Previously, Greg Heaton outlined how listing sponsors became gatekeepers of the Hong Kong Stock Exchange (HKEX). He now reviews recent regulatory developments.
The Securities and Futures Commission (SFC) customarily prioritizes enforcement actions of high deterrence value. In capital markets, SFC has aimed enforcement firepower at sponsors of big initial public offerings (IPOs) – not because those institutions are necessarily the worst, but because their public disgrace is the most newsworthy.
Sponsors punished in 2019 for a spate of disastrous listings ten years earlier were subsidiaries of international banks. In the last few years, SFC has shifted its enforcement focus. The change is not deliberate, and still does not hold the true perpetrators of the worst misconduct accountable. Instead, SFC has settled for trophy hunting among a less glamorous subset of the sponsor community. Having bagged the big deep-pocketed sponsor firms, SFC turned to small impecunious ones. There are plenty of those.
There has been a step down, also, in the quality of the frauds: from sensational swindles of tycoons who vanished with millions, to the sideshow hustles of small-time grifters. Yet it remains the reality that sponsors bear most of the punishment for the sins of company insiders who abscond with investors’ money.
Aside from regulatory risk, sponsors face stiff competition for fees. New sponsor coupling requirements are intended to redress imbalances between sponsors’ commercial power versus that of underwriters, but will render some boutique sponsors obsolete.
The IPO sausage factory
The SFC’s most recent disciplinary action against sponsors concerned an unprosperous firm called Changjiang Corporate Finance. CJCF churned out a string of six failed listing applications, oblivious to regulatory requirements and specific risks threatening each company’s business. SFC fined CJCF HK$20 million and suspended its sponsor license.
China Candy
An earlier case concerned TC Capital International, for its sponsorship of China Candy. While the IPO raised just HK$57 million, expenses burned through HK$21 million, meaning over a third of the cash was lost to underwriters and other service providers. Most of the rest was supposedly for expanding production. According to the prospectus:
“With an increasingly sophisticated consumer base, an increasing number of young and fashionable people are attracted by exotic sugar confectionery in first and second tier cities. … As China gradually eases its restriction on birth control, birth rates are estimated to pick up in the years to come. A larger population of children, who are the primary target market of confectionery products will translate into a larger customer base and bolster sales… Functional pastilles, gums, jellies and chews, added with vitamin C, vitamin E, calcium or DHA, claim to provide consumers with nutritional supplements in addition to being just a snack food. Such products are gaining in popularity due to their claimed health benefits.”
If that wasn’t fanciful enough, investors might have guessed China Candy was doomed if they read in its 2016 Annual Report: “To enhance the value for the Shareholders, the Company decided to expand its business into investment business, mainly in listed shares.” Worse, this random pivot was financed by a loan from the company’s co-founder and CEO, Hong Yinzhi.
The stock was suspended two years after listing, when it emerged that RMB178 million had been transferred from company bank accounts to personal accounts of its senior managers. Recipients included Hong and her husband, China Candy’s chairman. Some of the money was eventually recovered or accounted for, but the disappearance of RMB12 million remains a mystery. While Hong resigned as CEO in 2019, her daughter was then appointed deputy.
The company allegedly also falsified accounting records and overstated its 2016 cash balance by 97%. SFC has not attempted prosecution of key perpetrators (in the mainland beyond its jurisdiction) but merely sought their disqualification as directors. Meanwhile, SFC punished the sponsor for failing to properly investigate China Candy’s purported pre-IPO revenue. SFC fined TC Capital $3 million, saying the fine would have been heavier “but for the firm’s financial position”.
Two failed frauds
SFC’s action against TC Capital echoed its earlier punishment of two sponsor firms for inadequate due diligence of listing applicants’ purported revenues. Those cases were significant for another reason: they demonstrated that sponsors can face serious penalties even if the application fails and no harm is done to the investing public.
In the madcap goldrush of Hong Kong’s listing industry, applications sponsored by smaller firms are often launched speculatively then abandoned before their approval. A change in HKEX protocols has facilitated SFC’s ability to build enforcement cases against sponsors involved in those assignments. Previously, regulatory action in response to complaints against applicants ceased if the application terminated before approval. SFC now expects HKEX to consider whether further action is warranted, such as a referral to SFC.
Ample Capital was one of the first sponsors disciplined for an abandoned listing application. The applicant, COCCI International, claimed to receive much of its revenue from one distributor, in bags of cash at rendezvous points in Hong Kong. Various individuals, who were not COCCI employees, then carried the cash to the mainland.
The SFC said: “Settlement of payments through third parties by a customer is a red flag as third-party payments might be used to disguise the original source of funds and facilitate a fraudulent scheme.”
The implication is that COCCI conspired with its purported distributor and supplier to generate bogus transactions, creating a circular flow of funds to inflate revenue artificially. After SFC’s second rejection of the draft prospectus, Ample Capital did not respond, and the application lapsed. SFC reprimanded Ample Capital and fined it HK$5.5 million.
Similarly, SFC disciplined Yi Shun Da Capital (YSD Capital) for its sponsorship of Imperial Sierra Group. The application was under consideration when unknown persons, calling themselves “Blazing Research”, reported that major customers’ purchases were “most likely to be fabricated”. They presented evidence that Imperial Sierra’s young founder, Aric Yip Wik, was the son of Michael Yip, who in 2010 was jailed for stealing HK$180 million from Ocean Grand Holdings. Michael founded Ocean Grand with his father in 1990, took it public in 1997, and then promptly foundered it, siphoning off assets by making bogus purchases from his family’s other companies.
Blazing Research concluded:
“Imperial Sierra is just another fraud designed by Mr. Yip Kim Po after his release from jail, so as to earn the ‘shell’ price of Hong Kong listed companies. … Due to the high premium of ‘shell’ price in Hong Kong listed market, some companies collude with sponsors to conduct fraudulent IPO and earn huge profits by selling the company’s shares after lock-up period. Although many companies merely use accounting tricks to meet the profit test requirement, some companies use transaction without any commercial substance to fabricate revenue and net income to pass profit test. We believe the fraudulent extent of Imperial Sierra is the most serious among these companies, since Imperial Sierra does not have any operation with commercial substance at all.”
After the application lapsed, SFC concluded YSD Capital had failed to perform all reasonable due diligence. Appealing to SFAT, YSD Capital asserted it was entitled to rely on the accountant’s confirmation of the financial statements. SFAT held that YSD Capital could not use the accountant’s report to “wash its hands of the matter”.
With respect to SFC’s $4.5 million fine, although considerably less than the $14 million originally proposed, YSD Capital lamented it would still suffer a significant loss. Its fee for the listing assignment had been a pitiable HK$2.5 million. Noting that a firm cannot be entitled to make a profit on work that “has been undermined by its own culpability”, SFAT nonetheless further reduced the fine to HK$3 million in view of YSD Capital’s “financial straits”.
It is not apparent that Yip family members who allegedly conceived the scheme suffered any regulatory consequences, though creditors sued Aric Yip Wik regarding an unpaid debt and a bond issued to raise money for the listing attempt.
Sponsor coupling
Last year, 75 companies completed IPOs on HKEX − an annual total that has been declining in recent years. The applications were shared, unevenly, between 130 licensed sponsor firms. While the potential rewards of listing are enormous for pre-IPO shareholders, especially if they disappear with the proceeds, sponsorship is a competitive business with thin margins. Commercial pressures may encourage sponsors to offer a cut-priced service so that a group company can head the underwriting syndicate, which enjoys higher fees. In effect, sponsors provide loss-leaders for more lucrative underwriting work.
An analysis of IPOs in 2020 revealed average underwriting fees of HK$49 million, versus sponsor fees of HK$6 million. SFC said this indicated “misalignment between fees and sponsor costs and responsibilities.” This doesn’t elucidate the problem, which is that misalignment of fees creates misalignment of incentives. When the economic incentive of its corporate group is to complete an IPO, a sponsor doesn’t simply face a temptation to offer a cursory and inexpensive service, but to actively ignore red flags. Discovery of fraud or falsity, through assiduous performance of their duties, could imperil underwriting fees.
In response to sponsors’ commercial weakness, SFC in 2022 introduced a “sponsor coupling” requirement. Main Board applicants must now appoint at least one sponsor which is also part of the underwriting syndicate, or related to one of the underwriters. Also, an underwriter must be appointed when it (or its group company) is appointed sponsor.
The SFC stated, “it appears that the sponsors presently have too little bargaining power. The ‘sponsor coupling’ requirement is aimed at redressing that”. It is intended to ensure sponsors are not incentivized to compromise due diligence to secure the underwriting appointment. When sponsors also act as underwriters, “total fees may properly compensate the additional sponsor resource commitments and responsibilities.” In effect, SFC hopes underwriting will cross-subsidize sponsor work.
It is not logical to hope that tying sponsors’ remuneration to underwriting will advance sponsors’ independence and performance. On the contrary, it will exacerbate conflicts of interest and entrench misaligned incentives. If an applicant’s share issue is underpriced, underwriters assume minimal risks and potentially gain huge profits at the applicant’s expense. Applicants cannot receive impartial pricing advice from sponsors also acting as their underwriters.
Additionally, sponsor coupling has an anti-competitive effect, with underwriters locked in long before they would usually be appointed. So, it is questionable whether the requirement is consistent with SFC’s objectives, anchored in legislation, which include promotion of the security industry’s competitiveness. Moreover, the requirements prejudice sponsors which are not part of a corporate group that includes underwriters. Although underwriting involves completely different capabilities, firms that cannot offer underwriting will only be able to sponsor Main Board listings as co-sponsors with firms that can. This severely limits their opportunities because most listing applicants appoint only one sponsor. Responding to objections on this point, SFC concluded, “The impact on small boutique sponsors should be limited” because 72% of all sponsors (or their group companies) are also engaged in underwriting. Presumably the logic was that the changes will, at most, put only 28% of sponsors out of business.
A corollary of requiring at least one sponsor with underwriting capabilities is that at least one underwriter must have a sponsor in its corporate group. Underwriters thereby face pressure to participate in relatively unprofitable sponsor work. Or, at least, be appointed as a sponsor and accept the regulatory risk, even if most of the work is done by another sponsor. This increases the likelihood that for each IPO there will be a sponsor that is part of a highly capitalized financial group. That reinforces the allure of scapegoating sponsors for frauds committed by others.
Conclusion
While seeking to unlock the treasure chest of public capital markets, some company insiders fall to the temptation of falsifying disclosures. Whether the charades unravel before listing or after, regulators usually now focus on finding fault with the due diligence performed by sponsors. More than ever, sponsors face significant regulatory risks for limited financial gain.
This article first appeared in the October 2023 issue of Hong Kong Lawyer, the official journal of The Law Society of Hong Kong.