July 21, 2011 / 10:54 AM / 6 years ago

Moody's China red flag report under scrutiny by HK regulator

SINGAPORE (Reuters) - Rating agency Moody’s (MCO.N) may face regulatory action in Hong Kong for publishing a report on corporate governance at Chinese companies that sent some of their share and bond prices spiraling.

Moody’s published a July 11 report picking out potential weak spots in some Chinese companies’ corporate governance and accounting practices.

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.

“We are aware of the Moody’s report and are looking into it,” the SFC said in a statement to Reuters on Wednesday.

Fitch, a Moody’s competitor, released a similar report on Monday, though it caused less of a market reaction.

Credit rating agencies in Hong Kong only came under the regulatory oversight of the SFC on June 1 this year, having previously been unregulated. They now have to follow a code of conduct which includes requirements that they deal with investors and the issuers they rate “honestly and fairly.”

“What the SFC will be looking at will include what methodology the agency applied, how it works, whether it is rigorous, systematic and independently verifiable,” said a Hong Kong securities lawyer.

“They will want to make sure it’s not some form of arbitrary opinion without a solid research foundation,” said the lawyer, who did not want to be identified as his firm may become involved if the investigation progresses.

“We are not in an appropriate position to comment on this at the moment,” said Eleanor Sheung, a Moody’s spokeswoman.

FLAGGING PROBLEMS

Moody’s used a “red flag” system for its analysis, picking out 20 different indicators that could indicate possible weaknesses in a company’s corporate governance, a risky business model or concerns over a company’s financials.

Some analysts believe the report unnecessarily spooked investors, and they questioned Moody’s criteria.

“The risk-assessment framework of the ‘red flag’ report appears debatable in many cases -- failing, for example, to take sector-specific factors into consideration,” Macquarie analysts wrote in a note titled ‘Overly moody?'.

The SFC may also reprimand the agency if the report is found to contain unjustifiable mistakes.

Property developer Kaisa (1638.HK) was given a red flag under the heading “auditor change” but the company has since issued a statement saying it has had the same auditor since incorporation.

The company’s filings show it has always used PricewaterhouseCooper for its audits since it listed. Kaisa even issued a statement refuting Moody’s auditor claim.

“The SFC will look to see whether the agency did proper due diligence to make sure it was correct before it was published,” said the Hong Kong securities lawyer.

    Last week one of the report’s authors, senior credit officer Elizabeth Allen, said they issued the report because of a series of inquiries on Chinese corporate governance after a string of accounting scandals at mainland companies.

    “These (issues) have always been incorporated in our rating analysis but we didn’t have these topics addressed in one single report,” she told Thomson Reuters publication IFR.

    “We call it red flags rather than concerns or negative, because we think people should be aware of these aspects specifically.”

    CONCERNS MERIT REPORTS

    Some investors said the report was well within a rating agency’s role.

    “For the Moody’s report, it serves as a caution note for investors on certain issues faced by the companies, such as whether they are issuing too much debt or using unethical methods to chase higher margins,” said Patrick Shum, president of BMI Funds Management in Hong Kong.

    Fitch’s report outlined criteria in a company’s corporate governance and accounts that may signal a possible weak spot but did not use a “red flag” type indicator term.

    Fitch said its report is justified as it provides a clear framework for investors to use when looking at a company’s corporate governance at a time when the issue is in the spotlight.

    “When you get caught up in the Chinese growth story it’s quite easy for investors to not place as much reliance as they ought to on these emerging market characteristics that we highlight in the report,” said Andrew Steel, head of Fitch’s corporate rating group for Asia Pacific.

    “Therefore if we can consolidate that knowledge to the benefit of the debt investors then we will do so,” he said.

    Additional reporting by Lee Chyen Yee and Umesh Desai, senior analyst for IFR, in HONG KONG; Editing by Anshuman Daga and Michael Flaherty

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