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Sponsor Work Standards Expected by the SFC

Deficiencies in Sponsor Work Identified by the SFC

  1. Introduction

    On 26 March 2018, the SFC issued a Circular to licensed corporations on expected standards for sponsor work (the Circular) following the release of their Report on the thematic review of licensed corporations engaged in sponsor business (the Report).

    The deficiencies in sponsor work highlighted by the SFC include:

    • failure to follow up on apparent red flags during due diligence;
    • box-ticking standard due diligence checklists resulting in failure to address issuer-specific matters outside the scope of standard checklists; and
    • failure to confirm that persons interviewed had the authority and knowledge to confirm or provide requested information.

    The Report notes that these deficiencies were especially common for sponsor work conducted for GEM IPOs.

    Between October 2013 and December 2017, 44 listing applications were returned or rejected due to concerns raised during the vetting process. Sponsors whose listing applications have been rejected or returned may expect more frequent SFC inspection visits and supervisory actions.

    The Report assessed the standard of sponsor work against the requirements of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Code of Conduct), Corporate Finance Adviser Code of Conduct (CFA Code) and the Listing Rules. The Circular draws attention to the standards of sponsor work expected under the Code of Conduct.

  2. The Circular – Expected standards of sponsor work

    The SFC’s Circular notes the following expected standards of good practice for sponsors.

    1. Due Diligence

      1. Exercising reasonable judgement and applying professional scepticism
      2. Understanding the listing applicant

        Sponsors are expected to develop a good understanding of the listing applicant’s business through measures such as:

        • Verifying the accuracy of the description of the listing applicant’s business operations in the listing application by obtaining sales walkthrough documents. Red flags in such documents include third parties’ unrelated payments on behalf of customers, contractual arrangements outside of the ordinary course of business and goods not shipped to customers;
        • Conducting proper due diligence on major retail or online customers of the listing applicant. This is particularly relevant where certain customers account for a materially larger portion of sales than others; and
        • Conducting proper due diligence on the volume of business at the applicant’s major retail stores.

        Sponsors should perform background research on listing applicants and regularly update it, especially for listing applications which are expected to continue for some time or for listing applicants in fast-evolving industries or regulatory environments.

        Due diligence plan and checklist

        • Sponsors should develop robust, comprehensive and customised due diligence plans at the start of each sponsor engagement. Generic due diligence check lists should not be relied on. Due consideration needs to be given to all major areas of due diligence at an early stage.
        • During the listing process, sponsors should adapt due diligence plans and checklists for listing applications. Plans, checklists and subsequent updates should be approved by designated senior members of the Transaction Team and properly recorded.
        • Sponsors should keep proper records of due diligence documenting the breadth and depth of the due diligence and results. The records should include specific issues identified, how they were resolved, and a log of all identified material risks and issues, and should be accompanied by stand-alone due diligence notes. For example, sponsors should document the criteria for selecting business locations or customer premises for site visits (such as the percentage of sales covered), the names of sites inspected and of persons participating in site visits, any verification work, and all instructions or guidance given to participating staff.

        Relying on third parties

        The SFC reminds sponsors that they are responsible for tasks undertaken by a third party and that they cannot use the work of a third party as evidence that they have discharged their obligation to conduct due diligence. A third party’s work in itself is not sufficient evidence of sponsor due diligence.

        Sponsors should be able to explain:

        • The reasons for relying on a particular third party to discharge their due diligence obligations giving consideration to the third party’s qualifications and competence;
        • Whether the scope and extent of due diligence to be conducted was communicated to the third party; and
        • Whether the third party’s work gave sufficient basis to conclude that reasonable due diligence had been conducted and whether further due diligence was necessary, taking into consideration whether:
          • the work was conducted as envisioned by the sponsors;
          • the due diligence met the standards expected of sponsors; and
          • the bases and assumptions for the third party reports or opinions were considered to be fair, reasonable and complete.

        Relying on experts

        Experts’ opinions are expected to be critically reviewed by the sponsors, and any material discrepancies, irregularities or inconsistencies should be followed up on.

        The SFC notes that audits of the listing applicant’s accounts do not relieve sponsors of their responsibility to assess applicants’ financial and business performance.

        Identifying and following up on red flags

        Sponsors are required to take reasonable steps to identify red flags and cross-check information obtained from different sources. Any material irregularities should be followed-up and resolved.

        Claims that an unusual practice or business conduct is common for a particular industry should be viewed with scepticism. Sponsors should consider the practice from the perspective of whether it calls into question the genuineness of the financials, or the legality and commercial rationale of the listing applicant.

      3. Interview practices
      4. Sponsors should exercise due care in confirming interviewees’ bona fides to satisfy themselves that interviewees have appropriate authority and knowledge. In particular:

        • Sponsors should, as far as possible, conduct interviews at interviewees’ business premises, and perform cross-reference checks of multiple types of proof of identity.

        • For telephone interviews, sponsors should verify telephone numbers and interviewee identities. Reliance should not be placed on telephone numbers provided by listing applicants. Instead sponsors could call the general line of the interviewee’s company obtained from a reliable public source, such as a telephone directory to verify the interviewee’s position and confirm that the individual participated in the interview.

        Sponsors should also document the interviewee selection criteria, the reasons and the follow up on a refusal of a selected person to attend the interview, and the name and position of any other person present during the interview.

        To ensure that interviewees’ representations correspond to those of the relevant company, sponsors may require telephone interview notes to be validated by the interviewees’ companies and attach interviewees’ identity documents.

    2. Proper records

      Sponsors are required to keep sufficient records to demonstrate that they conducted proper due diligence and adequately investigated contentious issues and record how conclusions were reached.

      The SFC recommends sponsors use the decision of the Securities and Futures Appeals Tribunal (SFAT) in Sun Hung Kai International Limited v Securities and Futures Commission as guidance, which provides that:

      “The rules and principles of conduct within which sponsors work demand that they maintain records that are sufficiently exact and detailed to enable them, upon request by the SFC, to provide a ‘proper trail of work done’. Such a trail must include documentation of due diligence planning which itself demands a demonstration that sponsors have turned their minds to what enquiries are necessary by way of reasonable due diligence in the context and circumstances of an application. Importantly, sponsors are required to document the conclusions they reach regarding an applicant’s compliance with the listing rules.

      Accordingly, a ‘bare bones’ outline setting out only broad and entirely expected areas of due diligence is insufficient.”

      Comprehensive records should be maintained of due diligence on matters which are material to the listing applicant’s business including, among others:

      • Major customers, suppliers, bankers and creditors as well as the listing applicant’s directors and senior management;

      • Material assets used or to be used in connection with the business;

      • Contracts material to the business;

      • Legal proceedings and other material disputes the listing applicant or its subsidiaries are involved or may be involved in; and

      • The existence, validity and business aspects of proprietary interests, intellectual property rights, licensing arrangements and other intangible rights.

      Sponsors should ensure that records can be located and retrieved if/after Transaction Team members leave the sponsor.

    3. Resources, systems and controls

      1. Corporate Governance

        The Circular notes the following:

        • A sponsor’s Management is ultimately responsible for the firm’s compliance with applicable codes, rules and regulation including operational controls and risk management procedures.

        • In line with the Manager-in-Charge (MIC) regime, a sponsor’s board of directors and other members of Management, including designated committees, should be structured to enable the board to effectively oversee and control the firm’s activities. The firm’s organisational structure should be documented and approved by the board and clearly set out the MICs responsible for overall management oversight of the firm and the MICs specifically responsible for directing and overseeing the sponsor business, as well as their reporting lines.

        • Sponsors are required to have clear policies requiring the escalation of critical matters to the board, its designated committee or responsible MICs for consideration.

        • Management must ensure the appropriateness of the Transaction Team structure for each sponsor engagement. Sponsor Principals are required to maintain effective reporting lines and ensure communication on sponsor work among Transaction Teams and other members of Management.

        • The involvement of the sponsor’s Management in dealing with key issues is expected to be documented.

      2. Other aspects

        The compliance manual of one sponsor inspected by the SFC contained examples of material risks and issues and set the criteria for internal escalation; this sponsor was also about to introduce scenario-based staff training on identifying and resolving material issues.

        Sponsors are expected to dedicate sufficient resources to each engagement and provide sufficient training, guidance and management supervision. Transaction Teams must be supervised by sponsor Principals at all times and Principals should attend key due diligence interviews along with junior staff.

        On-the-job training should be provided to Transaction Team’s junior staff by the sponsor Principal or other senior staff. Escalation policies should give examples of material risks and issues and specify an appropriate threshold for internal escalation. Records should be maintained of the escalation of critical matters and how they were resolved.

      3. Annual assessment of systems and controls

        Annual assessments should not rely only on attestations by sponsor Principals.

        Compliance with the relevant codes, rules and regulations should be ensured by way of reviews of policies and procedures. Samples of listing applications should be reviewed to ensure effectiveness of the sponsor’s policies and procedures.

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