Six weeks ago, David Webb, an activist investor and former director of the Hong Kong exchange, issued a report titled "The Engima Network: 50 stocks not to own". On Tuesday, most of the shares he named abruptly plunged, pointing to chronic regulatory problems over small-cap shares in the Asian financial hub.
Webb's report mapped out a complex web of cross-shareholdings between companies listed on both the main board and its sibling, the Growth Enterprise Market, which he said created a breeding ground for volatility.
Tuesday's biggest decliners showed characteristics that have long worried regulators and which Webb highlighted in his report: high shareholding concentrations, unrealistic valuations, and complex relationships between companies and listed brokerages. The Hong Kong government and regulators are growing increasingly concerned that a series of company scandals, many of them centred on mainland companies listed in Hong Kong, have tarnished the territory's reputation as a financial centre as it marks the 20th anniversary of its handover to China this weekend.
Webb, a successful investor and author who studied mathematics at Oxford, told Reuters on Wednesday he had come across the network through his own research into annual reports and company disclosures. "I picked up on this network years ago when they started building it. The meltdown shows these stocks are closely related," he said.
His report only covers cross-shareholding relationships but the companies also have many directors in common as well as related transactions, Webb said. The purpose of such networks, Webb said, "is to defraud investors - extract and misappropriate money and part of that involves manipulating stocks."
Webb, an outspoken critic of the Hong Kong market since he quit the HKEX board in 2008, said it was unclear what triggered Tuesday's sell-off. "I can only speculate. But it's possible margin calls have been triggering the sell-off. It's possible the brokers involved have been told to stop lending against those shares ... Maybe the people operating the network have decided to dump and run."
The Hang Seng index tracking main board companies closed down 0.61 percent on Wednesday, while the GEM board was down 0.8 percent, having lost more than 8 percent of its market value the previous day. Webb said he never shorts Hong Kong shares.
"The bigger picture here is that this again reminds us that the current regulatory system is not working and these problems have been allowed to build up by the Hong Kong exchange (HKEX)." He also blamed the independent market regulator, the Securities and Futures Commission (SFC), "for not stopping it." An SFC spokesman declined to comment on whether the regulator was investigating any of the companies in the network.
In a statement, the SFC said: "The stocks which have experienced large price declines yesterday occupy a market segment characterized by thin turnover, small public floats, high shareholding concentrations, and multiple relationships between different companies and listed brokerage firms. These characteristics can be especially conducive to extreme volatility and also to market misconduct." The HKEX said on Wednesday it would closely monitor activities and take appropriate action when necessary.
WLS Holdings, which had a market value of HK$409 million, was the biggest loser on Wednesday with its shares sliding 47 percent, while Greaterchina Professional Services Ltd dropped 34 percent after a 93 percent drop on Tuesday. Webb said he opposed a recent HKEX proposal to add a third board, catering to start-ups, and argued the two existing boards should be merged and put under the jurisdiction of the SFC. The investor activist said Hong Kong also needs a class action legal provision so investors can hold boards accountable.