Introduction: Current Regime and Proposal
In September 2018, the Stock Exchange of Hong Kong issued a Consultation Paper for a proposed new Listing Rule 13.50A. The proposed rule seeks to immediately suspend trading of an issuer’s shares if their auditors are unable to greenlight their financial statements without qualification, with a risk of delisting if the issue is not fixed within 18 months (12 months for the GEM Board).
Under the proposed Listing Rule 13.50A, suspension of trading will be “normally required” when an issuer publishes preliminary annual results and its auditor has issued, or indicates that it will issue, a disclaimer or adverse opinion on the relevant financial statements (the proposal however does not apply to qualified opinions). In increasing degrees of severity, qualified opinions, disclaimers and adverse opinions are issued based on the risk of material and/or pervasive misstatements in an issuer’s financial statements. If the suspension is not lifted within 18 months, the Stock Exchange has the power to delist the issuer’s securities under Listing Rules 6.01A. In other words, on the issuance of a disclaimer or adverse opinion, the delinquent issuer’s shares will immediately be suspended from trading and a countdown to delisting begins.
In contrast, under the current regime, where a modification on the auditor’s opinion is likely, the issuer is only required to disclose additional information in its results announcement and annual report together with details of the modification. There is no hard and fast rule requiring suspension owing to the publication of a disclaimer or adverse opinion. Nevertheless, at present, Listing Rule 6.01 empowers the Stock Exchange to suspend or cancel the listing of an issuer to protect investors and/or maintain an orderly market, and in the Consultation Paper, the Stock Exchange gives the example of a disclaimer due to possible accounting irregularities as being one such cause for suspension in the current regime. In the event of suspension, the 18 months to delisting will begin to run. However, the major differentiating factor between the current regime and the proposal is that trading suspension, which triggers the countdown to delisting, remains for now at the discretion of the Stock Exchange, and is not a default penalty.
Analysis of the Benefits and Disadvantages of the Proposal
The new regime has the stated purpose of protecting investors and, on first blush, appears to accomplish this objective. By enhancing the punishment and the certainty of punishment, it incentivises issuers to improve the reliability of their financial information and cooperate with auditors by disclosing all requisite information; and, in the event of a disclaimer or adverse opinion, encourages issuers to cure the defects as soon as possible. But despite the good intentions, the new Listing Rule raises many unintended consequences that could well defeat its stated purpose and potentially harm the investors it seeks to protect.
(i) The Auditor’s Position
Firstly, it is worth noting that independent auditors occupy a position of conflicting interests. On the one hand, they are instructed by the directors of issuers and paid by issuers for rendering an audit opinion. On the other hand, their objective is to be independent and protect shareholders. It is not farfetched to think that issuers, when faced with a disagreement with their auditors and an impending modification, would attempt to bully auditors into a favourable opinion. They could threaten to take their business elsewhere and obtain a more palatable opinion. Auditors may feel pressured to water down what otherwise would have been a disclaimer or adverse opinion to appease paying clients. This is not to say there is no such conflict under the current regime, but auditors would feel more at ease in issuing a disclaimer or adverse opinion if they were not also given the seat of executioner. The proposed Listing Rule would shift the discretionary power currently vested with the Stock Exchange onto accountants, who, owing to their concurrent roles as independent auditors and service providers, are ill placed to take on such authority.
(ii) Reduction of Transparency
This ties in with a related concern regarding disclosure and transparency. If ramping up the conflicting pressures on auditors could undermine their independence and prompt them to issue opinions that are more benign than would otherwise be issued, this may introduce a sliver of suspicion for investors who rely on audited financial information and the independence of auditors.
But there is another factor that could further affect transparency which may result from the interaction between the existing Listing Rules and the proposed Listing Rule 13.50A. Under Listing Rule 13.50, suspension of trading is required when an issuer fails to publish its preliminary annual results announcement within three months of its financial year end. If the new Listing Rule is adopted, it would introduce a form of regulatory arbitrage in which the punishment is the same regardless of cause. An issuer faced with a disclaimer or adverse opinion may simply elect to delay the publication of its preliminary annual results beyond the deadline of three months. If only from a reputational perspective, a suspension owing to delay could be more palatable than a suspension owing to defective financial information. As a result, the proposed Listing Rule could inadvertently lead to a lack of transparency for investors, who in such a case would be unable to ascertain the true reasons behind a suspension. Indeed, it would not be surprising to think that the current rarity of adverse opinions may be due to the fact that at least some issuers currently suspended for failing to publish timely preliminary annual results have done so to avoid the taint of an adverse opinion. The new Listing Rule may further muddle the waters by enlarging the opportunities for issuers to shop around for a preferred indictment.
(iii) Defeat of Investment
The third point relates to the unintended harm that will be done to the investors whom the proposed Listing Rule purports to protect. Suspension and delisting deprives investors of a market for their shares and renders such shares worthless, even if the underlying assets and business of the issuers are healthy and profitable. Investors will be deprived of the ability to exit a poor investment in the event of suspension, and would see their investments becoming absolutely worthless if the issuer is ultimately delisted. If for instance a financially distressed issuer disputes the judgment of its auditors in respect of whether it can continue as a going concern, investors should be able to elect to dispose of their shares or hold and perhaps allow the company access capital from the markets and work its way out.
Furthermore, as the Consultation Paper states, many of the modifications issued recently resulted from failures by issuers to obtain documents following material changes to the board and failures to maintain proper records. It would be rather unfair for an investor to lose the entire value of his investment to an uncooperative former director or poor record-keeping, which are factors unrelated to the performance or value of the underlying assets and business of the issuer.
The suspension of an issuer’s shares may also trigger a vicious cycle, if a relatively small issue, such as poor record-keeping or an uncooperative former management, snowballs into a substantial threat to the issuer’s ability to continue as a going concern. An issuer’s creditors may for instance immediately call outstanding loans and thereby activate cross-default provisions in other loans, or key suppliers and clients may terminate major supply and purchase contracts, as a consequence of the suspension. This would only severely compound the issuer’s problems and hasten its delisting. A total defeat of an investor’s investment hardly protects his interests.
Besides, there is a question of whether 18 months (or 12 months, for GEM Board issuers) is sufficient for issuers to remedy their defects. Where the problem is financial distress, corporate governance or internal control issues, it takes a substantial period of time for a company to remedy these problems and to gain approval from the Stock Exchange. There is therefore the additional question of whether a hair-trigger suspension, and concomitant countdown to delisting, could force a healthy issuer off the capital markets before it is given sufficient opportunity to rehabilitate.
(iv) Squeeze Out
Finally, the total defeat of investment upon delisting can also become an opportunity for opportunistic shareholders. Financial statements with disclaimers or adverse opinions are not true reflections of the value of the issuer. Investors need to note that financial statements are merely records of historical financial performance of an issuer which were prepared based on recognised financial reporting standards. These financial statements are by no means the only tools for projecting future profits or estimating value of an issuer. What really matters is the future cash flow of an issuer. By reducing the share price to worthlessness irrespective of the underlying value of the issuer, suspension and delisting would also provide opportunity for controlling shareholders to buyout other shareholders at steep and possibly unfair discounts.
It appears that comparable stock exchanges approximate the current regime of Hong Kong, in which the relevant stock exchange retains discretionary power to suspend trading of shares in an issuer whose financial statements are not satisfactory.
As the Consultation Paper states, the US Securities and Exchange Commission require a clear expression of an opinion on financial statements. This requirement is not satisfied where an auditor has issued a disclaimer or adverse opinion. However, in the event a qualified, adverse or disclaimer opinion or unqualified opinion with a “going concern” emphasis is issued against issuers on the New York Stock Exchange (NYSE), the NYSE would deem the relevant issuer to be below the requisite continued listing criteria. Although the NYSE has the discretion to immediately suspend and delist the issuer’s securities upon the issuance of such modifications by auditors, there is no express provision that they by default are required to do so and indeed the NYSE adopts a wait-and-see policy to allow issuers a chance to correct their problems.
In the UK, the Financial Conduct Authority has the discretion pursuant to the relevant listing rules and guidance to suspend, with effect from such time as it may determine, the listing of an issuer where the issuer is unable to assess its financial position accurately and inform the market accordingly, which may include the situation in which an auditor issues a disclaimer or adverse opinion. Delisting may thereafter be considered if suspension exceeds six months.
We believe the current regime should be left intact, as it keeps the power of suspension and delisting within the discretion of the Stock Exchange. Auditors are ill-placed to and should not assume the responsibilities of the Stock Exchange. Although the intention underlying the proposal is correct, the execution of Listing Rule 13.50A could ultimately harm all stakeholders.
Hong Kong is a mature market populated by diligent investors. In the event an auditor’s disclaimer or adverse opinion is published with the financial statements of an issuer, a selloff and price correction would be due and expected. If the issuer shows no intention to or fails to solve its problems within a reasonable period, the Stock Exchange may exercise its discretion under the existing Rule 6.01 and suspend the issuer’s shares. It seems the elusive “right balance”, which all regulation ultimately seeks to strike, more closely approximates the present regime than the proposed one.
Editorial note: The Law Society previously published its submissions on the Stock Exchange of Hong Kong Limited’s Consultation Paper on “Proposal relating to listed issuers with disclaimer or adverse audit opinion on financial statements” in November 2018: http://www.hklawsoc.org.hk/pub_e/news/submissions/20181128.pdf