SFC reprimands and fines Moody’s over Red Flags Report

I have written many times (for instance here, here and here) about the need for negative viewpoints (on particular companies, or the market as a whole), to balance out the predominantly positive reports from brokers, research houses and journalists.

Relevant for this specific case: "Moody and its Chinese red flags".

Not everybody seems to share that stand, as witnessed by the decision of the SFC in Hong Kong:

David Webb wrote about this subject "SFAT's red flag on Moody's chills negative research".

His conclusion (emphasis mine):


Could the report have been better-written, and clearer in the limitations of its findings? Yes it could.
Could the flag-tests have been better than 98.8% correct? Yes, they could. Was the report of a lower standard than all the other pieces of (mostly positive) research that the SFC has allowed to circulate without interference? Certainly not. That's what makes a market - and research firms rise and fall based on the quality of their output.

We liked the Moody's report, and we want to see more of that kind of critical research - but what licensed firm will now dare to publish such a report if the regulator is going to pick it apart afterwards and then slam them with a fine and potential loss of licenses for the individuals involved?

If listed companies disagree with research reports, they are of course entitled to respond with rebuttals, clarifications of their past disclosures or explanations, to ask for corrections, or even to sue for libel or defamation. As far as we know, none of the companies involved has sued - the criticism wasn't that far wrong.

Not only has the SFC pursued a licensee's report, they have also gone after an unlicensed person in the Market Misconduct Tribunal for expressing his negative opinions about a company while putting his money where his mouth was and being short: Andrew Left, of Citron Research, writing about Evergrande Real Estate Group Ltd (3333). The verdict in that case (also Chaired by Justice Hartmann) is awaited. In our view, unless the SFC can show that Mr Left didn't believe what he was saying, then the statement of his opinion cannot be false - however wrong his opinion turned out to be.

The SFC, and now the SFAT, has done Hong Kong a disservice by chilling negative criticism of companies, thereby skewing the market even further towards positive research. "Sell-side" investment banks world-wide tend to withdraw coverage of a stock or use euphemisms rather than issue a sell note on a potential client. They will say "reduce", "hold", or "buy on weakness" (when it goes down) rather than say "sell". Hong Kong sits on the doorstep of a country which stamps out all forms of criticism. We need to strengthen and encourage, not weaken, freedom of debate and criticism of companies.


All very relevant also for the Malaysian and Singaporean markets.

Moody and its Chinese red flags

From Reuters: "China developer Kaisa says fails to repay $51 mln loan, may default on others"


Chinese property developer Kaisa Group Holdings said it had failed to repay a HK$400 million ($51.3 million) loan and warned it may default on more debt, the latest problem to hit the firm amid a downturn in the real estate sector. In a stock market filing late on Thursday, the company said the payment of the loan and its interest became compulsory on Dec. 31, following the resignation of its chairman Kwok Ying Shing. The failure to repay the HSBC term loan may trigger default on other loan facilities, debt and equity securities, co-chairman Sun Yuenan said in the filing to the Hong Kong exchange.


China observers are most likely not surprised, the Chines property market appeared to be red hot, and the balance sheets of many developers stretched, Kaisa was one of them.

As so often, with 20/20 hindsight we are all experts. But there was one company which did stick out its neck, namely Moody, in 2011. Its report "Red Flags for Emerging Market companies: A Focus on China" can be found here.

Kaisa does indeed feature on the list of Chinese property issuers, with seven possible red flags being tripped and a negative outlook on its bond rating:

We know now that Kaisa is indeed in big troubles, so it appears to be a job well done by Moody's.

But quite soon after publishing the report drew the attention of the Hong Kong regulators, according to this article from Reuters:


"The report caused a sharp fall in the stock and debt prices of some Hong Kong-listed companies it flagged, including West China Cement (2233.HK) whose shares slumped 17 percent before rebounding. That prompted stinging criticism from some market analysts who debated the agency's risk framework, especially since at least one of the so-called "red flags" was publicly denied by one of the companies. The Moody's note also grabbed the attention of the city's market regulator, the Securities and Futures Commission."


David Webb wrote "SFC actions risk chilling critics" about this issue:


.... let's look at the total returns on the stocks since the day before the report (8-Jul-2011) up to the end of 2014 to see whether Moody's scoring system was broadly right. Kaisa's stock is down 42.07% , but it wasn't one of the top 5 companies singled out by the report, which tested 61 companies with 20 possible red flags. The top 5 were: West China Cement Ltd (2233), down 69.76%, Winsway Enterprises Holdings Ltd (1733), down 92.14%, China Lumena New Materials Corp (0067) down 56.86% (and suspended), Hidili Industry International Development Ltd (1393), down 89.07% (source: Webb-site Total Returns) and last but not least, LDK Solar, which was US-listed and is  now bankrupt. We'd say that's a pretty good hit rate, even though industry factors are involved in some of the declines. For all HK-listed stocks, the median (718th) stock in that period returned 0.32%.

One can of course argue with Moody's methodology, but that kind of debate on which factors matter for future performance is what makes a market.

The Moody's appeal has yet to be heard, and the SFC's Decision Notice is not yet a public document, so we don't know what the precise allegations are, the arguments in their favour are or what Moody's full appeal will be, but we hope that the SFC has more grounds for complaint than a few errors in a report covering numerous companies, because it would be unreasonable to expect that a report on 61 companies with 20 different flag-tests would be correct on all of the 1220 tests.


And further down the article:


The risk of a chilling effect

Free markets depend on free speech and the open exchange of opinions and analysis, whether it turns out to be right or wrong. The SFC will need to tread very carefully in this area and show good grounds for their actions in the SFAT and MMT, otherwise they are likely to have a chilling effect on critical research. That would be very bad for the market, for at least three reasons:

1. There is a systemic skew in investment bank/broker research which produces far more "buy" or "hold" (don't sell) notes than actual "sell" recommendations, because banks face conflicts of interest in seeking business with companies and in maintaining open doors for their analysts. Often the diplomatic way out is just to quietly drop coverage rather than put out a "sell" note. So we need investors, short or long, to express their opinions freely.
2. In China, as with other emerging markets, there are vast problems with corporate governance, fraud and corruption, and these need to be exposed, partly to improve market efficiency and partly to deter such behaviour by reducing the chance that it will remain unnoticed.
3. One of Hong Kong's core competitive advantages over mainland China is supposed to be the ability to speak freely.

I can't agree more with that.


Wishing all readers a Happy and Healthy 2015!

Moody's: Fraud, Corruption, Greed

I blogged before about the non-event that S&P downgraded the AAA status of the US:

http://cgmalaysia.blogspot.com/2011/08/non-event-s-downgrades-us-to-aa.html

".. as usual, the rating agencies in the US have been hopelessly slow to adapt to reality. Similar to the enormous disservice they did a few years ago rating packaged mortgages as AAA while the collatoral was dubious to say the least. A huge bias due to the wrong incentive: if the agencies would offer high (unrealistic) ratings they would receive more work and thus more money."

There is more support for this:

"A former senior analyst at Moody's has gone public with his story of how one of the country's most important rating agencies is corrupted to the core."

"The primary conflict of interest at Moody's is well known: The company is paid by the same "issuers" (banks and companies) whose securities it is supposed to objectively rate. This conflict pervades every aspect of Moody's operations, Harrington says. It incentivizes everyone at the company, including analysts, to give Moody's clients the ratings they want, lest the clients fire Moody's and take their business to other ratings agencies. In short, Harrington describes a culture of conflict that is so pervasive that it often renders Moody's ratings useless at best and harmful at worst. "
Here are some key points:
 

Moody's ratings often do not reflect its analysts' private conclusions. Instead, rating committees privately conclude that certain securities deserve certain ratings--and then vote with management to give the securities the higher ratings that issuer clients want.

Moody's management and "compliance" officers do everything possible to make issuer clients happy--and they view analysts who do not do the same as "troublesome." Management employs a variety of tactics to transform these troublesome analysts into "pliant corporate citizens" who have Moody's best interests at heart.

Moody's product managers participate in--and vote on--ratings decisions. These product managers are the same people who are directly responsible for keeping clients happy and growing Moody's business.

At least one senior executive lied under oath at the hearings into rating agency conduct. Another executive, who Harrington says exemplified management's emphasis on giving issuers what they wanted, skipped the hearings altogether

http://globaleconomicanalysis.blogspot.com/2011/08/former-moodys-senior-vice-president.html

Munger and Buffett have often warned about giving people/institutions the wrong incentives, it will lead to highly biased situations (ironically, they did invest themselves in Moody's, one of the big three rating agencies).

In Malaysia we have exactly the same situation regarding the "independent" reports. It is in the benefit of the writers to follow the majority shareholders, writers who are critical of them will not be asked again for their services. It is therefore no surprise that these reports are so biased that they are completely useless.

Recommendation: Independent reports should be abolished and the Securities Commission and Bursa Malaysia should really have come down hard at the writers a long, long time ago. By not doing so they have done Malaysia a big disservice, credibility has suffered and Minority Investors had no chance to fight for their cause.