The world waited in excitement on May 18 for Facebook to launch its highly publicised initial public offering (IPO). But eager anticipation turned into alarm as the social media giant’s share price plunged from $38 to $27 over the next 10 trading sessions, wiping out roughly $30 billion of its market capitalisation. A few weeks later, Graff Diamonds, a British high-end jeweller, abandoned its $1 billion listing in Hong Kong because of economic uncertainty. Dubious equity markets have resulted in Asian IPOs worth nearly $8 billion being pulled this year. Most recently, the Securities and Futures Commission (SFC) in Hong Kong fined and stripped Mega Capital (Asia) of its licence for its sub-par underwriting of Hontex International Holdings, which was investigated for financial fraud in 2009.

A series of fraud scandals last year surrounding Chinese companies that went public in Hong Kong has spurred the SFC to take action. In a consultation paper released on May 9, the SFC proposed, among other recommendations, that IPO sponsors be made both civilly and criminally liable for faulty listings. The proposals, which will give investors some much-needed reassurance, have received staunch resistance, not surprisingly, from IPO sponsors – banks or smaller corporate finance houses that are responsible for preparing IPO documents and ensuring compliance with listing rules. Faced with such rules, the larger investment banks may shy away from some IPOs, which could potentially create more opportunities for the smaller players. Another related worry for the big banks could be class action lawsuits for investors seeking damages, which has been recommended by the Hong Kong Law Reform Commission.

Guiding sponsors

The SFC’s two-part consultation paper, which is open for comment until July 6, not only requires IPO sponsors to tighten their due diligence of target companies, but also holds the sponsors liable for the contents of listing prospectuses. The proposals, which look holistically at a sponsor’s role in the IPO process, mark one of the first major initiatives spearheaded by the SFC since its new chief executive officer, Ashley Alder, took charge in October 2011. “I believe the SFC is trying to indicate to sponsors what they should ideally be doing when they are guiding a company through the IPO process. A good due diligence process leads to confidence in the information that is provided to the market from the IPO,” says Jill Wong, a counsel at King & Wood Mallesons in Hong Kong.

Regulators stand as the only enforcement mechanism for faulty IPOs since there is at present no meaningful civil litigation in Hong Kong, say lawyers. “As a result, the SFC wants sponsors to act as gatekeepers to make sure listing applicants are doing the right thing,” states Steven Winegar, a Hong Kong-based partner at Paul Hastings.

Wong agrees: “One important thing that comes out of the proposals is that the sponsors are ultimately responsible for due diligence. The SFC recognises that although many other professionals have input, sponsors should not blindly rely – reasonable reliance is acceptable – on them.”

For their part, sponsors believe they are already shouldering more responsibility. Many of the companies listing in Hong Kong are from mainland China, and regulators find it difficult to take action against such companies when a faulty offering is uncovered.

A series of scandals

The SFC is determined to see new regulations enacted. Fierce opposition from financial institutions had shot down similar proposals in 2005. But a lot has happened since then. The Hong Kong IPO market, which raised $97.9 billion between 2009 and 2011, was the world’s largest for two of the last three years, according to Reuters. Despite these mammoth numbers, the city’s stock exchange in recent years has been rocked by scandals surrounding companies that went public, only to be scrutinised for fraud soon after their listing. An SFC inspection of 17 sponsors, conducted in March 2011, found a host of deficiencies in their IPO-related work, including inadequate due diligence and questionable disclosures in listing applications to the Hong Kong Stock Exchange.

In the infamous case of Hontex International Holdings, a Chinese textiles manufacturer, Mega Capital (Asia) lost its licence and was slapped with a fine of HK$42 million ($5.4 million). The SFC cited Mega Capital’s sub-standard due diligence work and failure to act independently and impartially as the motivator. According to Reuters, Chien Hung-Wen, chairman of Mega Capital’s parent company, Mega Securities, has said that the company would not appeal the regulator’s decision. Hontex had its shares suspended by the SFC just three months after it went public on the grounds that it had overstated its financial position. The commission has since frozen the $128 million that Hontex raised from its listing, and a court settlement reached on June 20 confirmed that investors will be able to get most of their money back. Under an agreement reached between the SFC and Hontex at the High Court, the textiles maker will repurchase shares held by minority stakeholders at HK$2.06 a share, the last price traded before the stock was suspended.

Market segmentation

The SFC’s proposals have sparked fierce opposition from the wellestablished investment banks, which are likely to lobby aggressively, in particular against prospectus liability, asserting that sophisticated fraud is near impossible to detect. However, many legal experts believe that the banks will not be able to prevent tougher rules this time around. A strengthening of rules could cause some larger investment banks to pull back from the market, causing IPO sponsor work to trickle down to less experienced financial institutions. “Indeed, there will be a niche created where the up-and-coming banks will try and find their way into the market by taking on more risky roles,” says Jeckle Chiu, a partner at Mayer Brown JSM in Hong Kong. “This is very natural in terms of business development. By moving in this direction of tighter regulation on sponsors, there will definitely be an opportunity for them.”

Even so, some lawyers feel that smaller players will have to reflect on their own due diligence practices if they want to become bigger. “Sponsors should be looking hard at their due diligence process, bring it up to scratch if they think there are inadequacies, and make sure they can meet the expectations of the SFC going forward. Those that do will continue to prosper,” says Wong of King & Wood Mallesons.

Regardless of size, sponsors are likely to be more discriminating about the IPO work they take on, lawyers note, even though the Hong Kong market is currently sluggish. “Many sponsors are already selective as to who they work with, but I think you might see that caution increasing if the proposed amendments are effected,” says Matt Emsley, a partner at Herbert Smith. His colleague, Tim Mak, also a partner, opines that sponsors will have to consider their risk-reward framework very carefully: “This is where the rule changes come in. If sponsors risk facing additional regulatory and legal liability, particularly any potential criminal liability, that might well change the risk equation.”

The risks are surely piling up. Besides the proposals, recent incidents this year have jolted sponsors. In March, accounting firm Deloitte resigned as the auditor of Daqing Dairy Holdings and Boshiwa International Holdings, two mainland Chinese companies. Both are now being investigated for possible financial irregularities. These are not isolated cases. There are others, including Ausnutria Dairy and Ports Design Ltd, who had their shares suspended after they missed deadlines for annual report filing because their auditors wanted more time.

Weighing the costs

With greater risks may come greater rewards— but at a cost. The heightened level of due diligence required of IPO sponsors may make deals more expensive, which will cut profit margins and potentially drive some banks out of the IPO market. It may also lead to some law firms being squeezed out. “It will introduce costs because the banks will have to put in place more intense procedures, and a lot of that will fall on the lawyers to help implement. Certainly, the cost of providing those services is going up, but whether fees go up as a result is a different story,” says a Hong Kong-based lawyer, who asked to remain anonymous. He adds that the SFC’s measures will hopefully introduce ore responsibility, and lead to more experienced people working on the deals.

Several of the SFC’s proposals can be found in regulations in other jurisdictions. For example, the requirement to publish early drafts of prospectuses, as well as the liability of sponsors and underwriters are already present in the U.S. However, lawyers agree that the consultation paper explores features that are unique to Hong Kong. “Hong Kong regulators will usually consider what regulators are doing overseas. But regulators elsewhere will probably also be looking at Hong Kong quite closely to see how things develop here, because of the particular characteristics of the Hong Kong market,” says Emsley of Herbert Smith.

Class action ?

Meanwhile, just two weeks after the SFC disseminated its consultation paper, Hong Kong’s banking and financial institutions had another reason to worry. The territory’s Law Reform Commission recommended legislation to allow class action lawsuits to help investors seek damages as a single representative. The proposed system would only apply to consumer fraud and product liability cases, but not investments such as securities. “Right now, the incentive for an investor to sue is low. The amount you spend on litigation could easily outstrip any loss you have on your investment,” says Winegar of Paul Hastings.

But the introduction of class action could possibly see Hong Kong’s financial houses face a rise in lawsuits, as ordinary retail investors band together with renewed impetus. Banks will have some time to prepare, however, as lawyers agree that such action may take several years to implement. “I think it would be a seismic event in the market, and for that reason, a class action regime will take years to work through the system. There are no assurances that this will get done,” says Winegar.

The SFC’s proposals however, are tipped to see the light of day soon. IPO sponsors will need to carefully monitor their risk profiles and brace themselves for more stringent due diligence procedures and increased scrutiny from regulators. “The SFC is serious about wanting to improve quality and to change behaviour. They said the proposals were influenced by deficiencies they have seen in sponsor work in recent years; now is as good a time as any to do it,” says Wong. Mak agrees: “There is no doubt the regulators mean business, and there is a strong will to tighten regulation. I think the devil is going to be in the detail.”

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