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SFC Report: Deficiencies in IPO Sponsor Work

The Report is based on the findings of the SFC’s inspection of the work of 31 sponsors undertaken between October 2013 and December 2017. It reports deficiencies in IPO sponsor work and instances of non-compliance under the Code of Conduct, the CFA Code and the Listing Rules.

  1. The Code of Conduct

    Deficiences in IPO sponsor work and non-compliance were identified in relation to:

    1. The conduct of due diligence in relation to:
      1. Exercising reasonable judgement and applying professional scepticism; and
      2. Interview practices;
    2. Record keeping; and
    3. Resources, systems and controls, namely:
      1. Corporate governance
      2. Annual assessment
      3. Other aspects.
    1. Due diligence

      Exercising reasonable judgement and applying professional scepticism

      The Report details six cases of unsatisfactory sponsor due diligence work. In 5 cases (Cases A-E) sponsors failed to take reasonable steps to follow up on obvious red flags. In Case F, some sponsors followed standard due diligence checklists and failed to adapt their due diligence to the specific circumstances of the listing applications.

      Case A

      The SFC identified a number of significant red flags which cast doubt on the genuineness of the listing applicant’s largest customers which accounted for over 50% of its total sales. Shipment and settlement arrangements among the listing applicant and its largest customers relied heavily on third parties, however, the sponsor failed to conduct due diligence on these third parties.

      Other red flags which the sponsor failed to follow up on were:

      1. material discrepancies between the sales amounts stated in invoices obtained by the sponsor and the payments made;
      2. significant discrepancies in the weights of goods reported in the bills of lading and the export forms; and
      3. inaccurate descriptions of the goods shipped in the bill of lading.

      Case B

      According to the prospectus disclosures, the five largest suppliers of the listing applicant were independent third parties. The sponsor claimed that the listing applicant’s controlling shareholder held shares of one of the largest suppliers on trust for a third party. However, the trust documentation contained inconsistencies, backdating, and other errors, which should have raised a red flag as to the validity of the trust arrangement, and the likelihood of the controlling shareholder having a beneficial interest in the supplier.

      Rather than conducting due diligence to follow up on these issues, the sponsor relied on a statutory declaration by the controlling shareholder and a confirmation provided by the listing applicant, which the SFC considered inadequate to ensure the accuracy of the prospectus disclosure and prevent material omissions.

      Case C

      The listing applicant’s sales to certain customers were found to be significantly larger than suggested by local government figures, which the sponsor had access to and reviewed. The sponsor failed to follow up on the discrepancies despite their calling the figures’ reliability into question.

      Case D

      The listing applicant had arrangements whereby most of its customers liaised with it via representatives and paid it via third parties from different countries. The opaqueness of the third parties, the excess of authority given to the representatives, and the inconsistencies in the listing applicant’s sales figures should have prompted the sponsor to conduct an extensive follow-up due diligence on these irregular arrangements.

      The sponsor claimed that its due diligence confirmed that indirect payment is a common practice in the industry and that the legal opinion confirmed that such practice was not illegal or invalid in the relevant jurisdictions. The SFC considers, however, that the sponsor should have considered the broader implications of the arrangement on the authenticity of the listing applicant’s sales.

      The sponsor indicated that the reporting accountants had not raised concerns with respect to the arrangements. However, the sponsor was unable to demonstrate that it had discussed the audit procedures with the reporting accountants. It could not therefore show how concerns relating to the payment arrangements were satisfactorily addressed.

      Case E

      In selecting interviewees, the sponsor relied on the listing applicant’s summary table of amounts spent by the top users of its services. The SFC noted that these amounts were inconsistent with the raw data generated from the listing applicant’s internal system. The sponsor failed to follow up on this inconsistency.

      Case F

      In their due diligence procedures, a number of sponsors adopted a box-ticking approach and failed to conduct due diligence on key aspects of the businesses of listing applicants which were outside the scope of the standard checklists. Even when checklists contained key aspects relevant to listing applicants, sponsors failed to exercise reasonable judgement as to the breadth and depth of the due diligence required. An example was a listing applicant whose organic products were highlighted in the prospectus disclosures, but insufficient due diligence was conducted on the organic certifications of the largest suppliers.

      Practices meeting the required due diligence standard

      The Report notes the following practices of some sponsors which met the required due diligence standards:

      1. One sponsor required background research on listing applicants to be updated regularly during the course of the listing application process, particularly if the application was expected to take some time or the listing applicant was involved in a fast-evolving industry or regulatory environment.

      2. Another sponsor required designated members of the Transaction Team to approve the customisation of due diligence plans and subsequent updates.

      Interview practices

      Deficiencies and non-compliance

      The SFC considered some sponsors’ practices in relation to due diligence interviews of major business stakeholders to be unsatisfactory. Particular criticisms were that important interviews were scheduled at a very late stage of the due diligence process and some sponsors failed to confirm the bona fides of interviewees and that they had appropriate authority and knowledge. In some cases, questions unanswered by interviewees were not followed up on by sponsors.

      Case G

      A sponsor interviewed some of the business stakeholders on the day of submission of the listing application, which would not allow enough time to consider issues raised by interviewees or resolve potential red flags.

      Case H

      A sponsor failed to conduct proper verification of the bona fides of almost half of the interviewees. The SFC was particularly concerned because most of the interviews were conducted at the listing applicant’s office premises or by calling the interviewees’ telephone numbers provided by the listing applicant without further verification.

      Practices meeting the required due diligence standard

      Practices identified as meeting the required standard included:

      1. Conducting interviews at the business premises of interviewees and conducting cross-reference checks relying on more than one type of identity proof. For example, interviewees were required to provide business cards and government-issued identity cards or staff cards with photographs.

      2. For telephone interviews, another sponsor contacted interviewees or reconfirmed their identities by calling the company’s general line obtained from a reliable public source such as a telephone directory.

      3. One sponsor requested notes of telephone interviews to be validated by the interviewee’s company and attached copies of the interviewee’s identity documents to the notes. This practice was noted to offer the advantage of ensuring that the interviewee’s representations reflect the company’s position.

    2. Proper records

      Deficiencies and non-compliance

      Many of the sponsors inspected could not provide relevant records to demonstrate that major issues had been considered and dealt with. Some sponsors also failed to keep a proper due diligence plan and documentation of due diligence conducted, such as reviews of material business contracts and interviews with a major business stakeholder.

      Practices meeting the required due diligence standard

      One sponsor had a policy which required all material risks and issues identified to be documented in the form of a log accompanied by due diligence notes.

    3. Resources, systems and controls

      Corporate governance

      Deficiencies and non-compliance

      The SFC identified insufficient supervision of sponsor work. In one case, the involvement of the sponsor’s Management in considering key concerns, including regulators’ concern about the ownership of certain material assets, could not be demonstrated.

      In another case, the Transaction Team failed to escalate critical issues to Management for consideration, including where a listing applicant refused to accept some of the sponsor’s due diligence measures and threatened to change sponsors if it insisted on carrying out such measures.

      Practices meeting the required due diligence standard

      Some sponsors had established committees comprising independent sponsor Principals and senior staff from the risk, legal and compliance departments to supervise, and provide written guidance with respect to, the due diligence process.

      Other aspects

      Deficiencies and non-compliance

      The SFC notes that some sponsors provided insufficient training and guidance to staff and in some cases sponsors had insufficient resources to undertake sponsor work.

      In one case, a sponsor Principal was overseeing six active listing applications simultaneously raising doubts as to whether the Principal could adequately supervise all Transaction Teams. Most survey respondents indicated that sponsor Principals and staff handle an average of two to three IPOs simultaneously.

      Annual assessment

      Deficiencies and non-compliance

      Some of the sponsors failed to conduct annual assessments of their systems and controls.

      Annual assessment by one sponsor was based solely on the attestation by the sponsor Principals, with no details of the work or samples reviewed.

  2. The CFA Code

    Chinese walls

    Deficiencies and non-compliance

    The SFC notes that some sponsors failed to maintain effective Chinese walls to prevent the flow of confidential information between sponsors and related listed corporations (LCs). In some cases, Transaction Teams passed not yet public information related to listing applications to staff of related LCs before wall-crossing approvals were obtained.

    Receipt or provision of benefits

    Deficiencies and non-compliance

    Some sponsors did not have a written company policy on the provision of benefits to clients, did not comply with the company policy on the receipt of benefits from clients or had insufficient documentation to demonstrate compliance.

  3. Listing Rules requirements

    Deficiencies and non-compliance

    Poor internal control procedures for independence checks, such as not confirming independence of Transaction Team members, directors of the sponsor groups or their close associates, were common among the majority of sponsors.

Deficiencies in IPO sponsor work in Hong Kong

Sponsor non-compliance under the Code of Conduct SFC Hong Kong

HK Sponsor due diligence requirements

Deficiencies in IPO sponsor work SFC Sponsor Guidelines

Sponsor Non-compliance under the Code of Conduct, the CFA Code and the HKEx Listing Rules

Securities and Futures Commission Sponsor due diligence requirements

Report on the thematic review of licensed corporations engaged in sponsor business

Unsatisfactory sponsor due diligence work examples HKEx

Hong Kong Sponsor due diligence standards SFC Code of Conduct 2018

Hong Kong IPO sponsor practices SFC Thematic Review Sponsor

Circular to licensed corporations on expected standards for sponsor work

SFC disciplinary action against Citigroup for sponsor work on Real Gold Mining IPO