Due diligence for IPO gatekeepers
Hong Kong’s Independent Commission Against Corruption (ICAC) argues that the new regime for the regulation of IPO sponsors in Hong Kong is part of a new drive by regulators, both in Hong Kong and globally, to hold IPO gatekeepers accountable.
It would not be ludicrous to suggest that competition amongst financial centres gives rise to competition amongst regulatory regimes – despite their close cooperation – in modern global financial markets. This is particularly true for initial public offerings (IPOs) where the leading stock markets compete to woo new public listing candidates. It is in the DNA of most capitalists to seek the best place to park their money and it is generally recognised that, other global and macroeconomic factors aside, the market with the best practices and regulatory climate offers the least risk and enjoys a higher reputation.
This is precisely why the guardian role of listing professionals and practitioners, especially listing sponsors, has come under the spotlight, and in the case of Hong Kong there is no better time to up the periscope and review the current environment.
In December 2012, Hong Kong’s securities watchdog, the Securities and Futures Commission (SFC), released its consultation conclusions aimed at enhancing the regulatory regime for IPO sponsors by clarifying their criminal and civil liabilities, and to top up recent requirements under the listing rules of the Hong Kong Stock Exchange that called for more extensive due diligence of listing candidates.
These regulatory tightening measures are mainly aimed at addressing the risks associated with sponsors involved in IPOs, in particular enhancing their ability to detect risks before formally filing companies for listing. Obviously, a failure on their part to identify these risks prior to bringing companies to listing would translate into potential risks and financial losses for the investing public. Hence regulators in many jurisdictions, including Hong Kong, are increasingly holding listing professionals and advisers, many of whom are IPO sponsors, accountable.
Complex risks and challenges
To be fair, professionals like sponsors are facing unprecedented challenges and difficulties. One underlying problem all IPO professionals face is the time issue – thorough due diligence and background checks on companies and directors simply takes time, the more the better, especially for businesses involved in complex business models in certain industries such as mining, gaming and green businesses.
The risks, compliance issues and due diligence concerns apply not only to listing sponsors but also other listing professionals involved in the due process, such as lawyers, auditors and underwriters.
The increasingly cross-border nature of IPOs these days also tends to complicate matters for listing professionals. A recent report by auditing firm PwC and law firm Baker & McKenzie found that listing venues like Hong Kong witnessed significant growth in cross-border IPOs between 2002 and 2011 and Chinese companies registered the largest number of international listings comprising almost a third of all cross- border listings over the same decade.
‘The rising tide of cross-border IPOs and capital raising has implications for how underwriters deal with risk and compliance issues, particularly when the issuer has a business or assets in emerging economies,’ said Frank Castiglia, a Sydney-based Baker & McKenzie partner, as quoted in the Thomson Reuters newsletter Compliance Complete. ‘The cross-border dimension means that it is more important than ever for underwriters to ensure that thorough due diligence is done to meet the requirements and identify any deal with issues and risks in both the listing jurisdiction and the jurisdictions in which the issuer is based and in which it operates.’
Hong Kong was the world’s top IPO venue from 2009 to 2011. It fell to fourth place in the 2012 global rankings as a result of the faltering Chinese economy, but the windfall brought its share of bad apples: the rush to market and plain avarice. The impact of falling fees is also raising concerns that the quality of due diligence may be compromised. Data compiled by Bloomberg showed that underwriters in Hong Kong earned about US$250 million from first-time share sales last year, down from the average of US$775 million each year since 2006.
A more fundamental issue is the underlying and inherently positive correlation between the fate and interests of both the sponsors and listing candidates. The eventual outcome of the listing attempts have tremendous impact on the well-being and balance sheet of the sponsors, to the extent that there may be more incentives for the sponsors to push through the listing than to ‘kill’ the deal.
Spotlight on risks and pitfalls
The challenges, difficulties and potential pitfalls faced by professionals involved in listing can be best demonstrated by a headline-hitting case last year. Hontex International Holdings Company Ltd, a Fujian-based fabric maker, was listed on the Hong Kong Stock Exchange on 24 December 2009 and raised approximately HK$1 billion in capital, but its trading was suspended three months later at the direction of the SFC after a report to the regulator on materially misleading overstatements of its turnover, profit and cash in its IPO prospectus.
Hontex subsequently admitted that the amounts stated in its IPO prospectus for its turnover, profit before tax and its cash and cash equivalents were materially false and misleading. The Court of First Instance ordered Hontex on 20 June 2012 to make a HK$1.03 billion repurchase offer to investors who subscribed for Hontex shares in the initial public offering or purchased them in the secondary market. The Stock Exchange eventually decided in December 2012 to cancel its listing.
The SFC also went after Mega Capital (Asia) Company Ltd, the sole sponsor of Hontex, for its untrue IPO prospectus. It imposed a ban against advising on future listings or dealing with securities in Hong Kong and a record fine (HK$ 42 million) for its multiple failures as a listing sponsor – including inadequate and sub-standard due diligence; failure to act independently and impartially; inadequate audit trail of due diligence work; inadequate supervision of its staff; and breach of the sponsor’s undertaking and filing an untrue declaration with the Stock Exchange.
Additionally, the SFC has revoked the licence of a former director of Mega Capital and banned another former executive director from re-entering the industry for three years for their supervisory failures and refusal to accept their responsibilities as sponsor principals.
‘Given the important role played by sponsors, these failures must be regarded most grimly,’ said Mark Steward, the SFC’s director of enforcement in a statement on the Hontex case.
The Hontex case was not the first of its kind in Hong Kong. A decade earlier, Hong Kong-listed Euro-Asia Agricultural (Holdings) Co Ltd, a China-based orchid grower from Shenyang popularly referred to as Euro-Asia, was involved in a similar case. In 2002 its founder Yang Bin was suspected of committing corporate fraud by using fake records. The Euro-Asia case highlighted similar problems involved in IPOs since the sales, earnings and other figures were inflated and yet escaped the scrutiny of sponsors, underwriters, auditors, lawyers and regulators.
These cases underscore not only the crucial gatekeeper role and responsibilities of sponsors but also
the importance of their professional competence and integrity, and the negative consequences resulting from their malpractices and inadequate due diligence. Regulators and the investing public expect sponsors to demonstrate that they have done their best with integrity and professional judgement intact. Media reports have voiced public concern about sub-standard sponsor work, pointing out that sponsors
should exercise reasonable judgement in conducting due diligence on listing applicants and should ensure that all major issues are properly addressed before submitting listing applications. After all, the sponsors are the only ones closely involved with the preparation of the new applicant’s listing documents and their capacity is specifically licensed by the SFC.
The Hong Kong ICAC has also had its fair share of enforcement actions against listing frauds. Past cases which involved directors, executives and professional staff of listed companies highlight other areas of misconduct, such as alleged acts of corruption, insider dealing, embezzlement, falsifying documents, conflict of interest. Sponsors need to identify such failings in their due diligence work.
A case in point is an ICAC investigation which led to six people – including the former chairman, vice-chairman and a certified public accountant – being charged in 2003 for alleged conspiracy to defraud over the listing of a company and applications for letters of credit. The defendants were sentenced to jail terms of 8 to 10 years. Apart from imprisonment, the court also ordered the defendants to be disqualified from being company directors for a period equivalent to their prison terms.
The alleged offences that occurred between 1998 and 2002 include falsifying sales invoices and accounting records to inflate the turnover and profit figures of the company and misrepresenting the company’s financial position in its IPO prospectus. The judge said that the sentences should reflect the seriousness of the offences and emphasised that the use of fraudulent accounting to get listed would have disasterous consequences for the public. The case involved over HK$85 million and the investigation lasted about three years.
As mentioned earlier, Hong Kong has recently slipped from its global top listing status. This period of market consolidation may well be a timely opportunity to review the role of listing practitioners, including sponsors. In this regard, the Consultation Conclusions on the Regulations of IPOs Sponsors announced by the SFC in December 2012 is in line with its earlier
stance to step up its review of the quality of due diligence of a number of IPOs in the city to restore investors’ confidence of newly-listed share offerings. The new regime which became effective in October this year, highlights two core areas:
1. The directors of the listing company, the sponsors and ‘any person who has authorised the issue of the prospectus’ faces up to three years in prison and a HK$700,000 fine if it is found that untrue statement(s) in the prospectus brought losses for investors.
2. The listing documents need to be filed earlier – when the company applies to the stock exchange for approval to list rather than when the new shares are prepared to be sold. This is designed to give investors more time to digest, analyse and hopefully understand the listing debutant before making their investment decision.
The objective of these new requirements is to clarify the standard and quality of work the sponsors are expected to meet. Hopefully, the new requirements will enable and encourage the sponsor community to take a more responsible, proactive and constructive role in new IPO cases.
According to the SFC consultation conclusions, the proposals are aimed at encouraging best practice across sponsor firms. ‘The whole idea is to try to lower risk rather than increase it, so you lower risk for the sponsors because they can do their jobs properly, you lower risks for the markets because they have better gatekeepers and then you lower risks for investors,’ the SFC’s Ashley Alder was quoted as saying by Reuters.
The core problem is that some practitioners exhibited deficiency in due diligence in some cases, thereby damaging the reputation of the market as a whole. Consider for example, the SFC said they inspected 17 sponsors in 2011 and found various problems such as inadequate internal systems and controls as well as unsatisfactory due diligence, including a number of cases where underwriters submitted a company for listing even when due diligence was incomplete (see ‘Common deficiencies in IPO sponsor work’ on page 27).
Hence, the recent amendments proposed by the Hong Kong authorities are meant to set the minimum conduct or behavioural standards applicable to market practitioners by providing the ‘hardware’ to them – that is, the rules and guidelines which form the regulatory framework. The ICAC on its part, through its Hong Kong Ethics Development Centre (HKEDC), provides the ‘software’ to the market from the corruption prevention perspective, by means of value education which helps to develop an ethical culture in the field. Amongst its materials and courses made publicly available, the HKEDC educates and helps enhance professionals’ capabilities to resist temptation and act appropriately when they face ethical dilemmas and other challenges during the IPO preparation and due diligence process, such as standing firm to decline unlawful offers, blow the whistle whenever necessary, recognise the repercussions of their every decisions, etc.
In addition to all this hardware and software, however, it is important that there is an ethical culture within the profession given the guardian role of these listing professionals and practitioners. In upholding their personal reputation, as well as the reputation of Hong Kong as a global financial centre and IPO market, not forgetting the interest of the investors, their value judgement and their ‘call of the moment’ is crucial in handling many of these temptations and risks that could potentially lead IPOs astray.
The implications are thus loud and clear: sponsors must exercise care in client selection and meet the standards of work expected of them. They need to ensure proper and thorough due diligence to gain full understanding of the local environment the company in question operates in and also to ensure proper disclosure. It is also of primary importance that they equip themselves with the necessary skill sets in handling possible ethical challenges and dilemmas.
The Hong Kong Ethics Development Centre
Independent Commission Against Corruption
SIDEBAR: Common deficiencies in IPO sponsor work
1. Unsatisfactory due diligence on listing applicant’s business:
(a) insufficient due diligence on major business stakeholders (b) insufficient due diligence on material changes in business shortly before listing, and
(c) insufficient due diligence on the works of third party professionals/ experts.
2. Questionable disclosure to the stock exchange during the listing application process.
3. Failure to maintain proper documentation of due diligence.
4. Inadequate internal systems and controls over sponsor work:
(a) inadequate manpower and resources to undertake sponsor work, and (b) inadequate annual assessment of internal systems and controls.
Source: Report on Sponsor Theme Inspection Findings (March 2011), SFC
SIDEBAR: Ethics and compliance for SMEs: a new guide
The English version (CD-ROM format only) of Business Success: Integrity & Legal Compliance Corruption Prevention Guide for SMEs in Guangdong, Hong Kong and Macau is now available. The Chinese version of this Hong Kong Ethics Development Centre guide has been available since October last year. The guide features the anti-corruption laws and regulations in Guangdong, Hong Kong and Macau; illustrative cases; common corruption risks and the corresponding preventive measures. The guide also introduces skills in managing staff integrity and the services available for SMEs operating businesses in Guangdong, Hong Kong and Macau.
To obtain a copy of the guide, request other corruption prevention services or enquire about the details of organising seminars on related topics for your organisation, call the Hong Kong Ethics Development Centre at (852) 2587 9812, or email: firstname.lastname@example.org.
SIDEBAR: About the EDC
The ICAC, in its role as an anti- graft enforcement agency, actively promotes the practice and awareness of professional ethics. The ICAC offers capacity building programmes for financial practitioners. For example, The Hong Kong Ethics Development Centre (HKEDC) of the ICAC promotes business and professional ethics in Hong Kong as the first line of defence against corruption. The HKEDC offers the following services:
- integrity training for the business and professional sectors
- code of conduct formulation and review for business organisations
- advice to companies on internal controls, and
- tailor-made training videos and practical guides for different trades and professions.
Please visit www.hkedc.icac.hk or call 2587 9812 if you are interested in using these services to strengthen the corporate governance of your company.