Will consolidating Chinese capital markets

bring storm warnings for Caribbean companies?

In the January issue of this Cayman Financial
Review, Mr Gene DaCosta offered an insightful analysis of why companies
incorporated in the Cayman Islands enjoy such prominence on the Stock Exchange
of Hong Kong (SEHK) – the equity market which led the world in capital raised
for 2009 and 2010. The content of Mr. DaCosta’s piece is especially interesting
because it helps readers discover a fact that often escapes many observers of
the SEHK – that is, of its 1,413 listed companies, 1,211 are incorporated
outside of Hong Kong, under foreign law.

However, quite surprisingly, the SEHK’s
statistics categorise foreign-incorporated companies as “domestic” unless the
majority of their business is done outside of Hong Kong. It applies a test with
undisclosed parameters to determine the actual economic centre of operations,
rather than categorising companies simply by the nationality of the law
governing their internal affairs (eg, the rights of shareholders against the
company and each other or how the corporate capital should be constituted and

Thus, in a world where hundreds of thousands of pounds, dollars or
euros in advisors’ fees might be spent debating and lobbying for specific
models of corporate governance as expressed in companies acts and in the rules
of securities regulators and exchanges, the governance of most companies listed
on the SEHK is currently governed in the first instance by a law that is not
disclosed prominently to investors, at least not after the initial public
offering or listing. As discussed in this brief exposition, if Chinese capital
markets consolidate following the current world trend among exchanges, as
evidenced by the merger plans of the London Stock Exchange (LSE) and Toronto or
Deutsche Börse and the New York Stock Exchange (NYSE), a shift in policy could
potentially bring turbulence into the calm waters surrounding the
Caribbean-incorporated companies discretely constituting the bulk of SEHK

Let’s review some of the figures, based on
the recently released Factbook 2010 of the Hong Kong Exchanges & Clearing
Ltd. (HKEx), which owns the SEHK. Caribbean companies clearly dominate the
SEHK: of the 1,244 companies listed on the SEHK Main Board, 900, or about 72
per cent are incorporated in either the Cayman Islands or Bermuda, as opposed
to only 198, or 16 per cent, being incorporated in Hong Kong itself. On the
Growth and Enterprise Market (GEM), the balance is even more uneven: of the 169
companies on the GEM, 130, or 77 per cent are incorporated in the Cayman
Islands or Bermuda, and only 4, or 2 per cent, are incorporated in Hong Kong –
the remainder being incorporated in the People’s Republic of China (PRC). At
least for the SEHK’s Main Board, these figures do not at all correspond to
market capitalisation.

Indeed, Caribbean companies constitute only about 28 per
cent of market capitalisation, whilst Hong Kong and PRC companies constitute
more than double that figure, at about 62 per cent thereof. As will be
discussed below, this last ratio could be very important for the SEHK in weighing
its choices as it grows in international stature, or joins the global trend of
consolidation in securities markets by merging with one or both of the
exchanges in Shenzhen and Shanghai, or even joining a broader global group of

The undisputed engine of growth at the SEHK
over the last 15 years has been the listing of PRC companies, which Hong Kong
attracts both because of the freely transferable Hong Kong dollar and the
quality of its investor protection laws, including its company law. The SEHK’s
expansion has largely tracked that of the Chinese economy. However, as the
PRC’s official currency, the renminbi, becomes more freely convertible and
increasingly available outside of China, Hong Kong will begin to lose its
function as a currency window. Thus the effect of high quality Hong Kong law
“bonding” the accuracy and completeness of information that PRC companies
provide to investors and the diligence and loyalty of directors in PRC
companies to shareholders could increase in importance as a factor the SEHK
presents to investors and potential issuers.

The quality of Hong Kong company
law is indeed high – it contains rules for the disclosure of information to
shareholders that exceed those found in both the UK Companies Act and the Delaware
Corporation Law, and its provisions on capital are not burdened by
much-criticized requirements that the UK has been forced to adopt because of
its EU membership. The SEHK’s standard technique for listing foreign
incorporated, or “overseas” companies is first, to scrutinise the home
jurisdictions and list those which provide acceptable standards of investor
protection, and second, to supplement such foreign law by ensuring that
companies from some jurisdictions include specific provisions and protections in
their constitutional documents. For overseas companies such as those
incorporated in the Cayman Islands and Bermuda, these requirements are found in
Chapter 19 of the SEHK Listing Rules, including Appendix 13 thereto, and for
PRC companies, corresponding requirements are found in Chapter 19A and the same
Appendix 13.

No company can change the law of the
jurisdiction where it is incorporated, and provisions of law thus provide
secure protection for minority shareholders. However, when rules are introduced
into the “constitutional documents” of a company to create protections
equivalent to those provided in Hong Kong law, shareholders with sufficient
voting power can change or remove them.

Thus investors should be able to
monitor against any such change, especially as the available sanction for the
removal of shareholder rights would be delisting from the SEHK, which actually
inflicts punishment primarily on the minority shareholders. It cannot bode well
for Hong Kong’s reputation as a supplier of high quality law that nearly three
quarters of the companies listed on the SEHK are greatly governed by
constitutional provisions that majority shareholders could change with little
warning. Perhaps this is why the SEHK does not in its publications prominently
announce to the world that the majority of its “domestic” companies are
actually “overseas” incorporated companies whose business operations are
primarily in Hong Kong.

The listings from the PRC, which are also not declared
to be listings of “foreign” companies, have by contrast obtained considerable
notoriety as the well-known “H shares” from China. Those companies incorporated
in the Cayman Islands and Bermuda go mostly unnoticed by students of the Hong
Kong market as a whole, and primarily owe their acceptance in Hong Kong to a
common legacy of British rule and British law – a legacy that slips further
into the past each day.

It is wholly possible that future events
could bring storm warnings for the Caribbean companies that have enjoyed such
popularity in the stock exchange on Victoria Harbour. First, as the SEHK
continues to grow and begins seriously to challenge the international dominance
of exchanges like the LSE and the NYSE, it will be increasingly judged on a
world-class standard, which may not accept the classification of non-Hong Kong
companies as “domestic” for listing purposes just because their business takes
place primarily in Hong Kong, their constitutional documents contain minimal
guarantees, and ample disclosure of their origin was made on the primary market
at the time of their initial offerings.

Indeed, EU law subjects the LSE to a
very strict regimen of differentiated treatment for companies incorporated in
the UK, other EU member states, and third countries. US law also imposes strict
distinctions between American and foreign companies, even if it has
traditionally attempted to accommodate the latter. Second, the trend toward
consolidation among the world’s securities exchanges will almost certainly
bring Hong Kong into its vortex at some point.

This could take the shape of a
Chinese “National Market System” (linking Hong Kong, Shanghai and Shenzhen) in
which the relatively informal and undisclosed accommodation of British
territories might decrease. Further, such relatively casual and lightly
disclosed accommodation could, as discussed above, threaten the SEHK’s
reputation for solid and transparent governance rules, and the latter is the
hook on which its attempt to support the shaky reputation of PRC investor
protection hangs.

Indeed, the use of tax-efficient Caribbean vehicles by
Chinese and Hong Kong entrepreneurs to conduct business in Hong Kong, all the
while drawing their financing from investors’ on the SEHK, can raise
significant questions about Hong Kong’s and the HKEx’s campaign to sell high
quality law and regulation to China and the world. Third, although Caribbean
companies constitute nearly three quarters of those listed on the SEHK Main
Board, they contribute somewhat less than one third of its market
capitalisation, which lessens their importance for the SEHK’s overall liquidity
and economic status, thus reducing the bargaining power of advocates for such
companies with respect to the arguments outlined above. 

Will the growth of the SEHK and its
eventual consolidation with the larger Chinese market decrease the use of
Caribbean companies in Hong Kong? It certainly may for listed companies.
Private, unlisted holding companies would be another matter. Almost none of the
foregoing discussion would be relevant for an unlisted holding company
incorporated in the Cayman Islands or Bermuda. Thus the versatile, low tax
vehicles offered by these jurisdictions might just move to higher ground on the
corporate pyramid so as to escape any waves of controversy in a Chinese
National Market System. Such use would depend on the shape of tax and
securities laws in a China with unrestricted currency flows, and such shape is
as difficult to predict as the course that China itself will eventually follow
in its navigation between the varieties of capitalism. 


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David C. Donald

David C. Donald is a Professor, Faculty of Law, The Chinese University of Hong Kong, and Director of the CUHK Centre for Financial Regulation and Economic Development. Together with Andreas Cahn, Donald has recently published Comparative Company Law: Text and Cases on the Laws Governing Corporations in Germany, the UK and the USA (Cambridge: 2010).  

David C. Donald
Faculty of Law
The Chinese University of Hong Kong
Shatin, New Territories

T: + 852 2696 1042
E: dcdonald@cuhk.edu.hk
W: www.law.cuhk.edu.hk/people/donald-david-c.php  

Chinese University of Hong Kong

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As a top university in Hong Kong and Asia, CUHK aims to nurture students with both specialized knowledge and wisdom for life. The education experience here is distinguished by a flexible credit unit system, a college system, bilingualism and multiculturalism. There are general education courses to broaden students' perspectives and develop in them the ability to face the challenges of contemporary society. Our eight Faculties offer a wide array of excellent undergraduate and postgraduate programmes.

The Chinese University of Hong Kong
Shatin, New Territories

T: + 852 2696 1042
E: dcdonald@cuhk.edu.hk