Thirty years ago, Tsingtao Brewery became the first mainland Chinese company to list on Hong Kong Stock Exchange (HKEX). Over 1400 others followed, scams included. Company insiders’ criminal self-enrichment has contributed to HKEX stocks, on average, suffering comparatively poor returns.
Regulators struggle to prevent listing fraud and hold fraudsters accountable. So they found a softer target: licensed sponsors. Once a mere quirk of Hong Kong’s listing regime, sponsors became the primary enforcement focus, from which the Securities and Futures Commission (SFC) has extracted substantial fines. While SFC still hasn’t found a way to penalize the actual perpetrators of listing fraud, sponsors know they’ll now be blamed for it.
That’s peculiar, because sponsors have limited commercial bargaining power and no responsibilities at all under legislation. Disciplinary action against them is useless for investor compensation, because fines are paid to the government. It might discourage poor due diligence but can’t deter fraud.
HKEX’s annus horribilis
SFC’s sentiment, that a campaign against sponsors is the solution to cleaning up HKEX, emerged after a blizzard of fraudulent IPOs in 2009:
- Trading in Hontex was suspended just three months after listing, following allegations it massively overstated profits. SFC secured a share buyback requiring the return of funds raised in the IPO, but never attempted proceedings against the insiders who committed the fraud. Instead, SFC fined the sponsor, Mega Capital, HK$42 million and revoked its licence. This was only the second time in over a decade that SFC fined a sponsor, and the first time ever it revoked a sponsor’s licence.
- Two years after listing, Real Gold Mining confessed to secretly transferring HK$1.4 billion to its founder, Wu Ruilin. Although SFC sought court orders that Wu and others compensate minority shareholders, it appears that no writ was ever served and no particulars ever pleaded, meaning the defendants had no case to answer. To punish the sponsor, Citigroup Global Markets Asia, SFC had to identify deficiencies occurring before the IPO. SFC found Citigroup’s due diligence of Real Gold’s customers was inadequate. Citigroup argued that, gold being a commodity with a ready market, it was reasonable to focus on the company’s production, rather than its customers. SFC disagreed, and fined it HK$57 million.
- China Metal Recycling was suspended after short-sellerscalled its growth “suspiciously amazing”, return on capital “Madoffian” and revenue per employee “absurd”. They asked, “How many suspicious metrics do investors and regulators need to realize that the only explanation for the Company’s unusually strong performance is that [it’s] dabbling in the dark arts of accounting?” Liquidators chased founder Chun Chi Wai for HK$822,900,000 he milked from China Metal after the IPO. While Chun’s wife and a manager were jailed, Chun escaped prosecution, having fled to mainland China.
- China Forestry was suspended after KPMG belatedly flagged massive accounting irregularities. While the IPO prospectus claimed a book value of RMB7.4 billion, the true figure was a net liability of RMB323 million. SFC litigation seeking compensation for public shareholders is on hold pending Market Misconduct Tribunal proceedings, in which SFC alleged insider dealing and false or misleading disclosures. Hearings concluded in 2020 but no report was released. Three years later MMT ordered a rehearing, the judge having become unable to discharge his duties.
Another horrible year
Two IPO scams in 2014 further exposed SFC’s difficulties bringing perpetrators to justice:
- Tianhe Chemicals was suspended after a “hacker collective” alleged Tianhe’s sales were fictitious. Associated Press said Tianhe’s chairman, Wei Qi, founded Tianhe with assets he transferred to himself for free from a state-owned company. Also, a supposed key customer’s office was “an unoccupied room containing broken furniture and old mattresses in a dilapidated apartment building”.
SFC sued Tianhe and its CEO, Wei Xuan (Qi’s brother), and instituted MMT proceedings. It is unclear whether any IPO funds will be recovered. Moreover, while MMT can order disgorgement of profits it cannot impose prison terms. In practice, commencement of MMT proceedings precludes prosecution. MMT found Tianhe and Xuan committed market misconduct, and barred Xuan from managing listed companies for four years. The finding exposes defendants to civil liability but might be futile, considering Tianhe declined to participate in proceedings and Xuan vanished before they even started.
- Fujian Nuoqi was suspended after Ding Hui (chairman and CEO) disappeared with HK$292 million (over 90% of IPO funds). No-one has been held to account, through criminal conviction, administrative sanction or restitution. Ding joined a long list of “pao lu lao ban” (runaway bosses) who, in the absence of extradition agreements with mainland China, would not face rendition to Hong Kong.
SFC never disciplined CCB International Capital (CCBIC) for its sponsorship of Fujian Nuoqi, but disciplined it for an unsuccessful listing application of Fujian Dongya Aquatic Products. Leery about punishing the subsidiary of a state-owned mainland bank, SFC fined CCBIC HK$24 million but noted “no evidence [of] systemic failure in CCBIC’s policies, procedures and practices”.
The law
Pre-IPO shareholders maximize their returns by persuading public investors of their company’s financial prospects. To protect the integrity of this process, legislation and listing rules prescribe disclosure requirements. Company directors must accept responsibility for the accuracy of a prospectus and confirm it contains no untrue statement or omission of material fact.
The Securities and Futures Ordinance imposes civil and criminal liability on anyone who discloses or disseminates false or misleading information likely to induce another person to subscribe for or deal in securities.
The Companies (Winding Up and Miscellaneous Provisions) Ordinance (CWUMPO) provides that directors, promoters and persons who “authorized the issue of a prospectus” have civil liability to persons who subscribe for shares on the faith of the prospectus and who sustain a loss due to any untrue statement therein. Experts, such as accountants, who consented to the issue of a prospectus containing their professional statements, are liable in respect of their own untrue statements. A person is not liable if they prove they had reasonable grounds to believe the untrue statement or, in relation to untrue statements by an expert, had reasonable grounds to believe the expert was competent.
CWUMPO also imposes criminal liability on any person who authorized the issue of the prospectus containing an untrue statement, unless they prove the statement was immaterial or they had reasonable grounds to believe the statement was true.
This legal framework gives regulators a range of options for taking action against a listing applicant, its directors and auditors.
Sponsors
Unlike most jurisdictions, Hong Kong also requires applicants to engage a sponsor to assist with the listing process, despite IPO sponsors not even being mentioned in legislation. Their role is codified only in HKEX listing rules and SFC conduct codes.
SFC asserts that persons who “authorized the issue of a prospectus” include sponsors. However, the legislation is ambiguous and no case law confirms that interpretation. In 2005, and again in 2012, SFC proposed statutory amendment to include sponsors explicitly within the scope of liability. On both occasions, SFC quietly dropped the proposals, claiming CWUMPO already covers sponsors and no revision is necessary.
In SFC’s view, “investors rely on sponsors to act as key gatekeepers of market quality and, at the heart of this is the expectation that sponsors have conducted sufficient due diligence to properly understand and assess a company aspiring to join the stock market.” From a rules-based perspective, however, it is not for sponsors to police “market quality”. Their responsibilities are less lofty, and include:
- being “closely involved” in preparation of the prospectus;
- conducting “reasonable due diligence”; and
- using “reasonable endeavours” to address all matters raised by HKEX.
Decisions of the Securities and Futures Appeals Tribunal confirm that sponsors must ensure listing applicants issue a good quality prospectus. SFAT said sponsors “must act with independent professionalism in ensuring that all information placed before [HKEX] and investors generally is fully, fairly and accurately presented.” But sponsors are not required to “chase every rabbit down every hole”, nor to ensure the applicant is a good quality company. Case law does not support SFC’s implication that sponsors’ duties extend to rejecting any applicant that offers a poor investment opportunity.
Moreover, there is no public policy rationale for requiring sponsors to assume greater responsibility than accountants for accuracy of financial statements. A note buried in SFC’s licensee Code of Conduct acknowledges: “As a reporting accountant performs audit procedures on information received from a listing applicant under applicable professional standards, a sponsor is not expected to carry out any further due diligence on this information.” However, SFC disciplinary announcements give no hint of this.
In fact, when listings go awry, sponsors risk being the first parties SFC pursues, and possibly the only parties pursued successfully. Being licensed, sponsors can be fined, reprimanded, suspended and stripped of their licences by SFC – in effect wielding disciplinary powers as prosecutor, judge and jury – without any need to make its case in court.
Outsourcing
When disciplining CCBIC, SFC complained the sponsor commissioned a due diligence plan from lawyers but didn’t follow it. The finding is perverse because sponsors, not their service providers, are responsible for determining due diligence plans. A plan’s adequacy should be assessed objectively, not against whatever some lawyers happen to propose. SFC has itself warned of sponsors’ habitual delegation of responsibilities, and insisted, “Sponsors remain ultimately responsible for the quality and substance of the due diligence undertaken by agents they appoint.”
Problematically, some sponsors lack the competence to fulfil that responsibility. With lawyers and accountants cutting fees to compete for work, cutting the quality of services correspondingly, outsourcing might fail to fill the competency gap.
Reliance on accountants is inescapable, because prospectuses must include an auditor’s report. IPO fraud usually involves paying accountants to sign off false financial statements. That begs the question whether accountants were negligent in failing to detect the fraud, which should expose them to prosecution. Invariably, however, accounting firms escape SFC’s attention.
Punishment
In 2013, SFC introduced a new regime seeking to make sponsors explicitly accountable. Two previous attempts at statutory reform having failed, the regime was implemented by inserting a new paragraph into the Code of Conduct. It is arguable whether the change amounted to new regulatory standards, or simply a more detailed expression of SFC’s expectations. In any case, SFC codes do not have force of law. They serve legitimately only as tools of statutory interpretation. However, SFC staff seldom appreciate the difference, so codes are commonly regarded unquestioningly.
Further clues to SFC’s expectations are found in circulars, regulatory bulletins and thematic reviews. Typically, SFC alleges failure by sponsors to:
- conduct reasonable due diligence, confirm material customers and conduct face-to-face interviews;
- investigate red flags;
- properly supervise team members;
- keep proper records; and
- ensure that information submitted to the regulators is complete and accurate.
Initially, SFC took little regulatory action reinforcing its rhetoric. Perceptions lingered that SFC was struggling to figure out how to use coercive powers without tainting Hong Kong’s reputation as an attractive listing venue. HKEX has become increasingly reliant on mainland companies, which account for 80% of market capitalization and 90% of turnover. A crackdown on fraud might scare some of them off.
Any doubt that SFC would act was dispelled in 2019, when SFC fined sponsor subsidiaries of four international banks:
- UBS AG and UBS Securities Hong Kong − HK$375 million, and 12 months licence suspension (for sponsorship of China Forestry, China Metal and Tianhe);
- Morgan Stanley Asia − HK$224 million (Tianhe);
- Merrill Lynch Far East − HK$128 million (Tianhe);
- Standard Chartered Securities (Hong Kong)− HK$59.7 million (China Forestry).
SFC later fined China Merchants Securities HK$27 million for neglecting “a number of unusual facts and findings on China Metal and its customers”. China Merchants had only a token involvement in the listing, being appointed just a few months before China Metal’s second application. Strangely, SFC’s summation of China Merchants’ failings focused almost entirely on activities of its co-sponsor, UBS. This suggests co-sponsors might be unable to mitigate risks by contractually delineating the extent of their responsibilities. SFC might consider all the sponsors culpable for any supposed shortcomings in the whole sponsorship process.
Conclusion
Hong Kong’s absorption into China over recent decades has been a bonanza for HKEX but the scourge of many investors, introducing a slew of scams to public markets. SFC has limited success holding fraudsters accountable, and has shown no inclination to pursue auditors who sign off false company accounts. Instead, enforcement efforts are primarily focused on sponsors. As licensees, sponsors are attractive candidates for punishment.
A version of this article first appeared in the September 2023 issue of Hong Kong Lawyer, the official journal of The Law Society of Hong Kong.