but only if issuers choose to waive it.
It can be argued that market expectations of SFC rules have already shifted to begin with.
Technically, the SFC only has jurisdiction over Hong Kong-based entities; players from Mainland China and the rest of Asia are out of its purview.
Another fundamental problem with the rules is that they are intended to govern the behavior of bookrunners, not issuers. In volatile times like today, issuers should also be held accountable for using the best standards in the market.
The SFC is aware of the limits of its regulations and those of the bookrunners. But in its attempt to introduce better bookbuilding practices, it ended up making the processes cumbersome, less transparent and not up to global market standards.
Given the fragmented nature of the Asian bond market and the region’s multiple jurisdictions, the SFC could take a more collaborative approach by engaging with regional regulators to align the rules, if only in spirit.
The rules, despite the many loopholes available, also provide the regulator with the ability to exercise their enforcement rights. Without being overly authoritarian, the authority could tighten up its own auditing processes and hold companies that defy the rules accountable.
No regulator likes to go back on previously unveiled rules and guidelines. But the SFC still has the ability to adjust the rules based on real-time market reactions. Prioritizing simple market features, such as preventing conflicts of interest and enhancing transparency, will move the needle much more than focusing on the details of one’s regime.
Organizations like the International Capital Market Association can also be a stronger force in serving as a voice for market participants. Issuers and law firms also have a responsibility to uphold high quality standards for transactions.
The extent of the damage caused by the new rules will only become clearer when the flow of transactions resumes in the region. But if market concerns are to be believed, the rules have missed the mark.