Hong Kong’s securities regulator last week finally revealed its plans to improve the regulation of sponsors of initial public offerings.
The Securities and Futures Commission (SFC) launched a two-month industry consultation back in May amid growing concerns about the quality of some companies that have sought to list in Hong Kong, in a move that was aimed at maintaining investor confidence in the city’s IPO market.
The consultation did not come as a surprise, but still caused controversy. One of the most hotly debated issues was the one dealing with civil and criminal liability for information contained in the prospectus.
Despite opposition from sponsors and law firms, however, the regulator decided to proceed with the recommendation that the law be clarified so that sponsor firms have civil, as well as criminal, liability for defective prospectuses, it said in an announcement on December 12.
It argued that criminal liability should depend on whether a sponsor firm knowingly or recklessly approved a prospectus containing an untrue statement, including an omission, which was materially adverse from an investor’s perspective.
“In any market, there are forces at work that can tend to bring down the standards of the market,” said Syren Johnstone, adjunct associate professor at the University of Hong Kong’s Asian Institute of International Financial Law.
“So the SFC is saying ‘it’s time to take some sort of action, to draw a line’ ... It’s not so much that the proposed changes are improving or changing the expected standard but rather they are fortifying the standard.”
In a widely publicised move earlier this year, the SFC revoked Mega Capital’s licence to advise on corporate finance and fined it HK$42 million ($5.4 million) for failing to discharge its duties as a sponsor in relation to the listing application of Chinese fabric maker Hontex International in 2009.
The SFC has now also decided to proceed with proposals to publish the advanced draft prospectus filed with a listing application on the Hong Kong stock exchange’s website, saying that could result in better quality initial drafts. Critics have said that could lead to premature disclosure of company information and increase costs.
“Instead of asking the entire market to change fundamentally how they do IPOs, the SFC can strengthen its enforcement action — it can revoke licences, which is pretty powerful,” a source familiar with the matter said.
“If due diligence is not done properly, the exchange can stop vetting, which has always been done in the US. But, at the end of the day, it’s a cost-benefit analysis.”
As no one would want to be the first bank to be punished by the SFC, however, everyone will likely err on the safe side, the person added.
The current companies ordinance sets out provisions regarding civil and criminal liability for untrue statements, including a material omission in a prospectus, but the regulator had proposed to make clear that a sponsor has civil and criminal liability under the provisions.
Regarding its proposal to make sponsors in Hong Kong be held criminally liable, SFC chief executive officer Ashley Alder said at the time “we are not doing this in order to put people in jail”.
There were a few items that were not part of the original proposals.
A listing applicant is now required to formally appoint a sponsor at least two months before it submits a listing application, and sponsor fees are now required to be specified in its terms of engagement.
According to the listing rules, sponsors — investment banks and brokerages — are appointed by listing applicants to help with their initial applications for listing and be closely involved in preparing the listing documents.
“The changes, along with a streamlined regulatory process, will incentivise sponsors to raise standards, pick the right deals and manage them well, which should in turn reduce risks for investors and all those involved in IPOs,” SFC’s Alder said last week.
“Although we are now experiencing lower IPO volumes, these reforms will underpin market confidence during all market cycles.”
Meanwhile, the SFC decided not to proceed with the proposals to limit the number of sponsors on a deal. The securities watchdog said it agrees with respondents’ views that there may be good reasons to retain multiple sponsors, depending on the circumstance of a listing applicant, for example to involve different types of expertise.
The new requirements will apply to listing applications submitted from October 1, 2013, while legislative changes will have to follow a separate timetable, according to the SFC.
In the end, it received 71 written responses from sponsor firms, investors, lawyers, accountants and various corporate governance bodies.
As the volatile global markets kept investors nervous, IPO activity in Hong Kong dropped this year. After capturing the top position for the three years to 2011, Hong Kong now ranks fourth behind New York, Nasdaq and Tokyo, data show.
The effect from the tighter regulations on the city’s IPO market remains to be seen.
“What is the most important driver [to do an IPO]? The biggest concern is going to be ‘where am I going to get the best valuation?’” the source familiar with the matter said.
“I don’t think anyone would say ‘I’m going to a market where the application process is the easiest to get through.’ At least, that would not be the driving force. But that will be part of the consideration.”
The latest development comes after years of preparation. In late 2009, the SFC established a specialised team, which has since conducted a theme inspection on 17 sponsors, focusing primarily on their work undertaken in initial listing applications, the regulator said in a report in March 2011.
During the sponsor theme inspection, the SFC said it uncovered certain deficiencies in the work performed by some sponsors. It also found some inadequacies in their internal systems and controls, including unsatisfactory due diligence on listing applicant’s business and questionable disclosure to the Hong Kong stock exchange during the listing application process.
Hong Kong University’s Johnstone said the tighter regulations will not necessarily bring in negative results.
“In one sense, the clarification is a small change in detail but a significant development in concept,” he said. “I don’t think it’s in any way disadvantaging the city. Rather, in the Asian and Chinese context, they are showing the way. This can be seen as part of a larger story.”