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Hong Kong corporate finance regulation 2014 and 2015 – IPO sponsor due diligence regime update

Hong Kong corporate finance regulation  2014 and 2015 – IPO sponsor due diligence regime update


The Top 11 regulatory developments in 2015 should include the following:

  1. New Measures for Shanghai-Hong Kong Stock Connect:
    • covered short-selling of eligible A Shares is allowed (with effect from 2 March 2015
    • institutional investors will be able to sell A Shares held through custodians without having to transfer them to brokers’ accounts one day prior to sale from 30 March 2015
    • Chinese mutual funds have been allowed to trade Hong Kong-listed shares through Stock Connect since 30 March 2015. This has significantly boosted trading in Hong Kong listed shares through the southbound link.
  2. Implementation of Shenzhen-Hong Kong Stock Connect.
  3. New China-Hong Kong Mutual Recognition of Funds (MRF) scheme to be introduced to allow Hong Kong domiciled funds authorised by the SFC to be sold in China and CSRC-authorised funds to be sold in Hong Kong.
  4. Publication of HKEx’s conclusions on Weighted Voting Rights Concept Paper and a decision on whether its Listing Rules should be amended to allow companies with dual class share structures and other WVR structures to list. If WVRs are to be allowed to list, HKEx has said it will publish a further consultation paper on the rule changes. Publication of the conclusions on the concept paper and a further consultation paper on the scope of the regime for listing WVR companies are expected soon.
  5. The FSTB should publish its consultation conclusions on allowing open-ended investment funds in corporate form under amendments to the Securities and Futures Ordinance.
  6. Stamp duty on all Hong Kong-listed ETFs was waived with effect from 13 February 2015.
  7. The current profits tax exemption for offshore funds will be extended to offshore private equity funds.
  8. New mandatory reporting obligations for OTC derivatives are expected to come into force in Q1 2015 on implementation of the Securities and Futures (OTC Derivative Transactions – Reporting and Record Keeping Obligations) Rules.
  9. New fathers’ statutory entitlement to 3 days’ paid paternity leave took effect on 27 February 2015.
  10. The Securities and Futures Appeal Tribunal will begin its review of the SFC’s disciplinary decision against Moody’s Investors Service on 10 September 2015.
  11. EY’s appeal against the court order to produce documents held by its Mainland affiliate should be heard in 2015.

Due Diligence Update

The New IPO Regime: A Recap of Sponsors’ Due Diligence Obligations

The new sponsor regime was implemented on 1 Oct 2013 under Paragraph 17 of the SFC’s Code of Conduct for Persons Licensed by or Registered with the SFC (Paragraph 17) and amendments to the Listing Rules. As I mentioned earlier, the key changes were the requirement to publish a “substantially complete” Application Proof on the Exchange’s website at the time of submitting the listing application. This meant that the due diligence process has to be front loaded so that it is completed before the A1 filing. The new regime also imposed a number of new diligence obligations which apply on top of the requirements already spelt out in Practice Note 21. Some of these were reactions to things that had gone wrong on specific IPOs – for example the specific requirements for interviews of suppliers, customers and franchisees stem from the Hontex/Mega Capital case, which I’ll talk about later. Another key change related to sponsors’ ability to rely on third parties – e.g. lawyers and reporting accountants – with new requirements for sponsors to assess whether it is reasonable to rely on experts’ reports and prevent them from being taken at face value as happened in both the Hontex and SinoLife/Sun Hung Kai cases.

Reasonable Due Diligence Requirement

The requirement to front load due diligence was introduced in new Paragraph 17.4(a) of the Code of Conduct which requires that:

Before submitting an application on behalf of a listing applicant to the Stock Exchange a sponsor should have performed all reasonable due diligence on the listing applicant except in relation to matters that by their nature can only be dealt with at a later date, and ensure that all material information as a result of due diligence has been included in the Application Proof.”

Obligation to Identify Material Issues

The new regime also introduced a new obligation for sponsors to notify issues that are material to the listing applicant’s suitability for listing to the Exchange. Paragraph 17.4(d) of the Code of Conduct requires that:

When submitting an application on behalf of a listing applicant to the Stock Exchange, a sponsor should ensure that all material issues known to it which, in its reasonable opinion, are necessary for the consideration of:

  1. whether the listing applicant is suitable for listing; and
  2. whether the listing of the applicant’s securities is contrary to the interest of the investing public or to the public interest,

are disclosed in writing to the Stock Exchange.”

Deficiencies in Returned Application Proofs

For the first year of the new regime, the HKEx carried out an “Initial 3-Day Check” of Application Proofs. In the first 6 months of the new regime, the fact that an Application Proof was returned to the issuer and its sponsor for failing the Initial 3-Day Check or the Exchange’s subsequent qualitative assessment was not published on the HKEx website. According to the Exchange, in the first 4 months of the regime (to 31 Jan 2014), 4 out of 18 new listing applications were returned for failing the Initial 3-Day Check. The deficiencies noted by the Exchange were as follows:

In one case, the listing applicant had failed to follow Guidance letter HKEx GL6-09A in that the listing application was filed before the end of the 3-year trading record period but did not provide 9-month financials for the latest financial year end.

Paragraph 4.2(b)(ii) of the Guidance Letter requires an applicant that is unable to include financial information for the most recent financial year in an audited or advanced form in its Application Proof, to include with its listing application financial information for a stub period of at least 9 months and comparative information and the related Management Discussion and Analysis.

Paragraph 5.2 further provides that the earliest time a listing application can be filed is after the end of the 3-year trading record period.

In another case, insufficient information was submitted for assessment of whether the applicant satisfied the ownership continuity and control requirement under Main Board LR 8.05(1)(c). In a further case, insufficient information was submitted to assess whether the applicant satisfied the minimum profit requirement under Main Board LR 8.05(1)(a).

Other deficiencies in the information disclosed in Application Proofs included that:

  • one applicant failed to submit a reply to the outstanding comments on the applicant’s compliance with the minimum cash flow requirement under GEM LR 11.12(1) which had been raised by the Exchange during a previous application;
  • another applicant failed to provide Liquidity Disclosure as defined in Guidance Letter HKEx-GL38-12 to a date no more than 2 months before the date of the Application Proof;
  • There was one case where a controlling shareholder’s conviction was not disclosed;
  • In another case there was insufficient disclosure on the proposed issuance of corporate bonds on which guidance had previously been provided in a pre-IPO enquiry; and
  • There was one case which lacked sufficient information on the performance of the listing applicant’s business

Deficiencies noted in qualitative assessment

Two other cases that passed the Initial 3-day Check in the first 4 months of the new regime failed the subsequent qualitative assessment. The Application Proofs were returned because the information disclosed was not substantially complete in all material respects.

The following deficiencies were noted:

  • Insufficient disclosure on the applicant’s business model, non-compliance incidents, use of proceeds and hedging policy;
  • Insufficient information to enable investors to assess the extent of the applicant’s reliance on a major customer;
  • Insufficient information to enable investors to assess the impact of certain disputes and complaints, suitability of directors and sustainability of the applicant’s business; and
  • Insufficient information to assess whether the applicant satisfied the management continuity requirement under GEM Listing Rule 11.12A(3).

No Application Proofs have been returned since the Exchange’s ability to name and shame the issuer and sponsor by publishing the fact of return became effective on 1 April 2014. Sponsors have made huge efforts to make sure that theirs is not the first Application Proof to be rejected and thus, to that extent, the new regime may have achieved its aim of improving the standard of due diligence, or at least improving the quality of draft prospectuses submitted with listing applications.

Disciplinary Decisions to Date under Old IPO Regime

The disciplinary decisions relating to IPO sponsors were made under the previous IPO Regime. So far there have only been 2 disciplinary actions brought against sponsors, and both involved sole sponsors: Mega Capital (Asia) Company Limited (Mega Capital) for its work on the IPO of garment manufacturer Hontex International Holdings Company Limited and Sun Hung Kai International Limited for its work on the IPO of Chinese funeral company, Sinolife.

Mega Capital (Asia) Company Limited (Mega Capital)

The SFC revoked Mega Capital’s corporate finance adviser licence and fined it HK$42 million for inadequate and sub-standard due diligence work on Hontex’s 2009 IPO. The findings against Mega Capital related firstly to inadequate and sub-standard due diligence work.

The principal businesses of Hontex group were fabric sales and garment manufacturing (on an Original Equipment Manufacturing (OEM) basis for apparel owners and for Hontex’s franchisees). The SFC considered that due diligence on the group’s customers, suppliers and franchisees was necessary to assess the authenticity of the group’s business performance.

The SFC reached the conclusion that Mega Capital’s due diligence work was inadequate and sub-standard on the basis that:

Firstly, material information (such as transaction figures with the group) was missing from questionnaires that Mega Capital completed with suppliers and customers. Mega Capital then failed to follow up on the missing information.

In addition, a number of interviews with suppliers and customers were conducted on the phone in haste on the same day Hontex filed its listing application.

The SFC also found that franchisees’ information provided by Hontex (e.g. name, address and turnover of each franchisee) was not properly verified and that transaction records between franchisees and the group were not obtained.

The second failing identified was that Mega Capital failed to act independently and impartially.

The SFC found that Mega Capital relied on Hontex inappropriately without performing independent scrutiny and verification when sourcing important aspects of its due diligence work in relation to Hontex’s suppliers, customers and franchisees. The examples given by the SFC of inappropriate reliance included that Mega Capital complied with Hontex’s request not to approach the group’s suppliers, customers and franchisees directly. As a result, Hontex arranged all the interviews which were also attended by representatives of Hontex.

Mega Capital also accepted Hontex’s representation that some suppliers/customers refused face-to-face interviews with Mega Capital without inquiring further. It agreed to have telephone interviews with suppliers and customers arranged by Hontex and allowed Hontex to collect written confirmations from franchisees confirming their independence from Hontex.

The third failing identified by the SFC was that Mega Capital’s audit trail of its due diligence work was inadequate.

The SFC found that Mega Capital did not maintain adequate documentation of its due diligence planning and significant aspects of its due diligence work. For instance, Mega Capital kept no records showing what background or other due diligence searches were conducted on the group’s suppliers, customers and franchisees.

Finally, the SFC complained about Mega Capital’s inadequate supervision of its staff.

Most of the due diligence work was handled by junior and inexperienced staff of Mega Capital without adequate supervision. The two Responsible Officers both claimed that the other was responsible for supervision of the due diligence on the Hontex IPO.

Breach of sponsor’s undertaking and filing untrue declaration with HKEx

In view of the failures identified, the SFC considered that Mega Capital had breached its undertaking and declaration to the Stock Exchange confirming performance of reasonable due diligence inquiries and that all information provided to the Exchange during the listing application process, including information in the IPO prospectus, was true in all material respects and no material information was omitted.

The SFC found that Mega Capital had failed to use reasonable endeavours to ensure that all information provided to HKEx during the listing application did not omit any material information and its declaration that it had made all reasonable due diligence inquiries also appeared to be untrue.

However, the SFC found no evidence that Mega Capital was involved in any fraud and it denied all allegations of wrongdoing.

Separately, Hontex was ordered to buy back its shares from around 7,700 eligible shareholders based on its admission of disclosure of false or misleading information.

The inadequacies identified in the Mega Capital/Hontex case led to the introduction of new requirements for sponsors under Paragraph 17 of the Code of Conduct. In particular, new Paragraph 17.6(f) introduced specific requirements for the conduct of interviews of major business stakeholders such as customers, suppliers, creditors and bankers. These include obligations on a sponsor to:

  • Ensure that interview records are reasonably accurate, complete and reliable in all material respects;
  • Select interviewees independently based on objective and proportionate criteria; and
  • Carry out the interview directly with the person or entity selected for interview with minimal involvement of the listing applicant.

To address the issue of inadequate records being kept of sponsor due diligence work, Paragraph 17.10 of the Code of Conduct introduced a requirement for sponsors to maintain adequate records so as to demonstrate to the SFC its compliance with the Code and in particular compliance with the requirements of Paragraph 17 of the Code of Conduct. As well as specific requirements to document due diligence planning and changes to plans and the conduct of due diligence, Paragraph 17 further requires sponsors to document all significant matters arising in the course of the listing process, including internal discussions and actions taken, regardless of whether or not the relevant matters are disclosed in the final listing document.

Sun Hung Kai International Limited (Sun Hung Kai)

Another landmark disciplinary proceeding pursued by the SFC concerned the boutique bank Sun Hung Kai in relation to its work as sponsor on the IPO of Chinese funeral company, Sino-Life.

In Jan 2014, the Securities and Futures Appeals Tribunal (SFAT) upheld the SFC’s disciplinary decision against Sun Hung Kai. The bank was fined HK$12 million and had its licence suspended for a year for due diligence failures as the sole sponsor of Sino-Life Group Limited (Sino-Life)’s IPO.

The timeline of events, in summary, was as follows:

  • Sun Hung Kai was appointed by Sino-Life to manage its listing application on GEM in October 2007.
  • A change in the GEM Listing Rules in May 2008 required listing applicants to demonstrate a positive cash flow of not less than HK$20 million in the preceding 2 financial years.
  • The draft audit report obtained revealed a positive cash flow of less than HK$20 million.
  • Sun Hung Kai requested a waiver of the new cash flow requirement but this was refused by the Exchange and the listing application was not filed.
  • In October 2008, Sino-Life revived its listing application and appointed Sun Hung Kai as the sole sponsor.
  • A new accounting firm was employed and the audit report submitted to the Exchange demonstrated an operating cash flow that met the HK$20 million requirement.
  • A material difference was later found in the cash flow figure for the financial year ended 2007 used in the original and new audit reports.
  • According to the original audit report, the cash flow for the year ended 2007 was RMB 7.007 million
  • However, the new audit report stated the cash flow for the same period to be RMB 10.230 million – a difference of RMB 3.223 million.

The SFC commenced a 3-and-a-half-year long investigation after Sino-Life’s listing and found that Sun Hung Kai had failed to carry out proper due diligence in relation to 5 matters:

  1. assessing the accuracy and the completeness of the information submitted by Sino-Life to demonstrate that it satisfied the financial requirements to list on GEM;
  2. ascertaining the existence of various encumbrances on the title of a major business deal of Sino-Life in Taiwan;
  3. properly assessing the business of Sino-Life’s wholly-owned subsidiary in Taiwan;
  4. ensuring true, accurate and complete disclosure was made to the Exchange and in Sino-Life’s prospectus and breach of the sponsor undertaking to the Exchange by filing untrue statements in the sponsor declaration; and
  5. keeping proper books and records in relation to the sponsor work conducted.

The SFC considered that Sun Hung Kai had been selective in its disclosure to the Exchange during the listing application process.

On appeal, the SFAT confirmed most of the SFC’s findings and considered that Sun Hung Kai’s breaches were not the result of negligence. The SFAT identified the following failings by Sun Hung Kai as sponsor:

Failure to disclose and explain difference in 2007 cash flow figures

  • The SFAT believed that Sun Hung Kai’s team working on Sino Life’s listing application was aware of the 45% discrepancy in the cash flow figures between the original draft audit report and the report submitted with the listing application and was well aware of its importance to the listing application. It considered that the team chose to ignore the difference and not to reveal it to the Exchange even upon subsequent inquiries.
  • The omission was a clear breach of GEM LRs 6A.04 and 6A.15 which set out a sponsor’s obligation to exercise reasonable due diligence in ensuring that any opinions or forward-looking statements of the directors of the applicant have been made on fair and reasonable bases and assumptions and that all information is true in all material respects and does not omit material information.

Failure to ascertain and disclose encumbrances on title of a major business deal

  • Sino-Life disclosed in its IPO prospectus its intention to invest HK$13.1 million raised from the IPO to furnish a columbarium in Taiwan, to which it didn’t have title or any rights.

Failure to ascertain and disclose encumbrances on title of a major business deal

  • A Sun Hung Kai employee conducted an internet search and discovered that an auction against the columbarium had been halted, which hinted at the potential financial instability of the title owner of the columbarium.
  • The discovery prompted Sun Hung Kai to seek an opinion from a Taiwanese lawyer.
  • From evidence the SFC collected, Sun Hung Kai did urge Sino-Life to disclose relevant risks in their prospectus, but the issue was not taken further and not mentioned in the prospectus.
  • The SFAT found that Sun Hung Kai should not have accepted the advice of the Taiwanese lawyer which appeared to be inadequate. The Tribunal was convinced that Sun Hung Kai had failed to pursue irregularities discovered and had breached Paragraph 2.3 of the Corporate Finance Adviser Code of Conduct. Paragraph 2.3 CFA requires a corporate finance adviser to provide a proper trail of work done upon request by the SFC.

The main due diligence issue was the ability of the sponsor to rely on an expert’s opinion without further enquiry. The new regime under Paragraph 17 of the Code of Conduct imposes new obligations which sponsors must follow in order to be able to rely on an expert’s report. In addition to satisfying themselves as to the qualifications etc. of the expert, a sponsor is required under new Paragraph 17.7 to:

  • critically review the expert’s opinion and the rest of the information in its report against the totality of all other information known to the sponsor about the listing applicant through due diligence and the sponsor’s knowledge of the listing applicant; and
  • corroborate the information in the expert report with the information disclosed in non-expert sections of the prospectus and the sponsor’s knowledge of the listing applicant.

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