SFC bond code still hard to crack
Two years have passed since Hong Kong’s market regulator shook up bond bookbuilding practices, but while some of the new rules have resulted in visible improvements there are still many areas of confusion, according to market participants.
On August 5 2022, the Securities and Futures Commission implemented a bookbuilding code of conduct designed to enhance transparency and deal planning. The move came in response to complaints of late changes to syndicates, chaotic messaging to investors, and claims that some bookrunners inflated book demand through the use of anonymous or proprietary orders.
Under the new code, issuers have to decide before the start of bookbuilding which banks will lead the deal and set pre-agreed bookrunner fees, while bookrunners need to disclose all end-investors and allocations.
An SFC spokesperson said the main goals of the code are to “clarify the roles played by intermediaries in DCM transactions and set out the standards of conduct expected of them in bookbuilding, pricing, allocation and placing activities”.
Under the old regime, it was not uncommon for bookrunners to place "X orders" to disguise the identity of investors, making it impossible for other arrangers to know the quality of the bid or even if it was real. The line-up of bookrunners in some deals, especially from Chinese issuers with mainly Chinese syndicates, could change during bookbuilding, as issuers promoted, demoted or dropped them entirely according to the amount of demand they brought in.
“When some of the malpractices were happening, the market was just so hot people were piling in and not really thinking about it,” said an investor at an international firm. Allocations were sloppy and deals fell apart in secondary trading, but the market moved on. “The standards have picked up, in terms of bank disclosures. It’s refreshing to see.”
Significant change
Bankers say the new rules have been net positive, as banks have embraced the changes and worked to standardise practices. One Hong Kong-based lawyer called the code “a significant change to the regulatory landscape”.
But there is debate as to how often banks are ticking boxes versus following what one syndicate banker calls the “spirit” of the code, as the rules address both behaviour and practices.
“It’s very important to be constructive about the efforts here. The industry was initially and remains very supportive,” said the banker. “I’m not sure that the work is done, and I think there is still a lot of scope for improvement in terms of a consistent understanding of what it means to have integrity from a capital markets standpoint.”
The relatively low volume of Asian offshore issuance since 2022 has also made it hard to assess the true impact of the code. Issuers like Chinese real estate developers have been shut out of the offshore market since a wave of defaults began in late 2021.
“The deals that had a lot of scrutiny, the high-yield or marginal credit space ... there really hasn’t been enough deals to see the SFC code of conduct take effect,” said the investor. The repeat issuers that have sold market-driven bonds in the last couple of years have tended to be higher-rated, established borrowers that have long adhered to international standards, he said.
The investor said he still generally steers clear of deals that have syndicates dominated by Chinese brokers, but even if questionable high-yield deals return to the market in the future, banks will likely follow better practices than they did two years ago. There is more policing in the market, and the regulatory change demonstrated that people are watching, he said.
A second investor said, without elaborating, that she has not seen the code make a difference from her point of view.
Hong Kong-based bankers, from international houses to Chinese banks to securities houses, all agree that the SFC rules have cleaned up market practices by pushing for more clarity during a bookbuild and getting rid of anonymous “X” account orders.
“It’s been helpful,” said a banker at an American bank. “We have now established a standardised approach.”
Some bankers say little has changed internally, as they were already following international standards, but one banker at a Chinese institution said staff there now do more due diligence to better know their investors and understand who is behind orders. “After the new rules were implemented, we have more internal procedures,” she said.
Constant confusion
One of the key issues with the code of conduct is that it relies on self-reporting, particularly when it comes to defining which categories investors fall into and deciding whether a syndicate team is even subject to the code, since the rules do not apply if a transaction includes participants sitting outside Hong Kong.
“There is constant confusion around the complexity … around a mixed syndicate,” said the syndicate banker, noting that banks have “wildly different” definitions.
There is more clarity around true book demand under the new rules, said the first investor, but a lot of his comfort in a deal still comes down to seeing bookrunner names that he trusts, he said.
“Inevitably, it’s the same as the past,” said the banker at an American bank. “In certain deals you would question the quality of the JLM order.”
The first syndicate banker said many of the remaining problems stem from the fact that DCM is “inherently cross-border,” meaning that many of the participants in a transaction, from investors to issuers to syndicate teams, may not be in Hong Kong and under the SFC's supervision. This is “exponentially challenging”.
Bankers said they have seen issuers hire mixed syndicates deliberately so they can skirt some of the tougher SFC rules.
Market participants say that getting issuers on board with the new rules has been, and continues to be, a hurdle since issuers point out that they are not subject to such rules elsewhere.
“For issuers who don’t come to the Asian market as regularly … we need to spend some extra time to go through why we are doing this. This can sometimes create some issues,” said another banker at an international house.
The lawyer said his colleagues outside of Hong Kong regularly contact him in confusion over the rules.
Zero fixed fees
Areas of conflict and confusion include the additional paperwork and advance fee disclosures. Some issuers have tried to get around the latter by having a syndicate agree to zero fixed fees, leaving wiggle room for variable fees to be paid after the transaction, based on bookrunner performance.
“We understand that stakeholders involved in DCM transactions, including issuers, buyside and sellside market participants, hold different views on the standards and practices for DCM transactions,” the SFC spokesperson said, adding that the code is necessary for clarity and standard setting. The regulator continues to address enquiries, he said.
“It’s not helpful for making Hong Kong the competitive centre that we all want,” said the first syndicate banker. “Creating different sorts of standards for Hong Kong … makes things difficult.”
Market participants also questioned enforcement. The SFC has conducted spot checks but has not handed out any penalties or reprimands related to any DCM deal.
Sources feel there is a fair amount of self-regulation, with the threat of scrutiny keeping bad practices at bay while allowing for some interpretation of definitions and rules, such as the mixed syndicate. The SFC spokesperson said it has conducted on-site reviews and maintained ongoing dialogue to “enhance intermediaries’ understanding and compliance with the code of conduct”.
The lawyer noted that issuers and firms such as his have been saddled with extra work and costs that do not always feel worthwhile, particularly neither were even aware of many of the bad practices going on behind the scenes at banks. He estimates he worked more than 200 unbillable hours around the time of the code’s implementation.
“I have to say that it creates quite significant additional work for lawyers, for issuers, so one really does query the cost-benefit of it,” said the lawyer. “I wonder whether on a debt capital market transaction, the cost of doing that, based on what they’ve set out in the rules, is significantly higher than the realised benefit.
“Does that justify the hours and hours of work we’ve put in? The jury is still out on that. People are still pretty fatigued.”
Market sounding next
The next test will come soon, as the SFC has proposed guidelines for market soundings. DCM bankers and investors were initially concerned, as the restrictive rules seemed better applied to ECM, but the consultation and related discussions have resulted in a softening of the guidelines for DCM, according to sources.
While insider trading and bad behaviour need to be curbed, the initial definition of what would be considered confidential and price-sensitive in the bond market felt like overreach, said the first investor. “You’d just kill the entire CD or MTN market.”
The Chinese banker agreed, noting that sales could suffer. “They’re kind of using ECM logic to regulate the DCM business,” she said.