LegCo Panel on Financial Affairs
Meeting on 2 December 1996
Price volatility in second and third liner stocks

The Hong Kong stock market is now in a "bull run", and a considerable amount of speculative trading activities which contribute to volatility are going on. Volatility is not, in itself, any cause for concern so long as the risk management systems in the market are adequate. We believe that the market systems have stood the test over the past nine years since the 1987 crash. The Stock Exchange of Hong Kong Limited (SEHK) has in place criteria, procedure and systems for monitoring the trading activities of all securities to identify possible trading malpractice or breaches of the law, Rules and Regulations of the SEHK by its members, issuers of securities, their directors and major shareholders as well as investors. Nevertheless, as part of this monitoring system, the SEHK classifies certain movements in prices and trading volume of securities listed on it as abnormal.

Possible causes for abnormal movements

2. Abnormal movements can be caused by a number factors,including -

  1. corporate action being undertaken by issuer, e.g. acquisition, disposal or a new enterprise which is likely to be price sensitive;
  2. general price sensitive news about an issuer or an industrial sector, e.g. oil prices rise;
  3. market rumors about an issuer or an industrial sector which have an impact on the prices of the relevant securities;
  4. financial analysts’ comments on prospects and the expected earnings of listed issuers;
  5. disposal of substantial amount of shares by directors or substantial shareholders;
  6. warrants, futures or option contracts due to expire;
  7. covered warrants are to be issued; and
  8. OTC options has been issued or due to expire.

3. There tends to be more volatility in smaller capitalized stocks (which are referred to in the market as third liner stocks). This is because the number of shares available to the public for trading is smaller and the shares usually trade at a very low market price such that an increase in price of a small dollar amount, e.g. 50 cents, may be great in percentage terms, e.g. 50%.

Market Manipulation

4. In layman’s terms, market manipulation means the creation of a misleading appearance of active trading in a particular stock or the creation of a false market. This can happen when a trader, acting in concert with other persons, pushes up (or pushes down or stabilizes) the price of a stock to a level which is not justified by reference to the fundamentals of the company concerned based on profit performance or net assets.

5. Manipulation would be a breach of Section 135 of the Securities Ordinance (copy annexed) and, if knowingly conducted by a member of the SEHK or one of his employees, would also be a breach of Rule 545 of the SEHK, and would result in disciplinary action against the directors of listed issuers if there is supporting evidence of breach of the Listing Rules. Evidence of market manipulation and insider dealing by major shareholders and investors would be referred to the Securities and Futures Commission (SFC) for possible prosecutions for breaches of the relevant Ordinances.

SEHK’s Regulatory Controls

6. The SEHK is the front-line regulator of the securities market and takes continuous actions to guard against possible manipulation. This involves -

  1. requiring the issuer of the securities to ensure that the market is properly and fully informed by making public any insider information and making announcements denying or confirming that there are price-sensitive actions being considered by the company;
  2. identifying which members are most active in the securities experiencing abnormal trading activities and requiring them to identify the most active clients involved in the trading;
  3. liaising with the SFC immediately and continuingly. Normally, the SEHK deals with the members concerned and the SFC, the investors, i.e. the most active clients who have been identified by the members in (b) above;
  4. if the investigations indicate that directors of the listed companies may be involved in the abnormal trading, the SEHK makes enquiries of those directors to determine whether their actions have been in breach of the Listing Rules;
  5. referring any evidence of insider dealing or market manipulation by major shareholders and investors to the SFC for considering whether to take prosecution under the Securities (Insider Dealing) Ordinance or the Securities Ordinance; and
  6. prosecuting through the SEHK’s disciplinary system any member or employee of a member who is identified as having knowingly assisted in manipulation.

7. Provided that there is no unevenness of information in the market (e.g. insider information on an impending corporate action), the SEHK will not normally intervene in the market by, for instance, suspending trading in any securities.

8. During the period from 1 October to 18 November 1996, a total of 614 cases of abnormal price fluctuation were recorded by the SEHK. Of these, 55 cases had movements of ± 20% or more in prices comparing to the previous closing prices of the securities in any one trading day. Of the 55 cases, 46 (involving 35 securities) showed increases in stock price while nine, decreases. However, the volume of abnormal activities is not particularly unusual considering the overall high trading volumes and general bull run the market has experienced over the last few weeks. In all these cases, in accordance with established procedures, the SEHK took prompt action to make enquiries with the issuers and asked them to make appropriate announcements to the market. By these announcements, the market was made fully aware of what was happening with regard to these securities.

SFC’s Role

9. On the enforcement front, the SFC has prosecuted two cases of market manipulation in the past three years. The first case involved a shareholder of a company who manipulated the share price whilst off loading the majority of his holdings. He was sentenced to four months imprisonment, suspended for one year. He was directed also to pay $500,000 in costs. The second case involved a dealer’s representative who was convicted and sentenced to six months imprisonment suspended for 12 months and directed to pay $100,000 in costs to the SFC.

10. In addition, the SFC suspects that a number of market operators have been ramping the shares of a small number of third liner stocks over the past two years in ways which could amount to market manipulation and has, therefore, initiated a number of current investigations. Some of the methods by which these market operators carry on their activities include the making of placements and the issue of OTC options and covered warrants. Often, a placement is made by one or more major shareholders to a market operator at a large discount to market price. The operator then contacts a number of high worth individuals and they form a syndicate for the purpose of ramping. The market operator acts as a manager of the syndicate which buys and sells shares among its members and which, in turn, creates the appearance of active trading. The volume of daily turnover begins to increase substantially which attracts other traders and then the market price also begins to increase rapidly. Another method involves a major shareholder placing a block of shares and at the same time giving an OTC put option to an investment house which guarantees that the investment house can sell back shares to the major shareholder at a later date for a fixed price if so desired. Alternatively, the investment house might have agreed to issue covered warrants over the stock which are listed on the SEHK and has taken a block of shares from the major shareholders to hedge the warrants. These arrangements effectively reduce the number of shares available for public trading and makes it easier for the major shareholder and his accomplices to ramp the stock.

Conclusion and way forward

11. There is no evidence that small investors have suffered disproportionately or otherwise in the recent price and volume fluctuations. There have been no complaints to the SEHK from either large or small investors. Investors are and should be aware that price fluctuates. In this connection, the Uniform Client Agreement which the SEHK requires every member to sign with his clients before commencement of trading includes a "risk disclosure" statement in which the client acknowledges the risk in investing in securities.

12. Notwithstanding the difficulties in proving market manipulation, the regulators will continue to expose these practices and investigate cases which it believes breach the legislation or rules and regulations.

Financial Services Branch
Government Secretariat
26 November 1996

Last Updated on 18 August 1998