On 14 March the Securities and Futures Commission (SFC), Hong Kong’s securities regulator, imposed its largest ever fine on various international investment banks in connection with failures in their roles as sponsors for the IPOs of Chinese companies in Hong Kong. The failures were primarily to do with what the regulator regarded as insufficient due diligence. The specific IPOs to which the SFC referred took place a number of years ago but their comments in connection with these fines – and the size of them – are an important signal of a harder attitude that the SFC will take towards due diligence failures in listing applications in Hong Kong in the future.
What went wrong
The largest fine – HKD 375 million – was reserved for UBS and was in connection with three listing applications, including China Forestry (2009) and Tianhe Chemicals (2014). The main problems in the application of China Forestry, according to the SFC, related to a failure to examine and verify “fundamental aspects of China Forestry’s business - namely, its forestry assets, logging activities, insurance coverage and customers” (Standard Chartered was also fined just under HKD 60 million for similar breaches on the same IPO). In the case of Tianhe, the SFC criticised UBS for allowing “Tianhe to control the due diligence process and failed to take appropriate steps to address the red flags raised in the customer interviews” (Morgan Stanley was fined HKD 224 million in connection with the same listing, and Merrill Lynch was fined HKD 128 million). Unusually, the SFC also took the further step of suspending the licence of the former UBS banker Cen Tian for two years from 14 March 2019 to 13 March 2021 for “failing to discharge his supervisory duties as a sponsor principal in charge of supervision of the execution of China Forestry’s listing application”.
The SFC also went on to state that in listing applications: “the sponsor should ensure that the Principal is involved in determining the breadth and depth of the due diligence review, the amount of resources to be deployed for carrying out such work, making a critical assessment of the results of the due diligence and overall assessment of the adequacy of the due diligence review, and ensuring that steps have been taken to properly resolve all issues arising out of such review…”.
The SFC has in the past – following the imposition of a new sponsor regime in 2013 – stated its view that sponsors are subject to criminal liability in respect of material misstatements in a prospectus. This view remains controversial and has not yet been properly tested by case law, but clearly it is a position that should be taken seriously by all sponsors.
How should sponsors respond to the criticisms of the SFC?
First of all, it should be pointed out that the listing applications singled out by the SFC were in 2009 and 2014 respectively and sponsors have significantly changed their processes in the intervening period to respond to many of the issues outlined by the SFC. Our experience of working with sponsors on the due diligence process for IPOs is that they are far more aware of the importance of due diligence than they were prior to 2013 (and the suggestion of criminal liability for sponsors has certainly concentrated minds). One key aspect of the SFC criticism should be considered carefully, however.
Inherent in the due diligence process for a listing application is a potential conflict of interest. The sponsors stand to gain very large fees from the successful conclusion of the listing application; they also maintain their reputation as successful sponsors of IPOs, which is illustrated by the various tables that appear each year showing which sponsors are winning the greatest share of IPO business. This can give the bankers working on any listing application an incentive to play down any red flags that might come up during the due diligence process, or not to pursue the companies involved when they fail to provide comprehensive answers to questions raised during that process. It is notable that much of the SFC’s criticism was reserved for this latter aspect. For example, in the case of Tianhe, the SFC states that:
"Morgan Stanley had initially requested to interview the largest customer of Tianhe, Customer X, at its office, but eventually accepted Tianhe’s explanation that since an anti-corruption campaign in Mainland China was underway, Customer X, a large state-owned enterprise, would normally turn down any third party request to visit its premises.
Morgan Stanley then agreed to interview Customer X at Tianhe’s office. At the end of the interview, the representative of Customer X refused to produce his identity and business cards and stormed out of the meeting room. He told Morgan Stanley and other parties that he would not have agreed to be interviewed under Customer X’s internal procedure, and he only attended the interview to help the family of Tianhe’s chief executive officer (CEO).
Nonetheless, Morgan Stanley did not conduct any follow up inquiries to ascertain that the person it interviewed was the representative of Customer X and that he had the appropriate authority and knowledge for the interview."
All of this reiterates the key importance of engaging a credible and independent firm to conduct due diligence on the company that will be listed, its management and its operations. It is also vital that this firm should not be pressured to “tone down” any negative aspects of its report or not to pursue certain red flags that have arisen from the due diligence process. To be fair, when working with sponsors we have always been encouraged to pursue exactly this course when conducting due diligence, although the demands of time sometimes make it challenging to follow up on every red flag.
There has been a tendency, however, for some sponsors on occasion to take a tick-box attitude to the due diligence process when conducted by a third-party investigative firm, or to consider that the process is just one to fulfil the demands of the regulator as opposed to a genuine attempt to verify the claims of the prospectus. The SFO’s fines make it clear that a failure to take the due diligence process seriously will result in further large financial penalties in the future and in damage to the sponsor’s reputation; it remains to be seen whether in future this may also involve criminal sanctions given the increasingly tough attitude being taken.