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Tim Mak, Partner, Freshfields Bruckhaus Deringer, gives some tips on how initial public offering (IPO) sponsors can narrow the gap between their own and regulators’ expectations of the appropriate level of due diligence required in sponsor work.

In May 2003, Hong Kong Exchanges and Clearing Ltd (HKEX) and the Securities and Futures Commission (SFC) published their Consultation Paper on the Regulation of Sponsors and Independent Financial Advisers. Among various observations, the regulators said: ‘It has become increasingly clear… that an “expectation gap” remains between many sponsors (on the one hand) and regulators and investors (on the other) about the role and responsibilities of a sponsor’. Practice Note 21 to the listing rules (PN21) was later implemented to narrow the gap.

In May 2012, almost a decade later, the SFC returned to the same theme. ‘The SFC has been concerned that standards of sponsor work have fallen short of reasonable expectations,’ it said. Paragraph 17 of the SFC’s Code of Conduct (Paragraph 17) was later implemented to narrow the gap.

In October 2018, the SFC again returned to that theme. Thomas Atkinson, the SFC’s current Executive Director, Enforcement, told the attendees of a regulatory summit: ‘We continue to see sponsor work performed below expectations… from what we are seeing, the quality of sponsor work appears to have much room for improvement, and we will continue to focus on this area until standards have improved’. The SFC has done as it has promised, as its latest enforcement actions demonstrate.

Sponsors genuinely believe that they have done, and continue to do, enough. However, regulators can often disagree and believe that more could, and should, have been done. Why is it that the market has been out-of-sync for so long with regulators’ expectations, notwithstanding the implementation of increasingly granular and prescriptive regulatory rules and guidance about what regulators expect and an increasing number of enforcement actions designed to underline that?

The answer might be found in time and mindset. With respect to time, whether they want to or not, regulators are capable of being influenced or informed by hindsight. Often, by the time that they assess a sponsor’s conduct, many things about the listed issuer might become known, or might be much clearer than they were at the time when the sponsor(s) conducted due diligence. It is easy in those circumstances to find things that were not done, particularly if a subsequent regulatory investigation focuses on finding gaps. Because sponsor due diligence is supposed to be ‘reasonable’ and is not expected to be ‘forensic’, there will often be gaps. It may also be easy to feel that if the things that had not been done had actually been done at the relevant time, that might have made a difference to the outcome. Sponsors, however, do not have the luxury of hindsight. Their work is prospective and they are not clairvoyants. So how can they mitigate that disadvantage and, accordingly, their risks?

Mindset might provide an answer; mindset can be of critical importance because it drives behaviour. In this article, we examine the key areas where, from past regulatory pronouncements and enforcement action, and from our own experience of defending regulatory matters involving sponsors, we consider there might be an expectation gap between regulators and market participants in the sponsor space generally. In doing so, our intent is to help sponsors reflect on and, if necessary, recalibrate their mindset and approach to due diligence so that they can narrow that gap.

Overall mindset and approach

The regulators’ expectations

Since the implementation of PN21, regulators have emphasised the need for sponsors to adopt an attitude of ‘professional scepticism’ when conducting due diligence on a listing applicant.
That attitude requires a questioning mind and a critical assessment of information provided by the listing applicant and being alert to other information (obtained from other due diligence steps), including information from appointed experts, that contradicts or brings into question the reliability of that information. Put another way, that attitude might be described as ‘trust, but don’t trust too much, and certainly not unless the information that’s been provided has been properly tested against information that has been separately obtained from various other sources or angles’.
Behind that requirement is the regulators’ hope and expectation that after a sponsor has:

  • looked closely at multiple aspects of the applicant’s business, seen individually and collectively (for example its products, markets, competitors, customers, suppliers, creditors, key assets, management, finances, performance, internal controls and qualifications for listing), and
  • been closely involved in preparing the applicant’s listing document.

The sponsor will then be able to form a sufficiently complete and holistic view of the listing applicant and its business such that it can satisfy itself, as a proxy for the Stock Exchange, the SFC and the investing public (even though the sponsor’s client is the listing applicant), that:

  • the applicant is legitimate; its business is legitimate, viable and will continue to be viable; and those who run it are competent and can demonstrate a track record of performance, and
  • the applicant’s listing document is sufficiently full and meaningful such that it complies with the relevant content requirements and enables a prospective investor to make an informed assessment about whether to invest in the IPO.

If a sponsor is unable to satisfy itself of that, after taking all of those steps, regulators will expect the sponsor to take appropriate steps (including, for example, notifying the relevant regulators).

Where an expectation gap can arise

An expectation gap can arise where a sponsor is too trusting of the listing applicant and its management, and is not sufficiently critical and questioning of the information that it receives from them, and therefore does not take additional and sufficient steps to test that information against other available information. An example of this would be where the listing applicant provides to a sponsor a document purportedly issued by a governmental body, whether officially or unofficially, and the sponsor accepts that document and relies on it, or allows other professional advisers involved in the IPO to rely on it, without taking any independent steps to check or confirm whether that governmental body had in fact issued that document.

The disconnect with regulators’ expectations also applies to situations where the sponsor does not itself look closely enough at sufficient aspects of the applicant’s business, individually and collectively, to obtain comfort that:

  1. the applicant is legitimate, its business is legitimate, viable and will continue to be viable, and those who run it are competent and can demonstrate a track record of performance, and
  2. the applicant’s listing document is sufficiently full and meaningful such that it complies with the relevant content requirements and enables a prospective investor to make an informed assessment about whether to invest in the IPO.

Similarly, an expectation gap may arise where the sponsor relies too heavily on others, like lawyers and accountants, to do what it should itself do. For example, whilst a lawyer can assist with the review of material contracts from a legal perspective, regulators expect a sponsor to conduct a thorough parallel review from a business perspective and as a ‘sanity check’. In that review, if the sponsor identifies, for example, inconsistent material terms, this could be a ‘red flag’ which necessitates further investigative steps. Such further steps might include, for example, enquiries to seek to confirm the genuineness of the contract with the contract counterparty/counterparties.

The planning of due diligence

The regulators’ expectations

Regulators expect that due diligence on a listing applicant is carefully planned, in accordance with the guidance in PN21 and Paragraph 17, and tailored to the specific nature and circumstances of the applicant’s business. Each applicant’s business and circumstances will be different, and so must be the due diligence steps and enquiries that a sponsor should conduct. There is no one-size-fits-all.

Where an expectation gap can arise

An expectation gap can arise if, for example, a sponsor uses a ‘standard’ PN21 checklist, and adopts a ‘tick-box’ (form-over-substance) approach to due diligence. Where a PN21 checklist is
used, it should be supplemented with an additional, contemporaneous document, or documents, that explain(s) clearly the sponsor’s thinking, analysis, rationale and planning with respect to how due diligence on the applicant should be conducted.

The listing applicant’s key assets

The regulators’ expectations

A significant number of past cases where regulators have found problems or concerns with listed companies, where investors have suffered significant loss, have involved false assets, inflated revenue, false accounting and fabricated documents. In light of that, regulators expect sponsors to scrutinise carefully a listing applicant’s key assets (including the physical existence of those assets, the applicant’s legal title to them and an assessment of whether those assets are commensurate with the applicant’s business), and track-record period revenue.

Where an expectation gap can arise

A disconnect or gap can arise if, for example, a sponsor does not:

  • itself physically inspect and scrutinise the listing applicant’s key assets or, where it is not well equipped to do that, specifically instruct a suitable expert to do so and to provide an appropriate written report from which the sponsor can conduct its own assessment of those assets, and/or
  • take sufficient steps to confirm that the listing applicant has proper legal title in the relevant jurisdiction(s) to its key assets, including to confirm the genuineness and effectiveness of key title documents.

Customers and other third parties

The regulators’ expectations

In view of the risk of inflated revenue, as referred to above, regulators expect a listing applicant’s track-record period revenue to be carefully scrutinised, not just by the listing applicant’s reporting accountants and auditors but also by the sponsor(s). A key aspect of that scrutiny is not just the revenue itself but those behind it – the applicant’s customers.

The thinking is as follows: if a deceit involving false accounting and fabricated internal accounting documents is to be executed successfully, that deceit must, of necessity, also involve fabricated customer-related documents and fabricated customers. Put another way, if a listing applicant’s customers are not genuine, it is likely that its revenue is also not genuine, and vice versa.

For those reasons, regulators expect careful, methodical planning of customer due diligence and independent, thorough scrutiny of key customers with minimal involvement (and therefore control), if any, by the listing applicant, to reduce the risks of a deceit involving fabricated customers.

Where an expectation gap can arise

A disconnect or gap can arise if, for example, a sponsor:

  • does not plan customer due diligence and select key customers for interview in a sufficiently methodical, logical and objectively justifiable way such that mitigates the risk of deceit involving inflated revenue
  • does not take appropriate steps to ensure that a customer interviewee is a genuine representative of the customer and is properly authorised by that customer to be interviewed by the sponsor(s) about that customer’s relationship with the listing applicant over its track-record period, and is properly able to give the sponsor(s) the information about that relationship that the sponsor(s) seek(s)
  • does not contact a customer’s representative directly and independently of the listing applicant to arrange an interview with that individual
  • does not independently query a customer if that customer’s representative refuses, or is reluctant, to be interviewed by the sponsor(s) in person at that customer’s own premises, and the sponsor is not sufficiently satisfied that the customer’s response to its query is acceptable, such that it mitigates the risk that that customer might be fabricated
  • agrees to interview a customer’s representative face-to-face at a location other than that customer’s own premises, without a sufficiently good reason (with which the sponsor is satisfied for good reasons) and without taking any additional steps to mitigate the risk that the customer representative in question might be fabricated (for example through conducting internet searches, and making direct enquiries of the customer’s main office about the customer representative in question)
  • agrees to a telephone interview with a customer’s representative without taking any additional steps to mitigate the risk that the customer representative in question might be fabricated (for example through taking steps to confirm the interviewee’s identity, and making direct enquiries of the customer’s main office about the customer representative in question)
  • allows the listing applicants’ representatives to participate in or control the interview and/or interview process (for example by sitting in on interviews)
  • a customer representative’s conduct gives rise to questions about whether he/she is a genuine customer representative, and that conduct is not followed up with additional enquiries, the results of which reasonably mitigate the risk that the representative in question might be fabricated, and/or
  • subsequently becomes aware of information that might raise a question about whether a customer’s representative previously interviewed might be fabricated, and no additional enquiries are conducted to reasonably mitigate that risk.

Reliance on experts

The regulators’ expectations

Regulators expect that a sponsor will work closely with other professional advisers and experts in the course of conducting due diligence on the listing applicant. Regulators understand that each adviser/expert has a role to play, and generally do not expect a sponsor to replicate or duplicate the work of each adviser/expert. However, regulators do expect a sponsor to scrutinise critically an expert’s credentials, scope of work, assumptions, methodology, work product and conclusions and to ensure that the sponsor is reasonably satisfied about all of that in the circumstances of the case.

Where an expectation gap can arise

A disconnect or gap can arise if, for example, a sponsor:

  • has not carefully considered the assumptions underlying an expert’s or professional adviser’s work, to satisfy itself that those assumptions are reasonable and appropriate in the circumstances
  • does not fully understand how an expert has conducted its work and reached its conclusions, and/or
  • does not specifically instruct an expert to conduct work that would objectively be regarded as important or essential in the circumstances of the case.

Record-keeping

The regulators’ expectations

Regulators expect that a sponsor will keep a proper, contemporaneous, written audit trail of the work that it conducted as a sponsor, such that, if necessary, they can piece together after the event (including years after the event) what had happened, who did what and why, at the time of the sponsor’s work on the IPO in question.

Where an expectation gap can arise

A disconnect or gap can arise if, for example, a sponsor:

  • does not contemporaneously document, and document sufficiently fully and accurately, the planning and execution of key due diligence steps and enquiries. Documenting thinking, analysis and rationale is as important as documenting the conclusions reached
  • relies solely or predominantly on a ‘standard’ PN21 checklist for documenting its due diligence work. Such templates often do not include sufficient space for detailed text about the thinking, analysis, rationale and conclusions reached with respect to each key step
  • has not been closely involved in preparing notes of interviews with the listing applicant’s key third-party stakeholders, like customers, suppliers and creditor banks, and does not ensure that those notes are full, accurate and meaningful, and/or
  • relies solely or predominantly on others (for example sponsor’s/sponsors’ legal counsel) to assist with record-keeping.

Concluding remarks

The SFC’s pledge to ‘continue to focus on this area until standards have improved’ should be taken seriously. Given the SFC’s indication in October 2018 that it had investigated 30 cases of suspected sponsor misconduct involving 28 sponsor firms and 39 listing applications, the enforcement actions recently publicised by the SFC are unlikely to be the last of their kind. Accordingly, sponsors would be well advised to carefully reassess how they might be able to narrow, or further narrow, the expectation gap.

The risks for sponsors who find themselves in disagreement with the SFC about the quality of their due diligence are significant. In addition to an increasing magnitude of financial penalties, the risk of a suspension of sponsor authorisation is real, as is the risk of being the subject of a test case before the Market Misconduct Tribunal for suspected breach of Section 277 of the Securities and Futures Ordinance (SFO) and/or before the High Court for investor compensation under Section 213 of the SFO.

Tim Mak, Partner
Freshfields Bruckhaus Deringer
More information is available on the websites of Hong Kong Exchanges and Clearing Ltd
(www.hkex.com.hk) and the Securities and Futures Commission (www.sfc.hk).
© Freshfields Bruckhaus
Deringer LLP

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