A FIRM FOUNDATION:THE IMPORTANCE OF ADEQUATE DUE DILIGENCE IN PRE-IPO TRANSACTIONS IN HONG KONG

Dean Ward, Enhanced Due Diligence Director, Thomson Reuters

Statement of intentThe Hong Kong Securities and Futures Commission (SFC) wants to protect investors by raising the standard of pre-IPO preparation in Hong Kong. This means it is expecting greater insights in the draft listing documents, and a higher degree of certainty that important and relevant price sensitive information has not been excluded from prospectuses through negligence or lack of due diligence. This white paper highlights the importance of adequate due diligence in pre-IPO transactions in Hong Kong.

2 A FIRM FOUNDATION: THE IMPORTANCE OF ADEQUATE DUE DILIGENCE IN PRE-IPO TRANSACTIONS IN HONG KONG MARCH 2015

THE WINDS OF CHANGEIn mid-2013, the Hong Kong Securities and Futures Commission (SFC) introduced ‘the most sweeping changes to sponsor regulation in a generation.’1 The changes are intended to promote higher standards of IPO due diligence for Hong Kong equity listings and affect all IPO applications submitted on or after 1 October 2013. Not only are there now stricter regulatory requirements with which sponsors must comply, but the amendments include criminal liability for IPO sponsors who do not take sufficient care when preparing for a new listing.

In April 2012 The Securities and Futures Commission (SFC) revoked the license of Mega Capital (Asia) Company Limited. The loss of license meant they could no longer advise on corporate finance. In addition to this they were fined US$42 million. Both these penalties arose from their failure to fulfil their duties as sponsor during the listing application of Hontex International Holdings Company Limited. Particular failings highlighted by the SFC included “Inadequate and sub-standard due diligence work” as well as an “Inadequate audit trail of due diligence work”.2

Hong Kong already benefits from a robust legal framework (based on English common law) and its adoption of the International Financial Reporting Standards (IFRS) provides the city state with a credible degree of financial transparency. These two ingredients make a significant contribution to market integrity and help to make HK an attractive destination for capital market fundraising. Hong Kong cannot rest on its laurels, however.

The new regulations address issues arising in recent years which threatened to take the shine off Hong Kong as a place to raise capital. The

stated aim of the new regulations is (inter alia) to ‘maintain the integrity of the Hong Kong market by assuring the quality of information disclosed in listing documents, and include a requirement to publish initial application drafts of IPO prospectuses.’3

One of the major catalysts for the recent changes to regulation was declining standards amongst IPO sponsors, in particular inadequate due diligence leading to poor quality draft listing documents. By increasing the number and scope of regulations with which sponsors must now comply, the SFC hopes to have addressed these issues. Forcing more thorough preparation should, logically, lead to a smoother, more streamlined process and fewer queries and delays in the listing process.

The rationale is sound, but where does this leave sponsors, who are now faced with increasingly onerous requirements and the inevitable soaring workloads that will ensue?

WHAT THE REGULATOR EXPECTSIn essence the new requirements state sponsors need to demonstrate a thorough and complete understanding of the listing entity, and all related parties.

This includes, for example, researching the personal and business backgrounds of all directors, key senior managers, and even controlling shareholders. There is a requirement, in some cases, to verify the education and employment credentials of key directors to ensure they have the right experience and knowledge to manage a listed entity.

Complying with such requirements may not be without its hurdles. It is important to note, for example, it is not possible to verify the education and employment of an

1 http://www.reuters.com/article/2013/10/01/idUSnHUGdjLv+72+ONE20131001

2 http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=12PR39

3 http://www.reuters.com/article/2013/10/01/idUSnHUGdjLv+72+ONE20131001

3 A FIRM FOUNDATION: THE IMPORTANCE OF ADEQUATE DUE DILIGENCE IN PRE-IPO TRANSACTIONS IN HONG KONG MARCH 2015

individual without their consent. Accordingly it is common practice to obtain a Letter of Authorization from affected parties prior to the initiation of any assignment where this level of due diligence is required.

Extensive and detailed due diligence is necessary to demonstrate a complete understanding of the listing entity. It is also the best way to demonstrate appropriate effort has been directed to identifying and mitigating any potential operational, legal and reputational risks.

It should be noted that extensive due diligence means covering not just the soon-to-be listed entity, but also its subsidiaries and associated companies. Any ‘material deficiencies’ discovered during this process - whether relating to operations, systems, key management, or procedures - must be addressed, particularly if it could reasonably be assumed such deficiencies (were they known) might influence a potential investor’s decision.

Uncovering deficiencies on their own is not enough. Sponsors are further expected to make recommendations and offer assistance to remedy such deficiencies. Deficiencies that cannot be resolved must be disclosed in the listing application. In other words, all material issues relevant to the listing must be assessed, understood and, if necessary, disclosed to potential investors to allow them to make an informed decision.

In response to the new regulations, a diverse group of Hong Kong sponsors (including investment banks, law firms, two of the Big 4 accounting firms, and other financial institutions) spent a year producing a 762 page document entitled Due Diligence Guidelines (the Guidelines). As its title suggests, it was written to help sponsors to meet their new

obligations. The document provides practical advice to ensure adequate due diligence at every stage of the process. The Guidelines are available free upon application.

For ease of reference, the Guidelines have been broken down into three distinct parts, namely:

• Standards – this section outlines the new diligence requirements for sponsors

• Guidance – this section offers insights from the contributing parties as to what is actually expected in practice i.e. it explains and dissects the new requirements

• Recommended Steps – this section offers invaluable practical advice for easier compliance

Key principles from the regulations are highlighted in the due diligence guidelines. One section highlights how “Reasonable Judgment” should be applied when deciding the extent of due diligence to be performed. To quote, “…a sponsor should exercise reasonable judgment on the nature and extent of due diligence work needed in relation to a listing applicant having regard to all relevant facts and circumstances”4.

Whilst this appears to provide the sponsor with a degree of latitude, the extent of that latitude is limited. The SFC also states, for example, that “… a sponsor should conduct due diligence in order to have a thorough knowledge and understanding of a listing applicant”5 A thorough knowledge and understanding is a high bar.

The SFC’s Dual Filing Update of August 2011 sheds some light on concerns regarding a sponsors’ failure to exercise reasonable judgment during the due diligence process. In one cited instance, the listing applicant ‘operated an online trading platform for virtual

4 http://duediligenceguidelines.com/publication/ddg-03-01/

5 http://duediligenceguidelines.com/publication/ddg-03-01/

4 A FIRM FOUNDATION: THE IMPORTANCE OF ADEQUATE DUE DILIGENCE IN PRE-IPO TRANSACTIONS IN HONG KONG MARCH 2015

items of third party-operated websites’, but it emerged that there was blatant violation of signed user agreements between the applicant and various website operators. This type of breach could obviously lead to claims, but moreover, it cast serious doubt on the practices of the applicant’s management team – and on the sponsor’s apparent lack of reasonable judgment. Eventually the applicant changed its mode of operation, but the sponsor’s judgement remains open to question.

A second instance, involving a property developer, illustrated a serious discrepancy between the type of property that had been developed on a site and the permitted use of the land. This could expose the applicant to claims from buyers and tenants of the developed property. The draft listing document failed to address this issue satisfactorily and did not explain the potential consequences of the breach – again showing a potential lack of ‘reasonable judgment’ on behalf of the sponsor.

So, without making the question too rhetorical, is it possible for a sponsor to achieve “thorough knowledge” without conducting comprehensive due diligence? Unlikely. As stated earlier, even if the knowledge was there, the regulator wishes to see the quality of the knowledge, its provenance, and to see what has been looked at and what has not. It goes without saying that without a record of due diligence having been performed, a sponsor will struggle to show the SFC that they truly know the company they are sponsoring.

In January 2014, the SFC revealed that Sun Hung Kai International “had failed to conduct proper due diligence between October 2007 and September 2009 on Sino-Life’s business in relation to a number of material issues”6 – they were fined HK$12 million and had their license

suspended to provide advisory service on corporate finance for one year. Time and time again, sponsors are being pulled-up for poor due diligence on the sponsored party.

WHAT ORGANIZATIONS NEED TO BE DOING IPO sponsors have a real need to develop deep business intelligence that goes way beyond surface checks, if they are to satisfy the new regulations introduced by the SFC.

Penetrating interviews with a range of relevant sources can help to create a better understanding of the listing entity. Moreover, sponsors must be aware they need to develop an overview of potential risks. This might include risks associated with financial crime, including sanction, PEP, and reputa tional risks. Where risks are higher than normal, deepening the understanding of fund, income and other wealth sources, as well as having a grasp of the organization’s operational track record are essential. Nevertheless, such knowledge on its own is insufficient.

The following is a list of common issues identified by the SFC resulting from inadequate due diligence:

• The inaccuracy of information and significant errors in listing documents and responses to the regulators.

• Failure to demonstrate a basic understanding of the key factors affecting the historical performance of the listing applicant, such as the customer profile and competitive advantages.

• Failure to identify and explain relationships of significant stakeholders (such as distributors and suppliers) to the listing applicants.

• Failure to identify material noncompliance with rules and regulations.

6 http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=14PR13

5 A FIRM FOUNDATION: THE IMPORTANCE OF ADEQUATE DUE DILIGENCE IN PRE-IPO TRANSACTIONS IN HONG KONG MARCH 2015

• Critically important statements based on assumptions that conflict with observable facts.

• Failure to provide meaningful disclosures on the risks, historical financial performance and future plans of the company.

All of the failings listed above demonstrate a lack of knowledge or appreciation. Even if the sponsor knew everything pertinent about the listing applicant, there was a failure to appreciate the significance of certain issues. We are, therefore, back to the exercise of reasonable judgment.

Adequate due diligence is not just about gathering information. Analysis is a key part of the process. The minimum analysis that could be expected is as follows:

• Country analysis - an overview of the country in which the listing entity operates. This analysis could include any risks specific to the country concerned, as well as details of its major industries, legal system and regulatory bodies.

• Industry analysis – an overview of the industry in which the listing entity operates. This analysis should look at both the history and future of the industry, its strengths, weaknesses, opportunities and threats faced as well as relevant legislation and an understanding of both the supply and demand chains.

• Listing company analysis – detailed research into all aspects of each company. This should include information on the company’s history; research into the personal and business backgrounds of all directors, key senior managers and controlling shareholders; a financial review of the company; analysis of all publicly available information, for example in the media and on the internet; personal

interviews with relevant parties; details of any litigation; details of any regulatory issues; etc.

• Associated company analysis – further detailed research into associated companies, such as subsidiaries. The same level of research and analysis described above must be applied to all associated companies, not just the entity that is listing.

A methodical approach is essential. Analysis feeds off rigorous research, detailed investigation, and intelligent contextualization of the facts.

If these qualities can be demonstrated by sponsors, the pre-IPO process can be made as reliable and as efficient as possible, complying with the new regulations in a way that will deliver quality draft listing documents, and gain the trust and confidence of the SFC.

Given regulators routinely conduct post-listing appraisals to determine if sponsors have adequately fulfilled their many obligations, underpinning draft listing documents with quality due diligence makes sense. Equally, the following list of due diligence best practices should become second nature to sponsors:

• Conduct interviews with relevant company officers across different departments to gain a thorough understanding of the different aspects of the company’s business.

• Make contact with major customers, suppliers, distributors, licensees and bankers to double check any information given by the applicant.

• Undertake an inspection of any factories/premises in which the company’s products are manufactured.

• Thoroughly review the internal financial model with the company’s management and delve into projected financials.

6 A FIRM FOUNDATION: THE IMPORTANCE OF ADEQUATE DUE DILIGENCE IN PRE-IPO TRANSACTIONS IN HONG KONG MARCH 2015

• Review relevant trade journals and industry-related publications to understand industry and market trends and gather general competitor information.

• Scrutinize the company’s budget on a line-by-line basis.

• Review all material contracts, Board minutes and any other relevant corporate document

• Maintain close involvement with management throughout the prospectus-drafting process.

• Identify all ultimate beneficial owners (UBOs).

• Conduct, for example, PEP, sanctions and law enforcement checks on the directors, all major shareholders and identified UBOs.

CONCLUSIONSponsors for listings in Hong Kong need to understand the extensive due diligence requirements that now govern the IPO process.

It is important for sponsors to provide all relevant information in prospectuses. Relevance is not subjective, but “based on what a sponsor’s peers would consider objectively appropriate having regard to all relevant facts and circumstances at the time of making a listing application”.7 In other words the onus is increasingly on the sponsor to find out as much as possible, and the duty of the sponsor to inform.

The industry-generated Guidelines offer an excellent starting point to help sponsors understand their obligations, plus it contains practical pointers to streamline the process.

At the heart of the regulations is the requirement for sponsors to bring a degree of reliability and integrity to their research. Part of this is the ability to analyze and to understand their clients in greater depth than ever before. Inevitably country, industry and company intelligence will all be needed to complete the due diligence picture.

In short, the SFC wants to protect investors by raising the standard of pre-IPO preparation in Hong Kong. This means it is expecting greater insights in the draft listing documents, and a higher degree of certainty that important and relevant price sensitive information has not been excluded from prospectuses through negligence or lack of due diligence.

Disclaimer

Thomson Reuters is an information provider and aggregator and does not provide legal, financial or other professional advice. The information, materials and opinions (if any) contained in this article are for general information purposes only, are not intended to constitute legal or other professional advice, and should not be relied on or treated as a substitute for specific advice relevant to particular circumstances. To the fullest extent permissible under applicable law, Thomson Reuters excludes all liability for any damages or loss that may arise from any reliance by a reader on the information or other materials contained in this article.

RESOURCES http://www.thecorporatetreasurer.com/News/351656,hong-kong8217s-new-ipo-listing-rules-explained.aspx

http://www.charltonslaw.com/en/newsletters/HKLaw/2013/20130930/20130930-NewsLetter-HKLaw-detail.html

http://www.reuters.com/article/2013/10/01/idUSnHUGdjLv+72+ONE20131001

http://www.sfc.hk/web/doc/EN/speeches/public/dual/Aug11.pdf

http://media.mofo.com/files/Uploads/Images/121119-The-MoFo-Guide-to-Hong-Kong-IPOs.pdf

7 Paragraph 106 of the Consultation Conclusions on the regulation of IPO sponsors

© 2015 Thomson Reuters GRC02314/3-15

The Thomson Reuters Governance, Risk & Compliance (GRC) business delivers a comprehensive set of solutions designed to empower audit, risk and compliance professionals, business leaders, and the Boards they serve to reliably achieve business objectives, address uncertainty, and act with integrity.

Thomson Reuters Accelus connects business transactions, strategy and operations to the ever-changing regulatory environment, enabling firms to manage business risk. A comprehensive platform supported by a range of applications and trusted regulatory and risk intelligence data, Accelus brings together market-leading solutions for governance, risk and compliance management, global regulatory intelligence, financial crime, anti-bribery and corruption, enhanced due diligence, training and e-learning, and board of director solutions.

THOMSON REUTERS ACCELUS™

For more information, visit accelus.thomsonreuters.com