Hong Kong small cap stock plunges and pledges

7 minute read

I learnt about Webb-site this year and read some interesting articles about how stock pledges were causing small cap stock plunges here and here. This is a rather niche topic but an interesting look into incentive alignment.

Firstly, what is Webb-site? This is from the “about us” section:

Webb-site was established in 1998 by David M. Webb, a former investment banker who has lived in Hong Kong since 1991. Webb-site Reports provides reports and independent opinions with a focus on Hong Kong affairs, including but not limited to corporate and economic governance, business, finance, investment, legal and regulatory affairs.

What is a stock pledge, what’s the issue with them, and how is that leading to plunges in small cap stock prices?

The current situation, under Listing Rule 10.07, is that for 12 months after listing, if a controlling shareholder (holding 30% or more of the shares) pledges any shares as security for a loan, then he must disclose that to the company, and the company must announce it. […] However, after the first year is over, there is no longer any general obligation for pledges by a controlling shareholder to be disclosed, unless it relates to a loan or guarantee provided to the company,

For those unfamiliar with the concept of a stock pledge, it’s when company executives borrow money using their equity as collateral. This is a widespread and common occurrence among top executives, both in the US and in China. It’s also not just a public company thing

“But I thought Elon Musk, Larry Ellison, Evan Spiegel are all billionaires? Why do they need to borrow money? They could toss it out of a helicopter and still be richer than me”

A common misconception is that all of the net worth of rich people is just piles of cash, i.e. Bezos has $100bn in dollar bills lying around in his secret moon base. This is usually not the case [1], and most of the wealth is tied up in their stock holdings from the companies they founded. Since most people and companies still prefer getting paid in cash [2], what’s a billionaire to do when they want to buy their next $100mm yacht when they only have $10mm in the bank? It’s a hard life.

“Why don’t they just sell the stock they have? The yacht company might not want stock but the rich guy could just liquidate and then buy the yacht?”

There’s at least two reasons why execs are less willing to sell stock to finance purchases. Firstly, it’s usually a negative indicator to investors when large shareholders sell stock in the company. Investors speculate that the exec knows negative news they don’t, and is trying to front run them by cashing out before the stock falls. Enough people care about this that the SEC requires ownership disclosure and there are companies dedicated to monitoring insider sale history.

Secondly, if you believe that your stock is going to 10x in value, you’d rather sell it as late as possible. If you can borrow against it now, still keep the ownership, and then pay back the loan eventually, you’re coming out ahead. If you’re able to get a loan for 5% interest, when your stock is growing in value at 15% yearly, you’re making a good trade.

“What’s the catch?”

If the value of your stock goes down, you can face a margin call where your lender asks you to put up more stock (or cash sometimes) to ensure the lender still has sufficient value of collateral. If you can’t do so, the lender might do a forced sale to try and get as much value out of their shares before the share price plunges further. This could be a self-fulfilling event that causes a rout in the stock price.

With that in mind, what’s the issue that Webb-site is frustrated by?

Webb-site is concerned about the lack of disclosure of stocks that are pledged, because of loopholes mentioned below,

So any effort by the exchange to extend its jurisdiction beyond directors to plain shareholders would fail. The only time the exchange has any leverage is at the time of listing, when it can and does require controlling shareholders to enter into the 1-year undertakings described above. But after listing, any subsequent controlling shareholder is not within reach of the exchange unless they are a director.

The HK exchange has jurisdiction over companies and directors, but not over regular shareholders. Due to a variety of reasons, these regular shareholders could hold large portions of stock but not be under jurisdiction, even though they are directly related to the company management.

A person receives a security interest in shares when someone pledges shares to that person. So the good news is that the law already requires pledges to be disclosed! If you pledge 5% of a company to a friend, your friend has to disclose it.

The bad news is that there is a giant loophole. Under Section 323(1)(f), an “exempt security interest” does not have to be disclosed. This is defined by Section 323(6) to be an interest which is: “held by a qualified lender by way of security only for the purposes of a transaction entered into in the ordinary course of his business as such a qualified lender”

And a “qualified lender” is defined by Section 308(1) to be a bank (including a restricted licence bank or a deposit taking company), a stockbroker, insurer or anyone licensed by the SFC to provide margin finance on shares.

If a bank lends to a founder and ends up with a large position in the company due to the collateral, they do not have to disclose this. Webb-site is concerned that these large pledged stakes cause unnecessary downside risks for the stock.

The security interest only becomes discloseable if the lender effectively forecloses and starts selling the stock, and then he has the usual 3 business days in which to make the disclosure. By then, of course, it is too late to be of much use to investors as the stock will already have crashed.

It’s only when the lender starts selling the stock that the general public realises the issue. Since the lender would only start selling in bad times, this is already too late for the general public to act on the information.

HK gives a few reasons for not changing this, but Webb-site disputes those:

What is really behind this is not any practical difficulty in complying, but a wish on the part of banks and brokers for secrecy in their dealings. That is outweighed by the public interest in fair and orderly markets. If a lender wishes to keep its loans private, then it should not take such large positions (over 5%) as collateral.

Second, on the “disclosure is meaningless” argument, we strongly disagree. If a shareholding has not been pledged, then the probability of a forced sale by a lender is zero, but if it has been pledged, then the probability is greater than zero. That is what we call informational value.

Third, on the “privacy” argument, this is outweighed by the public interest. If you are a controlling shareholder who wants privacy, then don’t float you company on the Stock Exchange, and don’t ask the public for their money. If you want their money, then you must be willing to live with the transparency that goes with it. If you are an investor who wants privacy, then stay under 5% and you will be private.

These rebuttals make sense to me, and I’m wondering what the HK regulatory counterargument would be. Disclosure of long positions is usually a good thing [3] so more information about who owns what (and what the risks are of a sudden sale) is useful. All in, something to be aware of for HK small cap names when ownership can be concentrated among managment and a large portion of that pledged away for loans.

Footnotes

  1. Well I’m pretty sure this isn’t the case for Bezos, but if you have personal knowledge otherwise let me know… would explain his fascination for space travel. Looking at the ‘main source of wealth’ for the richest people in the world shows that all of them are wealthy due to their ownership stakes in companies.
  2. Defined here as not just physical paper money but wire transfers etc ‘liquid’ assets, as opposed to assets such as real estate, equity, gold etc
  3. Disclosure of shorts is more tricky and I don’t know if I agree that all shorts should be disclosed