COULD A "CHINA ENRON" HAPPEN IN HONG KONG?

C O N F I D E N T I A L SECTION 01 OF 04 HONG KONG 002606

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STATE FOR EAP/CM AND EB
TREASURY FOR OASIA GKOEPKE
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E.O. 12958: DECL: 06/23/2031
TAGS: ECON EFIN PGOV HK CH
SUBJECT: COULD A "CHINA ENRON" HAPPEN IN HONG KONG?

Classified By: EP Section Chief Simon Schuchat; Reasons: 1.4 (b/d)


SUMMARY/COMMENT
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1. (C) The expanding role of Hong Kong's stock market, now
Asia's top location for raising new equity, underscores the
importance of Hong Kong effectively vetting which firms list
here and then regulating those companies in a manner that
protects investor interests while also advancing China's
economic liberalization and promoting regional financial
stability. The contemplated listing by the Macau firm SJM --
associated with tycoon Stanley Ho, as well as allegations of
money laundering -- demonstrates how events on Hong Kong's
exchange, which to a significant degree is privately
regulated, might potentially be of concern to U.S. policy
makers. The Consul General recently held separate meetings
with the head of Hong Kong's Security and Futures Commission
(SFC) and Hong Kong Exchanges and Clearing (HKEx),the
company that runs the stock exchange. He emphasized the
importance of listing scrutiny to Hong Kong's reputation as a
finance center, noting the pending SJM listing in this
context. Both interlocutors described the thorough vetting
required to go public here and emphasized the self-interest
of Hong Kong and the mainland in preserving the exchange's
strong reputation so that it can continue to serve as a
catalyst for mainland firms to restructure and adopt global
practices.


2. (C) There is no doubt that Hong Kong's exchange plays a
positive role in promoting better corporate governance among
mainland firms. However, the positive comments made to the
CG by SFC and HKEx are not the whole story. The head of the
Asian Corporate Governance Association told us of "Faustian
bargains" made by HKEx to let mainland firms in the door, and
he assessed that most mainland companies listing here would
not dare go to New York, where they could be exposed to class
action suits. Hong Kong's SFC lacks jurisdictional authority
in China, and the SFC Chairman himself recognizes this as a
pressing matter, given that most new listing business for the
exchange comes from the mainland. Also of note is that many
of the companies that list here represent China's shaky
financial system or volatile sectors like energy and
telecommunications. A significant downturn in China's
economy might well lead to diminishing business prospects for
these firms, and investor losses coupled with reports of
malfeasance could well dent the exchange's ability to
maintain its reputation as a center of quality geared to
matching emerging mainland firms with global investors. END
SUMMARY/COMMENT

BACKGROUND -- A BOOMING EXCHANGE, THANKS TO CHINA
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3. (U) Hong Kong's stock market is eighth in the world by
market capitalization, fourth in the world for equity raising
(after New York, Toronto, and the Spanish Exchanges),and the
top location in Asia for companies raising money through
initial public offerings (IPOs) or follow-on fund raising
activities. The world's top two IPOs over the past year both
took place here: Bank of China and China Construction Bank,
which together raised approximately USD 20 billion. New
business for Hong Kong's stock exchange is overwhelmingly
driven by listings from the mainland.


4. (U) "Going public" for mainland firms in Hong Kong
involves issuing two kinds of shares, both well known to
China-oriented investors: "H-shares" are stocks of
Chinese-incorporated firms that trade in Hong Kong, such as
PetroChina, China Life Insurance, and Air China; Red Chips
are stocks of Hong Kong-based corporations that are
substantially owned by entities affiliated with the Chinese
government, including Lenovo and China Mobile. The Bank of
China is an H-share; the Bank of China Hong Kong subsidiary
(BOCHK) is a Red Chip.


5. (U) The issuance of shares by Red Chip and H-share
companies has, since 1993, raised approximately USD 150
billion in funds and created USD 460 billion of market
capitalization, 39 percent of the Hong Kong stock market's
total, representing a range of key sectors. This in turn has
provided significant volumes of cash to refine or expand the

HONG KONG 00002606 002 OF 004


business operations of major Chinese corporations (whose
activities, depending on the firm, are both domestic and
foreign) by attracting portfolio investment from foreign
shareholders via Hong Kong.

REGULATOR: TOP CONCERN IS JURISDICTION
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6. (C) In a meeting with the Consul General, Securities and
Futures Commission (SFC) Chairman Martin Wheatley lamented
that the Hong Kong's stock exchange's expansion is almost
entirely reliant on companies that are resident in locations
outside of local jurisdiction. This poses an enforcement
challenge. Except for London and New York, other exchanges
primarily serve companies in their geographical proximity.
In Wheatley's assessment, mainland authorities are keen to
ensure nothing goes wrong. All that said, Wheatley sees a
new and riskier stage coming in regulating mainland firms;
new companies from the mainland will increasingly be private
in nature rather than state-owned enterprises (SOE). He
explained that the Chinese government has actually done Hong
Kong a favor by vetting SOEs before they even seek to list
here. Such controls will not be in place for privately held
firms, he said.


7. (C) Wheatley was less concerned about the ability of
listing rules and procedures to filter out poor quality
companies in the first place. He acknowledged that Hong Kong
faces competitive pressure from aggressive exchanges like
Singapore, and that there is some tension with the mainland
exchanges (Shanghai, Shenzhen) that would like to start
attracting new listings from China's blue chips. However,
this does not translate into compromising the vetting process
for the sake of getting new business, Wheatley asserted.

EXCHANGE: HIGH STANDARDS MEAN TURNING AWAY BUSINESS
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8. (C) Like Wheatley, HKEx Chief Executive Paul Chow
underscored the pressure on Hong Kong from competing
exchanges. He had harsh words for Singapore, which in the
last year has reached agreements with Shandong and Zhejiang
provinces in China to set up what has been termed a
"systematic channel" for listings of companies from those
provinces. "We would never do that," he said while
criticizing other exchanges for lowering their standards to
get new business.


9. (C) Chow said Hong Kong's listing standards and vetting
procedures are so lengthy that he fields numerous complaints
from corporations frustrated by them. He criticized
investment banks that put forward questionable firms that are
unprepared to go public, leaving it to the exchange to play
the unpleasant role of refusing them. Chow spoke almost
enviously of Sarbanes-Oxley legislation (commonly referred to
as SOX) in the U.S., assessing Hong Kong as not as tight on
listing and regulation as the U.S. He is watching with
interest the implications of SOX for U.S. exchanges and
thinks all quality exchanges will ultimately have to move
towards SOX-like regulation.


10. (C) In Chow's view, HKEx needs to emphasize quality at
the expense of new business. This is key to China's economic
development, since SOE restructuring cannot otherwise move
forward successfully. HKEx could easily lower standards, but
any event along the lines of Enron, Parmalat, or China
Aviation Oil (a mainland firm whose collapse after
undisclosed derivatives trading posed a major challenge last
year to Singapore's exchange) would be a major setback. The
proportion of individual investors in Hong Kong is higher
than other places and HKEx's customers are critical by nature
-- they expect protection because they are not professionals,
he said.


11. (C) Chow said HKEx was branding itself in terms of
quality and integrity. China will ultimately lift controls
on its capital account, and many believe this will open the
floodgates for listings in Shanghai that are geared to
foreigners as well as locals, perhaps at Hong Kong's expense.
But Chow is preparing for another scenario: cautioning that
he could never say this publicly, he told the CG that capital
account liberalization will actually mean that mainlanders
will choose to put their money abroad, not in China, and they

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will be particularly interested in investing in Hong Kong,
based on the exchange's reputation as a host for premium
Chinese companies, relative to Shanghai or Shenzhen.

MACAU'S SJM: A LISTING OF POTENTIAL CONCERN
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12. (U) Macau tycoon Stanley Ho's monopoly on gambling in
Macau came to in end in 2002, after 40 years. Facing new
competition, Ho proceeded to carve a subsidiary out of his
holdings called Sociedade de Jogos de Macau (SJM). Ho
intends to list SJM publicly in Hong Kong, but in pursuing
the listing, he has become embroiled in a dispute with
minority shareholder (and sister) Winnie Ho; she has
subsequently filed suit against her brother to block the
listing.


13. (C) SJM's listing has subsequently been delayed. A local
media report said the delay is tied to SFC's concerns about
money laundering issues. VIP rooms in Ho's casinos have over
time been associated with criminal activity, including money
laundering. (Also of note: Ho also has a casino in North
Korea.) The money laundering is best summed up by the 2006
International Narcotics Control Strategy Report, which
states: "Under the old monopoly framework, organized crime
groups were, and continue to be, associated with the gaming
industry through their control of VIP gaming rooms and
activities such as racketeering, loan sharking, and
prostitution. The VIP rooms catered to clients seeking
anonymity within Macau's gambling establishments and were
removed from official scrutiny. As a result, the gaming
industry provided an avenue for the laundering of illicit
funds and served as a conduit for the unmonitored transfer of
funds out of China. Unlike SJM and new entrant Galaxy, the
Sands (new American entrant to Macau) does not cede control
of its VIP gaming facilities to outside organizations. This
approach impedes organized crime's ability to penetrate the
Sands operation."


14. (C) In his meetings with the SFC's Wheatley and HKEx's
Chow, the CG noted concerns raised in hearings held by the
U.S.-China Economic and Security Review Commission about
firms going to Hong Kong instead of New York, allegedly
because it is easier to list here. He noted the pending SJM
IPO and emphasized the importance of rigorous listing
procedures to Hong Kong's future role as a finance center.
Both the SFC and HKEx said that local vetting standards are
very high here and that Hong Kong is not sacrificing listing
procedures to accommodate new business.


15. (C) Hong Kong already has one listed gaming company,
Galaxy Entertainment (also named in the INCSR report quoted
above). A Cambodian casino operator owned by Malaysian
tycoon Chen Kip Keong, NagaCorp, also has plans to float
shares in Hong Kong. Singapore and Hong Kong have previously
rejected attempts by NagaCorp to list on their exchanges.

CONCERNS ABOUT HONG KONG'S EXCHANGE
--------------


16. (C) The Asian Corporate Governance Association (ACGA),
based in Hong Kong, has made a name for itself regionally
with its highly critical analysis and scorecards concerning
corporate behavior throughout the region. ACGA Secretary
General Jamie Allen gave us a generally positive assessment
of Hong Kong's stock market, describing it as highly
professional and not corrupt. Although Allen termed the
exchange as the best in the region, specifically placing it
above Singapore, he did express significant reservations
about listing practices with regard to mainland firms that
hold IPOs in Hong Kong.


17. (C) According to Allen, HKEx has over time adjusted its
rules to accommodate mainland firms, entering into a series
of "Faustian bargains." The exchange is motivated by a
desire for new business, he said, and its officials do not
really understand the corporate governance issues embedded in
some of the firms that have listed here. The problem is
exacerbated by second-tier investment banks -- specifically
not the well-known U.S. houses operating here, he said --
that represent some of the more questionable firms that wish
to issue stock in Hong Kong. These companies' managers have
little idea of what listing requirements mean. In general,

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however, the overall impact of preparing to list here is
positive for the conduct of the mainland firms that do so, he
said.


18. (C) Allen was critical of HKEx for bending or weakening
numerous listing rules in recent years in order to
accommodate mainland candidates. HKEx no longer has a profit
requirement -- they now allow firms to qualify through market
capitalization or revenue thresholds. HKEx has repeatedly
offered waivers on compliance with important listing issues;
for example, they have waived requirements that a certain
number of directors be based in Hong Kong, thus opening the
door to a situation where it may be difficult to field an
investigation should something go wrong later on. There have
also been numerous waivers issued with regard to disclosures
of connected transactions (which occur when a public firm
conducts significant business with a parent holding company;
such business may affect the fortunes of minority
shareholders). Disciplinary action is also very slow,
lowering its deterrent value, said Allen; a firm that
violated disclosure rules in 2003 is only now being
sanctioned.


19. (U) ACGA in general has a mixed view of Hong Kong. Their
snapshot report on the city notes that new listing rules
implemented in 2004 are still lax with regard to the
reporting of corporate results. ACGA assesses Hong Kong as
having sound securities regulation, strong disclosure
requirements on ownership, and detailed rules on the
disclosure of connected transactions. However, despite Hong
Kong's rule of law tradition, class action suits are not
permitted. ACGA evaluates the SFC as independent and
increasingly powerful and the anti-corruption commission
(ICAC) as strong. They suggest, however, that the stock
exchange is not robust in terms of enforcing its own rules.
Private enforcement by shareholders is termed as weak, and
high costs and unfavorable legal rules mean that minority
shareholders see little to be gained from suing companies and
directors in court.

WHY THEY DON'T GO TO NEW YORK
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20. (C) We have on numerous occasions encountered contacts or
seen media stories suggesting that recent listings by the
Bank of China and China Construction Bank took place here and
not in New York because of SOX. ACGA's Allen said this is
only partially true and that SOX is really a subset of a
larger issue: the right of U.S. shareholders to initiate
class-action suits, something that cannot be done in Hong
Kong. Allen said that top managers and directors of mainland
SOEs know very well that their management structures are not
under full control -- just look at all the malfeasance that
has been reported at local branches of the large Chinese
banks. Further, the mainland firms all watched China Life,
which listed on the NYSE in 2003, become embroiled in
shareholder suits. Some of these concerns have been
aggravated by SOX, but the fundamental issue is that no top
figure at an SOE wants to put himself in a position where a
shareholder can hold him liable by bringing a class-action
suit, said Allen.
Cunningham