The blame game

IFR Asia - Equity Capital Markets 2012
11 min read

Tough new regulatory proposals in Hong Kong will mean bankers will no longer be able to plead ignorance when an IPO prospectus contains misleading information. While the measures aim to restore confidence after a series of scandals, the threat of jail terms has serious implications for future deal-making.

Hong Kong police arrest a pro-democracy protester during a demonstration in Hong Kong

Source: Reuters/Siu Chiu

Hong Kong police arrest a pro-democracy protester during a demonstration in Hong Kong

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After some high-profile scandals, Hong Kong’s stock-market regulator wants to impose criminal liability on IPO sponsors that allow false information to be published in prospectuses. Banks have until July 6 to respond to the proposals of the Securities and Futures Commission, but, if they make it into law, the rules could see bankers locked up for the lies told by their clients.

Investment bankers and their lawyers argue that criminal sanctions seem both unfair and – worryingly for the regulator – potentially easy to dodge. They claim the SFC is placing too much responsibility on sponsors because it does not have a remit to regulate auditors or police company directors living in mainland China.

The proposals, however, highlight a general lack of confidence in due diligence standards.

“We have a problem with the accuracy of Chinese companies’ accounts. We often find liabilities that are not disclosed in prospectuses. We perceive that due diligence is handled by junior staff and that banks act for themselves first and the company and investors second,” complains Ashok Shah, chief investment officer of British asset manager London & Capital, which is responsible for US$3.2bn of client funds.

Yet, this high-profile salvo on sponsors’ liability from Ashley Alder, a former lawyer, who took over as chief executive at the SFC last year, will make Hong Kong one of the strictest listing regimes in the world.

Of developed stock markets, only Singapore and the US have similar provisions for criminalising bankers.

An SFC spokesman declined to comment for this article.

The case of Hontex International, a Taiwan-run sportswear manufacturer, has illustrated the SFC’s determination to toughen up on banks.

Hontex traded on the Stock Exchange of Hong Kong for less than three months after its December 2009 IPO, until the SFC froze its proceeds, alleging that its prospectus had been based on false information. This April, the regulator stripped the Hong Kong unit of Taiwan broker Mega Capital of its license to advise on corporate finance deals in the SAR. Mega Capital (Asia), the Hong Kong unit that sponsored Hontex’s listing, was also ordered to pay a HK$42m fine.

Wriggle room

While the Mega case could be a harbinger of things to come, some market participants also predict that it could be easy for banks to wriggle out of any criminal liability the SFC places on sponsors. Banks that take the lead on IPOs could simply take another name, such as “global co-ordinator,” or anything else league table compilers could be persuaded to agree on.

“It is not inconceivable, in an IPO situation, that the large bulge-bracket bank that has found the company it intends to bring to market will still act as an underwriter, but no longer as a sponsor,” says Jon Perry, a Hong Kong-based partner at British law firm Norton Rose.

The role of sponsor is distinct from that of an underwriter and banks do not need to take both roles. At the moment, lead advisors tend to do so, but economics suggest it is unnecessary.

Figures the SFC released in March 2011 showed sponsors derived 90% of the money they made from working on an IPO from underwriting.

“A global investment bank could bring in a small, local broker to take the sponsor role, which would then be paid sponsor fees,” Perry argues. “It won’t be much, compared to the underwriting fees, but, for a small shop, it could seem like good money.”

Aware that the SFC may close this glaring loophole, investment banks are carefully preparing a detailed response to the consultation on criminal liability.

Banks, including Goldman Sachs, Morgan Stanley and JP Morgan, have hired Martin Rogers, a partner at Clifford Chance, and Bonnie Chan, a partner at Davis Polk & Wardwell and a former head of IPO transactions at Hong Kong Exchanges and Clearing’s listings division, to respond to the SFC consultation.

Rogers will not divulge the industry’s full response to the issue of criminal sanctions at this stage, but he tells IFR that his clients understand why the securities regulator is boosting its efforts to keep the Hong Kong market clean.

“There are situations, such as Hontex, where [Hong Kong] listings have gone terribly wrong,” Rogers says. “Clearly, that is something the regulators are entitled to do their best to stamp out.”

Unequal treatment

Rogers suggests investment banks will take a constructive and conciliatory, rather than a combative approach, but he does not reveal much more.

A senior banking executive, who is also working on the industry’s response to the SFC, however, hints that banks are likely to focus on the issue of disproportionate liability.

“We should not face stronger sanctions than other advisors involved in IPO due diligence,” the banking executive says. “We rely on audited accounts when compiling a prospectus. We do not have the capability to audit forensically an auditor’s work.”

Hong Kong’s regulators, themselves, are not immune from criticism.

Take China Forestry, a Yunnan-based timber company, which, in April 2011, wrote down the value of its plantation assets by over Rmb2bn after its auditor, KPMG, highlighted accounting irregularities.

In China Forestry’s November 2009 listing prospectus, New Zealand’s Chandler Fraser Keating, the valuers hired to check plantation assets, admitted it had “not been able to independently verify” documentation. It is conventional for forestry valuers to conduct an aerial survey of stated land holdings. A senior Hong Kong regulatory source confirmed to IFR that the local government had not permitted flyover inspections of China Forestry’s assets because Yunnan is the site of a major military base.

“However, the Stock Exchange of Hong Kong listing division waved China Forestry right on through,” says a capital markets banker.”

Another investment banker, who leads IPO transactions, claims the SFC should not make bankers liable for false information in prospectuses relating to assets that non-banking specialists have to verify and value.

“We are not geologists or mining engineers or real estate appraisers. We cannot vouch for a mining consultancy’s report on a company’s reserves and resources.”

Limited powers

There is another potential reason why the SFC is increasing its oversight of bankers. It has few capabilities to police company directors.

Under Beijing’s so-called “One Country Two Systems” policy, Hong Kong and the mainland do not have a joint rendition treaty. The SFC cannot cross the Shenzhen border to investigate mainland companies without the permission of its Beijing counterpart, the China Securities Regulatory Commission. In the same vein, if the SFC suspects criminal behaviour by a mainland Chinese resident and reports this to Hong Kong police, no interviews or arrests can take place if the suspect is not on Hong Kong soil.

A salient example is that of Ocean Grand, the Hong Kong-listed, Guangdong-based aluminium extruder that collapsed in July 2006 after Rmb800m disappeared from the business.

The SFC launched an inquiry and informed the Hong Kong police of its findings. However, the police were not able to arrest well-connected Ocean Grand chairman Michael Yip Kim-po for over a year after the collapse. With a warrant out for his arrest in Hong Kong, Yip returned to Guangdong to try and revive his business. He was eventually brought to book in September 2007, when he tried to enter Hong Kong via the Lo Wu. He received a seven-year jail term.

“It is much more convenient for the SFC to focus on sponsors. Investment bank staff [those working on Hong Kong IPOs] tend to be based in Hong Kong. If the regulator asks them to attend a hearing or appear in court, they will probably go along,” says London & Capital’s Shah.

Of course, there is nothing to stop Hong Kong’s powerful investment banks from pressuring the SAR’s regulators and government to seek better, or even automatic, co-operation from the mainland authorities when it comes to dealing with company directors.

Bankers’ lobbyists also appear hopeful that the discussion on criminal liability for sponsors has a long way to run.

The SFC does not state in its consultation paper how the new sanctions on bankers will be implemented. One regulatory source said the SFC aimed to get government approval for this to be written into the Companies Ordinance. An SFC spokesman, however, declined to confirm or deny this.

“The SFC’s own consultation paper indicates reasonably clearly, there should be a separate consultation exercise in relation to criminal liability as it is a relatively complex question,” says Clifford Chance’s Rogers.

What Rogers has touched on here is that the issue of sponsors’ liability could well end up being kicked into the regulatory long grass for several years, while the SAR’s business-friendly Legislative Committee debates the issue. Delays to financial legislation in Hong Kong are nothing new. Rules to apply new civil sanctions to listed-company directors for withholding price-sensitive information, approved this April, were first put out to consultation by the government in 2003.

That rule also indicates that Hong Kong intends to be a lot stricter on bankers than it is on company bosses. While directors of Australian-listed companies can be jailed for keeping important information out of the market, in Hong Kong, directors failing to disclose such information face a maximum fine of HK$8m.