THE ROLE OF THE MERCHANT BANKER

by
W F W BlSCHOFF

Managing Director, Schroders & Chartered Limited I BACKGROUND IN THESE days of increasing and sizeable banking transactions the question is often asked, even by those in the profession, whether the role of the merchant bank is still relevant. In attempting to answer this question it is perhaps useful to trace the origin of the typical merchant bank and to examine its role in the past and how, in adapting to the present financial environment in South East Asia and elsewhere, it continues to create a need for the expert services it provides.
Origin

The origins of merchant banks go back to the early nineteenth century when a number of trading houses largely of non-British background and ownership were founded in the City of London to trade, and facilitate the trade, with the Empire in the East and with the North and South American continent. From trading it was only a short step to financing the trade at both ends of the line, the exporter from the United Kingdom and the importer in the developing country. The importer tended to be a government or semigovernmental body which apart from a requirement for the more sophisticated goods of the Old World required financing of infrastructure projects such as railways, roads and dams, as well as what might today be called balance of payment financing. This was difficult and adventurous (or entrepreneurial) financing which suited particularly the merchant banks of the time. The risks were perceived by others to be great, but so were the rewards to the merchant banks. The merchant banks who engaged in this business were singularly well placed in the City of London to benefit from

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the outpourings of goods and energy and the prestige of Britain and would undoubtedly not have been able to develop as they did had they been located, as their founding families were, in say Hamburg, Bremen, Frankfurt, Copenhagen or Paris. They were at the centre of things and the financial centre at that time was - and indeed even now is London. In size terms, these merchant banks were far larger, relatively speaking, than they are now. They had a sizeable balance sheet and a sizeable banking business and it was the banking business, rather than what is known now as the fee-earning business on which they concentrated and which provided the bulk of their earnings. At the same tune, being partnerships and very largely family owned which in the majority of cases they are to this day they did not see a necessity, nor was there perhaps quite the drive, to grow as quickly as other financial institutions did, particularly those who engaged in retail banking, spreading their branches throughout the land and even in a few rare cases overseas. The merchant banks had one place of business and that was in the City of London. They were thus the forerunners of wholesale banking. Since they did not choose to branch out - in the truest sense of that word in banking terms and relied for their deposits on a relatively small but wealthy private clientele and a few corporate customers they were able, and indeed had, to give a superior kind of personal banking service which inevitably led to the provision of services additional to those of banking. Additional services These services developed over a period of time into financial advisory services to corporations, governments and semi-governmental bodies, the raising of finance through all varieties of instruments both equity, semi-equity and debt as well as the provision of investment services to those of their clients who had accumulated sufficient wealth to wish to safeguard what they had got rather than to multiply it manifold through their own efforts. In this way the merchant

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the Banking Ordinance, banks started their investment management activities which have continued to this day, the only major change being that there are very few individual or family fortunes remaining to be managed (other than perhaps in the Middle East, South East Asia and South America where there are transfer difficulties) and the emphasis now is on corporate funds with pension and retirement schemes forming the bulk of these funds.

II

RECENT DEVELOPMENTS IN SOUTH EAST ASIA

Merchant banking outside Japan came to South East Asia in the late sixties, starting in Singapore and moving on very rapidly to Hong Kong and from there spreading to Malaysia, the Philippines and South Korea. Merchant banking originally was promoted by the British and it is conducted in English. Thus it has found it easiest to implant itself outside England in Anglo-Saxon countries; indeed outside countries with some English-speaking background merchant banks are not well-known. Partly this is of course due to legislation, as in the United States, or the fact that merchant banking functions are already carried out by universal, onestop banks, as in continental Europe. Now most countries in South East Asia have a merchant banking industry, no longer carried out exclusively by companies or individuals from the City of London but by a polyglot of nationalities and backgrounds. It has become one of the smart things to do, and even the largest and most impeccable names in retail banking have suddenly felt the urge to have their own merchant bank or a stake in a merchant banking operation. From being very much under pressure the concept of merchant banking is very much alive although merchant banking institutions are under attack by the multi-national retail banking batallions. Just as the multi-national banks have felt the need to provide inhouse the specialised and individual type of service of a merchant bank, so have the indigeneous banks in South East Asia joined the bandwagon in the belief that their clientele too would not wish to do without the services of

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a merchant bank. Thus there has been a proliferation of the, species and like all good things when overdone the quality has suffered. It would be difficult to hazard a guess at how many true merchant banks there are in South East Asia out of the hundreds calling themselves by that name; I would be surprised if there were more than a dozen or so. The others are either nothing of the sort or simply wholesale extensions of retail banks with no well-defined niche in which to operate nor market in which to offer their services, But imitation is the sincerest form of flattery!

I l l RECENT DEVELOPMENTS IN HONG KONG

In the proliferation of merchant banks Hong Kong has been very much in the lead. Its geographic position, financial and entrepreneurial acumen, lack of red tape, tremendous economic expansion and fairly well-developed economic infrastructure as well as and for the nurturing of merchant banks most importantly no particular dislike of things or inventions British, have provided fertile soil for the development of merchant banks. Indeed the trading companies, or 'hongs,' themselves are larger forms of the original merchant banks who, like the hongs, started as traders. It is not surprising therefore that merchant banking should have become so readily accepted in Hong Kong. The originators of merchant banking in Hong Kong were London merchant banks who were followed by local imitators and, following the stock market crash in 1973 and a suitable interval for recovery, by the new style merchant banking subsidiaries of the multi-national banks, particularly American banks. More recently the Japanese and the continental European banks, too, have found Hong Kong an enticing place for setting up merchant banks - or deposit-taking companies as they have to be called in Hong Kong where institutions which engage in banking cannot call themselves a 'bank' without having a banking licence. Merchant banking in Hong Kong has undoubtedly been

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a growth industry. However, there are drawbacks. Firstly if the returns look good, new entrants will come in by the dozens. This has already happened. Secondly a large number of institutions calling themselves merchant banks, and merchant banks not already established in Hong Kong feel that they simply have to be in Hong Kong, and are less concerned with the profitability of their operations initially at least than having a presence and being able to service their clients through Hong Kong, or providing a point of contact from here for the rest of South East Asia and to follow their clients to the acclaimed Pacific Basin with its enormous growth prospects and to the great hope of mainland China. Thirdly it must not be forgotten that the cost structure of any merchant banking operation, being so very largely based on skills developed over a long period of time, is high. This is because up to now an unduly large proportion of the executive staff is expatriate with all that this entails in terms of cost. While it is possible to train local executives it will be some time yet before even a 50:50 relationship exists between expatriate executives and local executives engaged in the fee business. Apart from any lack of experience which can be overcome with the passage of time, there is no doubt that at present the client still looks for international expertise acquired in London and New York and this can only be provided by executives with a familiarity of and long training in those markets. IV AREAS OF ACTIVITY

Banking and related finance As I have already indicated one of the main areas indeed the most important area of recurring earnings - of merchant banks is that of providing loans to customers. Linked with this activity is the provision of other banking services such as are carried out by retail banks for their customers. The banking services provided by merchant banks for their customers are

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no different to the services provided by the retail banks for their corporate customers. Merchant banking in the banking sense is banking for corporate customers or wholesale banking. The other areas of a merchant bank's activity provide little opportunity for growth in Hong Kong due to the rather restricted market for these kinds of services. This in turn has meant that the very large majority of, indeed almost all, merchant banks have primarily concentrated on the provision of banking services. In providing these services they have often been highly innovative and have encouraged new methods or more competitive services. For example it was merchant banks who introduced certificates of deposit to Hong Kong and who pioneered the introduction of commercial paper. Corporate finance advisory services While banking services provide the bread and butter income of any merchant bank, the corporate finance advisory services provide the prestige, excitement, the occasional large fee and the bulk of any publicity. The most prestigeous and most immediately profitable part of these advisory services is undoubtedly the merger and acquisition field. However this is work which takes a merchant bank a long time to develop. Yet once it is developed it looks to an outsider relatively easy. It does however require not only a significant degree of skill which has to be built up over a period of time but also, more importantly, a client who will trust the particular merchant bank with what in financial terms is likely to be one of the more important and public transactions he is likely to engage in. The reason that the merger and acquisition field is newsworthy is probably the adversary relationship which, like it or not and whether true or not, newspapers like to write about. This adversary relationship does exist in contested takeovers of which in Hong Kong there are very few. Hong Kong is a pragmatic place which realises that contested takeovers seldomly bring short or medium-term benefits and

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even long-term benefits are hard to come by. To be sure, while the two financial advisors put forward their clients' good points as strongly as possible and minimise any weaknesses there is no lasting adversary relationship since the very two merchant banks so ingeniously defending their clients' interest one day may be working together on a quite different transaction the following day. It is this ability of getting involved while not getting emotionally involved that Is important to a merchant bank's reputation for fairness and integrity with shareholders. It is partly this lack of emotional involvement which causes boards to seek financial advice to help them recommend to their shareholders the appropriate but perhaps unwelcome course of action. Mergers and acquisitions are the most exciting part of the corporate finance side of a merchant bank's activities but since there are in Hong Kong less than twenty such transactions in any one year it is obvious that only three or four of the many merchant banks in Hong Kong can keep their hands in by acting in at least half-a-dozen of those transactions every year. I doubt whether a merchant bank which is involved in one or two mergers or acquisitions a year only is likely to do as well as one that is consistently involved. Mergers and acquisitions and similar transactions may be the most public involvement of a merchant bank's corporate finance division. However a more continuing involvement is that achieved through general corporate finance advice on the structuring of the finances of a company and helping it to raise medium and long-term finance as well as equity finance through underwriting issues of debt and equity, a major example of which is 'going public.' This can be highly profitable or unprofitable if the issue fails and is left with the underwriter. The arrangement of finance As I have mentioned before the most common activity of most merchant banks in Hong Kong and elsewhere is the arrangement of finance. This is particularly the area on which

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the merchant banks of the multi-national banks have concentrated, none more so than the subsidiaries of the American merchant banks, the so-called 'yankee' merchant banks. This activity fits in well with their parent banks' large balance sheets and ability to lend. What happens is that the merchant bank obtains the mandate to raise a large loan, governmental, semi-governmental, or project related, by putting forward to a borrower its ability of tapping the substantial resources of its parent bank. This means that it can speak for up to twenty or twenty-five percent of a large loan which will form an excellent platform for syndicating the loan. It is not only large loans however which such 'yankee' merchant banks are interested in; the principle of speaking for a large portion of a loan is similar in any size of loan. While it would appear that the 'yankee' merchant banks and consortium banks with the fire-power of their parent banks have a considerable advantage, the traditional merchant bank with a substantially smaller deposit and capital base need not be entirely left out since it too can be involved in such transactions, particularly very large ones. Its involvement comes about through the premise, pursued with considerable success where complicated financial structures and security arrangements are necessary, that the borrower should be independently advised and secure for itself the best possible deal, not necessarily in terms of rate and maturity only but particularly in terms of financial structure so that the borrower will have a sufficient degree of flexibility for future borrowings. In these circumstances the merchant bank or its American cousin, the investment bank, is retained by the borrower to advise it without having any financial stake, in the form of a participation or management fee, in the banking transaction itself. For such benefits a merchant bank is paid a fee which, although small in comparison to the management fee paid to the managing syndicate, can be large in absolute terms given the size of some of the transactions involved. Also merchant banks act as lead managers or co-managers in bond issues, both in local and foreign currencies and, given

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the enormous appetite of large-scale projects in the area for funds, arrange for preferential export credits, both buyer and supplier credits. Investment management The managing of clients' funds has for a long time been a peculiarly suitable area for a merchant bank's skill, heritage and personal service. The credibility of the largest merchant banks in this field is considerable since their clients believe that having survived however many wars and inflationary periods, a merchant bank should be well-suited to protecting his funds against the vicissitudes of an economically uncertain world and perhaps in favourable stock market circumstances to increasing the funds. A number of British merchant banks are managers of very sizeable funds, a few managing on a world-wide basis more than US$5,000 million, and some over US $3,000 million each. A number of the British merchant banks as well as some other institutions are active in the investment management field from Hong Kong, managing international funds on behalf of their parent companies as well as funds in the South East Asian area and of course in Hong Kong. Although this activity is not nearly as profitable some would say that on its own it is not profitable since investment management fees do not cover the costs of an investment division of a merchant bank it provides a steady source of income. In this activity the merchant banks and fund managers in Hong Kong have been helped immeasurably by the fact that Hong Kong has become an investment management centre of major importance. It can be compared favourably with some of the better known management centres elsewhere such as London, Zurich and Geneva and New York. Of these three Switzerland is the only real international competitor to Hong Kong, the others being more involved with the management of funds invested in their local markets. Nevertheless British institutions and British merchant banks have long been convinced that the investment of funds on an international

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basis is a means of participating in economies which at any one time show better growth prospects and a useful weapon of combatting the weakness of Sterling, and thereby achieving in Sterling terms, an above-average return. Recently a modest retirement funds industry has developed in Hong Kong. Such funds are steady in their contribution rates unlike most funds placed in the care of merchant banks by individuals or institutions. The unit trust industry too has expanded, mostly through the realisation that Hong Kong is an ideal fund management centre served extremely well by brokers and situated in the centre of a very significant potential market for unit trusts and mutual funds. It has been helped, not unnaturally, in its growth by the excellent performance shown by a number of fund managers operating from Hong Kong over a number of years.

V LEGAL AND VOLUNTARY ASPECTS RELATING TO A MERCHANT BANK'S ACTIVITIES IN HONG KONG
Deposit Taking Companies Ordinance The banking operations of merchant banks in Hong Kong are governed by the Deposit Taking Companies Ordinance of 1976. This ordinance (i) established a Deposit Taking Companies Advisory Committee (if) requires the registration of deposit taking companies at a fee of HK$30,000 per annum. Deposit taking companies must have an issued capital of HK$5 million (or its equivalent in other currencies) half of which must be paid-up (iii) restricts the taking of deposits to amounts of not less than HK$50,000 unless the depositor is a licensed bank or a bona-fide employee (iv) requires accounts to be lodged with the Commissioner

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for Deposit Taking Companies annually and to be exhibited at the place of business of the company (v) limits advances to any one person, firm or company to not more than 25 percent of the paid-up capital and reserves of the company except (a) transactions with a bank or other deposit taking company (b) transactions covered by a guarantee acceptable to the commissioner (c) purchase of bills of exchange for goods exported (d) purchase of TT (vi) limits advances to directors or his relatives to one percent of the net worth of the company or HK$250,000, whichever is less. It also limits facilities granted to any companies in which a director is involved either directly or indirectly as director, partner, manager, agent or as guarantor to secured facilities only. There is a wealth of other information and obligations laid down in the ordinance such as official secrecy, liability of directors and officers for the acts of the company, the notification to the commissioner of any changes in the details of registration, returns of information within 21 days of every month of the assets and liabilities of the company, returns of statistical information within 21 days of every quarter and the provision for further information required at any time by the commissioner, The ordinance also makes provision for a minimum holding of specified liquid assets at a percentage not yet fixed. Such percentage of liquid assets has to be held as at a week day fixed by the commissioner at present every Wednesday, Lastly, the ordinance provides that the commissioner may, with or without prior notice, inspect the books accounts and transactions of the company. All of these requirements derive from the Deposit Taking Companies Ordinance of 1976 and its amendment of 1978. In many respects these requirements are similar, although as yet not as onerous in respect of liquid assets, as those of

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Hong Kong Code on Takeovers and Mergers In the acquisition business Hong Kong merchant banks have to abide by the Hong Kong Code on Takeovers and Mergers which is a voluntary code rather than legislation. As is generally known the London market works on a similar basis and the Hong Kong code is modelled on that of London. However, it is far more simple if volume is the test of simplicity consisting of sixteen pages (up from twelve pages when it was introduced in August 1975) as against the London code which is now in its third edition and is up to 67 pages, including the relevant practice notes. Over a period of time it can consequently be expected that the Hong Kong code will be expanded to reflect improvements, refinements and changes desired by the public. The stock exchanges of which there are four also have rules governing takeovers and mergers. These rules are however less comprehensive than those contained in the takover code and the tendency is for the stock exchanges to allow the Securities Commission which polices and administers the takeover code - to give the lead on mergers and acquisitions as also to police the relevant documentation. The main function behind a voluntary code such as that used in London and Hong Kong and incidentally also in Singapore and Malaysia is to ensure that rules are adhered to. If the voluntary code were not obeyed and were not seen to be working the government could decide to legislate. Legislation is indeed the method by which takeovers and mergers are controlled in the United States. It is impossible to cover by legislation all aspects in a field that is generally acknowledged to be highly inventive. This may be the reason why the legislation is so extensive and complicated necessitating the employment of teams of lawyers by both the offerer and the offeree companies. Nevertheless despite the farreaching nature of the securities legislation covering mergers and takeovers in the US there are a number of highly significant provisions which protect minority shareholders far better under the voluntary codes of the United Kingdom and Hong Kong than under legislation in the US.

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Takeovers and mergers in Hong Kong are administered by a committee. The chairman is the Commissioner for Securities and its secretary is the deputy chairman. In addition the committee currently consists of two members of the Securities Commission, a member representing the Hong Kong Federation of Stock Exchanges, representatives of six merchant banks and a representative of the Committee on Unit Trusts. The committee meets on average every two months unless a specific matter has been raised by any of the members and needs discussion. In these circumstances meetings are normally called at the instigation of the chairman. Since the takeover code contains provision for 'practice notes' it is relatively simple without amending the code to add rules which carry the same weight as the general principles of the code. This gives considerable flexibility since general principles and rules can be changed to clarify particular aspects of the code. In Hong Kong the takeover code has been observed in practice and this is not unconnected with the integral role that the practitioners the merchant banks have played in drafting the code and in administering it. The criticism that the code is without teeth has not yet been justified in practice since the criticism of one's peers who form the bulk of the committee is a fact not be under-estimated in view of the importance merchant banks attach to their integrity which after all is one of their major assets. The other criticism of the takeover code, that it is framed only to represent and reflect circumstances in Hong Kong, is justified. However the circumstances where the code differs from the London code are peculiar to the realities of Hong Kong, mainly reflecting the fact that a large number of its public companies are newly listed and are still controlled by the founding family. Thus there is no requirement unlike in London to make a bid for all the shares in a company once thirty percent of its capital has been acquired. In Hong Kong a bid is required only when there is a change of control which is defined as obtaining fifty percent or more of its voting capital.

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No doubt if in future circumstances arise under which control of companies changes as the result of the acquisition of thirty percent but less than fifty percent of a company's share capital, the principle of a trigger only at fifty percent will be looked at again. A further difference from the London code is the requirement in Hong Kong to post offer documents within forty days as opposed to within 28 days in London. This reflects the need for Chinese translation as also, the difference in the other services available in Hong Kong. Another country which has been examining the question of a voluntary code as against legislation is Australia. The latest position there is that an Act of 94 pages as against the Hong Kong code of sixteen pages is now being proposed but even these 94 pages have a large number of loopholes and inconsistencies which are currently being pointed out to government by merchant bankers and the legal profession, Overall I have little doubt that a voluntary code and the associated peer pressure is far more effective in policing transactions which can never wholly be legislated for, than legislation. New issues In contrast to takeovers and mergers which are largely regulated voluntarily through the takeover code, new issues are regulated by documentation and practices governed by the Companies and Securities Ordinance as well as the stock exchange rules. While somewhat simpler and less encompassing, they are no different in principle from those in London, or Singapore or Malaysia. The only drawback in Hong Kong is that the basic Companies Ordinance has not quite kept up with modern developments in other countries. But then Hong Kong has never been in the forefront of legal innovation, preferring to follow others than to be a pioneer.

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While there are no legal or voluntary guidelines that must be followed with loan agreements, the law has extended its encompassing grasp considerably into this area of merchant banking. It is the practice of the market place and the relative bargaining strength of the two parties - the borrower and the group of syndicating banks which determines the form of the contract that is entered into between the two of them. Contrary to practice even as little as ten years ago, loan agreements now are lengthy, highly complicated and peppered with such a large amount of legal jargon that few borrowers, unless they are skilled and often in the market place, can understand them without legal assistance. The growth of the legal complexity of loan agreements can be traced quite clearly to the beginning of multiple syndications. The reason is easy to explain: when a loan was given by a single bank to a borrower, it was usually in circumstances where the lender had an intimate knowledge of the borrower, its strengths and its weaknesses and had usually done business with it for a considerable length of time. As loan requirements rose and as the financial assistance which could be offered by a single bank was either inadequate for the borrower or unduly large for the bank, other banks had to be brought in. Often these did not have a well-developed knowledge of the borrower and they considered that, in order to protect themselves, they should restrict the borrower's activities or define what it could and could not do. In any case the presence of a large number of banks (and in particular American banks) has meant that simple one or two-page loan agreements are now no longer sufficient for syndication purposes. The over-complex documentation adopted nowadays reflects the practice in the Euro-dollar market. Lawyers blame leading syndicating banks and they in turn blame lenders' lawyers. However if the problem is looked at objectively there is simply no justification for blaming the lawyers since

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they only give the protection they believe the client wants or ought to have. All the same everybody admits that the protection given in loan agreements to both sides is often highly esoteric. In the growth of Hong Kong as a syndication centre for international transactions to a position second only to that of London, the merchant banks have obviously been assisted by working in a fertile environment with considerable demand for funds South East Asia. The very fact that syndications have been done from Hong Kong and have grown at an extremely rapid rate has led to a number of law firms skilled in loan syndication work to move to Hong Kong. This has benefitted their clients who have on the whole been the lenders, but indirectly also the borrowers whose local legal advisers have picked up the most modern practices in the field and have used them to protect the borrower. While the bulk of syndication work in Hong Kong is done for non-Hong Kong borrowers the increasing size of projects undertaken in Hong Kong has meant that a number of Hong Kong borrowers themselves have undertaken or are planning jumbo-sized loans the equal of those raised for non-Hong Kong borrowers. These loans are a feature of capital investments of a size hitherto unknown in Hong Kong. More recently there has been much discussion of lending to China. In the context of talking about loan agreements it must be mentioned how difficult it is likely to be, initially at least, to persuade the Chinese to comply with some of the 'standard' terms of international loan agreements agreed to by other sovereign borrowers such as jurisdiction, governing law, cross-default and the more esoteric interest cost clauses. Only time will tell when the first standard syndicated loan document involving China is going to see the light of day. Accountancy aspects relating to merchant banking The accountancy profession in Hong Kong has formed the Hong Kong Society of Accountants which serves the useful purpose of pooling the knowledge and the strengths of the

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profession in Hong Kong and enables it to set standards and codes of professional ethics which can be presented to its clients as mandatory upon each accountant. The Hong Kong society is closely linked to the Institute of Chartered Accountants in the UK and members of the UK body are automatically eligible for membership of the Hong Kong society. The Hong Kong society publishes three forms of statements and guidelines to members as follows: (i) Professional Standards Statements are policy accounting statements, each one dealing with a separate topic, the adoption of which by members is mandatory. They are therefore similar to Statements of Accounting Practice ('SSAP') in the UK. By making their adoption by members mandatory, the Hong Kong society ensures that companies who do not adopt such statements will have a qualified auditor's report. The Hong Kong society has issued 25 such statements up to the present time (Nos 101 to 125), the latest of which was issued in June 1978. (IF) Professional Conduct Statements deal with the way in which members should conduct themselves and they cover the ethics of auditors. Eight such statements have been issued (Nos 1 to 8) the latest in October 1974. (iii) Practice Guidelines are not mandatory but are issued to members as general advice on certain subjects. Seven have so far been issued (Nos 1 to 6 and No 8). An eighth practice guideline (No 7) is to be issued shortly. Guideline No 8 was issued in October 1978. The importance and relevance to the merchant banking community of these statements and guidelines is that they affect their clients and consequently merchant banks in advising their clients take note of them. Furthermore the statements and guidelines reflect the evolution not only of accounting practice but of the way standards and attitudes change in the financial field in general. Merchant banks as a whole applaud the efforts made by the accountancy profession in this respect since it makes their own job of advising their clients considerably easier.

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Legal aspects relating to the securities field (i) The Hong Kong Code on Unit Trust and Mutual Funds was approved by the Securities Commission in June 1978 and was drafted by a committee consisting of members of the staff of the office of the Commissioner for Securities and representatives of the unit trust industry. The format of a voluntary code was chosen following the success of the takeover code and the desire of Government not to introduce complex legislation. It was felt that the unit trust industry could be better regulated if the means of so doing was flexible, As with the takeover code the unit trust code does not have the force of law and is administered by the Committee on Unit Trusts. The committee consists of a secretary who is normally a member of the staff of the office of the Commissioner for Securities who has no vote, the Commission for Securities who is chairman and has a deliberative and a casting vote, plus five other voting members, two from the commission, two from firms engaged in unit trust management and one from a registered trust company. The committee can amend or extend the code in the light of experience. Under the unit trust code the Securities Commission has the power to grant authorisation to unit trusts but it normally acts on the recommendation of the committee. Furthermore any advertisement or other invitation to the public to invest in unit trusts requires the commission's prior approval under section 4 of the Protection of Investors Ordinance and such approval is not possible unless the trust has been authorised, and the trust will not be authorised unless it complies with the unit trust code. Thus compliance with the unit trust code is essential if a trust is to be marketed to the public in Hong Kong. The various requirements of the unit trust code relating to the trust deed and the publication of accounts are based extensively on legislation in the United Kingdom. There are other regulations governing the manager and the investment adviser, as well as marketing. You may be interested to know

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that radio, television, cinema and poster advertising is prohibited, as is door-to-door canvassing. The unit trust code also requires supplementary information to be supplied to the commissioner and updated every year on the day-to-day management of unit trusts, mechanics of valuations, investment policies, costs and charges payable by the unit trust as well as information concerning the relationship between the manager, investment adviser, and representative. While much of this information will not be made public, it is designed to enable the commissioner to monitor unit trusts. At the present time there is a serious backlog of unit trusts awaiting approval and existing unit trusts previously authorised prior to the implementation of the unit trust code are allowed to enjoy continuing authorisation only on the understanding that eventually they will comply with it. Apart from a more regulated supervision of the unit trust industry a possible by-product of the unit trust code may be the publication of more informative statistics on the industry in Hong Kong, (ii) The Protection of Investors Ordinance, as its name suggests, is designed to protect investors and its principle objects are to prohibit (a) recklessly inducing persons to invest for which there is a penalty of up to HK$ 1 million and imprisonment of up to seven years (b) issuing advertisements and documents relating to investment which have not yet been authorised or exempted. The penalty in this case is a tine of up to HK$500,000 and imprisonment of up to three years (iii) The Securities Ordinance is the principal form of legislation governing the investment activities of a merchant bank in Hong Kong. It runs to over one hundred pages and covers amongst other topics (a) the establishment of the Securities Commission (b) its membership, functions, rules and other matters touching upon it (c) the restriction on the establishment of stock exchanges, powers of search, their closure, etc

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VI MAJOR PRINCIPLES AND MATTERS OF CONFIDENTIALITY

Apart from the various legal and voluntary aspects and controls which govern a merchant bank's activities in most markets, including Hong Kong as described above, there are those principles by which each house imposes on itself internal restraints. A few of these might usefully be instanced here since in the context of a conference on legal principles there are, in the opinion of those houses that impose restrictions on themselves, other aspects which are taken as seriously as the legal principles. This whole matter has recently received considerable attention and indeed caused controvesy in the United States where the SEC is now looking at external controls on investment banks following what some say may have been a breakdown of the internal controls by which the profession has lived for so long.

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Conflicts of interest It is an axiom that information about clients operating in the same industry should not be divulged to other clients. Obviously the specialised knowledge gained by a merchant bank in assisting clients operating in the same industry is in general available to all those clients and, I suspect, clients are happy to benefit from this specialised knowledge. It makes the merchant bank that has a number of clients in the same industry that much more of an 'insider' in the traditional rather than stock exchange meaning of that word, and thus it is likely to be able to provide a solution precisely tailored to that client and the industry in which it is active. At the same time there are some clients operating in certain industries who do not wish, perhaps because the industry is dominated by a few companies only, to have a merchant bank act for another client in that industry. Conflicts of interest also arise in acquisition and merger transactions where an existing or new client may not be able to be accommodated due to the fact that another client who has divulged his tentative plans for expansion in a certain area, has first call on the services of that merchant bank. By this means very substantial business can and has been lost, but this is part of the system by which merchant banks choose to operate. Confidentiality of information Apart from its professional knowledge and skills the most important aspect of a merchant bank's reputation is its professional ethics. Similarly to other professions the question of confidentiality is always uppermost in the minds of directors and executives and since information can be, and very often is, highly price-sensitive, enormous care has to be taken that it is not divulged. To me it is a matter of considerable concern and some surprise that there are so many leaks of takeovers or rights issues, both of which are usually highly price-sensitive. Concern because such price movements should not occur

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and surprise because they do. If a merchant banker or a director of a company really wished to use price-sensitive information to his best advantage he should divulge it to no-one but deal on his own account. By divulging information he hampers his ability to deal and to maximise his profit. Consequently since I do not believe that most directors or merchant bankers are that foolish, I suspect that the divulging of price-sensitive information mainly occurs involuntarily: loose talk and the desire to appear well-informed without mentioning names can lead relatively easily to the correct but price-sensitive conclusion. Thus while merchant banks and their clients use code names, lock their files and do not mention the names of transactions to others, even their colleagues, leaks still occur, That they occur largely involuntarily has been proved in the majority of cases where The Stock Exchange in London has made enquiries into price movements. The fact that the takeover code acknowledges that price movements occur which do not originate from insider dealing, also gives some evidence to my belief that most leaks occur involuntarily.
Dealings

One of the more difficult and potentially troublesome aspects of a merchant bank's activities is the dealing in shares of companies in respect of which it has price-sensitive information. Such information should of course be kept entirely separate and within the confines of one or two people only in the corporate finance division. Nevertheless if the investment division of a merchant bank, entirely without this information or the knowledge that it exists within the corporate finance division, deals in the shares of a company and achieves, for itself or for its clients, large profits the suggestion is that this information has crossed what is called in America 'the Chinese Wall.' It might be considered unfair to stop the investment division purchasing or selling on information which it has acquired through the market or research purely because

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confidential information has also been received by another part of the house. The individual client or pension fund would certainly feel aggrieved if his investment adviser was unable to deal under such circumstances. But dealings on behalf of the house or executives of the house are a different matter. Even though executives dealing for themselves through the house or individuals dealing on behalf of the firm may not have known of the information, it is correctly held that neither should have been dealing under such circumstances and that a mechanism should exist whereby they would not, This can be achieved by what is known as the 'stop list' which cynics say should be called the 'go-list.' But this assumes that those in the know are willing not only to disregard the firm's rules but also to face dismissal and probable legal sanction. While there may be people in the profession who are prepared to run these risks my own view remains that it is preferable by far to have a 'stop list' and to run the risk that someone in a senior position has undetected character flaws. As a general rule therefore the firm and its executives ought not to deal until the information received is released and generally known in the market. This rule is considerably more difficult to apply and to justify although it often is in the case of cash flow information stretching out into the far future, given the uncertainty and general unreliability of profit forecasts beyond one year. In summary I believe that good judgement and the almost obsessive desire by the larger firms to maintain their integrity built up over so many years is still the best determinant of whether to deal or not, VII FUTURE DEVELOPMENTS

The larger merchant banks, now in the fourth quarter of the second century of their existence, obviously feel that they will have a continuing role to play. They have come far and are unlikely to stop here. I suspect that in an age where personal service is less

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frequent and the concept of universal shopping more prevalent though not necessarily with the agreement or at the wish of the customer an institution developing its relationships with a relatively small number of clients on a highly professional and individual basis will continue to be sought after. The merchant banks' importance in raising funds for their clients may be diminishing but their advisory role relating to raising funds is increasing. Merchant banks, similar to Hong Kong entrepreneurs, are highly flexible and even the larger ones move often quickly into new areas which they believe will be profitable. Lastly there is a certain mystique and prestige which attaches to their trade and these attributes are now also marketed by the retail banks, to the ultimate benefit of both types of institutions. Thus I believe that merchant banking will expand. In the final analysis the quality of the services will tell.