This legal update discusses the following six lessons for IPO sponsors resulting from the Sun Hung Kai International Limited v SFC (Application No.3 of 2013) decision in conducting due diligence and record-keeping:
In January 2014, the Securities and Futures Appeals Tribunal (the “Appeals Tribunal”) affirmed the decision of the Securities and Future Commission (the “SFC”) and imposed sanctions (including public reprimand, HK$12 million fine and one-year suspension of licence to advise on corporate finance) on Sun Hung Kai International Limited (“SHKI”) after concluding that there was clear evidence that SHKI failed to exercise due diligence and to maintain proper records in its sponsor work relating to the listing of Sino-Life Group Limited (“Sino-Life”) on the Growth Enterprise Market (“GEM”) of The Stock Exchange of Hong Kong Limited (the “Stock Exchange”). Sino-Life and its subsidiaries are engaged in the provision of different forms of funeral services. Sino-Life was listed on GEM in September 2009 and SHKI was its sole sponsor.
Summary of the SFC’s decisions affirmed by the Appeals Tribunal
The SFC’s investigations revealed that SHKI failed to carry out proper due diligence in respect of the following three principal matters:
The SFC also identified the following three instances of SHKI’s material failure to maintain records:
The Appeals Tribunal affirmed the SFC’s findings above (with one exception relating to one of the several aspects regarding the financial estimates). The Appeals Tribunal considered that SHKI’s culpability was not one of negligence as the evidence showed that SHKI’s deal team members were well aware that they were compromising their due diligence obligations by giving preference to their client’s interests over the interests of the integrity of the market and this was perhaps the most serious aspect of SHKI’s failure of due diligence.
The full text of the Appeal Tribunal’s reasons for determination is available at: http://www.sfat.gov.hk/english/determination/AN-3-2013-Determination.pdf
Lesson 1: Apply the same standards of due diligence in GEM and Main Board listings.
SHKI’s counsel, in advocating that a GEM listing application warranted a modified degree of due diligence on the basis of the lower level of fees charged by sponsors in a GEM listing as compared to a Main Board listing, used the following metaphor: “no one expects a Rolls-Royce for the price of a Mini”. The Appeals Tribunal rejected this argument and made it plain that in their view, there is no difference in the standards of due diligence expected in GEM and Main Board listings. Using the metaphor of SHKI’s counsel, the Appeals Tribunal expressed that “the same level of care and expertise is required in the manufacture of a Mini as a Rolls-Royce. Both must be fit for purpose. However, the fact that a Mini is a smaller and less sophisticated piece of machinery means that invariably it can be manufactured as fit for purpose more cheaply than a Rolls-Royce.”
Lesson 2: Make a reasonably detailed enquiry to address concerns raised by a “red flag”.
Having noted the huge difference in the 2007 cash flow figures between the draft audit report prepared by the old accountants’ firm and the one prepared by the new accountants’ firm, SHKI approached the new accountants’ firm but that firm told SHKI that it was inconvenient for it to express an opinion. SHKI then approached Sino-Life and was told that the old accountants’ firm should not be approached as there was no longer any professional relationship with it. Without making further enquiries, SHKI abandoned the issue. Based on the evidence before the Appeals Tribunal, it appeared that no approach was made to obtain from Sino-Life materials supplied by it to the two accountants’ firms on which the cash flow figures must have been based.
The Appeals Tribunal accepted that it is not the role of a sponsor to “chase every rabbit down every hole”, but remarked that a sponsor cannot turn a blind eye to a known issue and some form of reasonably detailed enquiry should be made in view of the huge discrepancy between the two draft audit reports.
The Appeals Tribunal further expressed that while a sponsor is entitled to rely on the correctness of an audit report prepared by an independent expert, the application of such a principle must always be considered in context. It gave an example in the reasons for determination: “[i]f, in respect of a listing application, one fully reasoned legal advice states that it is contrary to law to undertake a certain commercial act while a second states that it is in accordance with law to do so, a sponsor must surely seek some way of resolving the issue so that there is certainty as to the legal position. Enquiries are required. Are the two advices based on different facts and may the issue be resolved that way? If not, is there perhaps the need for a third defining advice from a known expert?”
The Appeals Tribunal was of the view that the decision to ignore the old audit report in light of the fact that new audit report went towards ensuring the success of the listing application while the old report raised at least the possibility of prolonged further enquiries constituted a tactical decision to abandon due enquiry and did not constitute reasonable due enquiry.
Lesson 3: Bear in mind the dual obligations of a sponsor; an obligation not only to the client but, equally importantly, to the integrity of the market.
There was no mention, whether in the documents submitted together with Sino-Life’s listing application or responses to the Stock Exchange’s enquiries regarding the change of accountants, about the material difference in the 2007 cash flow figures between the two draft audit reports as mentioned above.
The Appeals Tribunal considered that when there is a “midstream” change of accountants and that change results in a material change in figures, especially those going to the fundamental issue of listing qualification, the Stock Exchange, as a gatekeeper to the market, is entitled to know the reasons for the change for assessing whether the new figures are a true reflection of the financial well-being of the company.
The Appeals Tribunal expressed that SHKI was bound by a structure of rules and principles of conduct that obliged it not simply to represent the interests of Sino-Life but also the interests of the integrity of the market and hence it should give a complete picture of all material matters to the Stock Exchange.
As the Appeals Tribunal was satisfied that the difference in the 2007 cash flow figures in the two reports constituted a material matter and SHKI was at all material times aware of the importance of the issue, it ruled that SHKI’s failure to raise it to the Stock Exchange constituted an intention to mislead it.
Lesson 4: Blind reliance on an expert’s advice is not regarded as reasonable due diligence.
Other than undue reliance on the audit report prepared by the new accountants’ firm at the expense of the draft audit report prepared by the old accountants’ firm as discussed in Lesson 2 above, there was also purported undue reliance by SHKI on the legal advice regarding the extent of encumbrances on the title of the columbarium in Taiwan.
Sino-Life’s subsidiary was granted the right to sell storage space for funerary urns in the columbarium by a company which had been given the management authority from the owner of the columbarium. The post-listing success of the columbarium project could not be assured unless the owner remained secure in its title. However, an internet search conducted by SHKI revealed judgment against the owner followed by foreclosure proceedings. SHKI made enquiry with Sino-Life regarding, among others, the outstanding debt owed by the owner leading to the foreclosure and whether it was the result of foreclosure that led to no public sale of the columbarium niches by the owner with the support of Taiwan legal advice. Sino-Life instructed its Taiwanese lawyers to respond. As shown by follow-up emails from SHKI to Sino-Life suggesting that Sino-Life should provide information concerning any foreclosure risk, SHKI appreciated that the advice from the Taiwanese lawyers did not answer the questions posed. However, the matter appeared to have been taken no further and there was no mention in the prospectus of the owner’s financial position and/or risks related to the forced sale of the columbarium. There was no evidence that SHKI made any further independent enquiries, or otherwise, it would have learnt that there were many other actions against the owner in the same court.
In response to the assertion by SHKI’s counsel that there was no basis upon which the “core competence” of the Taiwanese lawyers could be challenged, the Appeals Tribunal remarked that the issue of whether or not a sponsor has conducted due diligence in considering an expert’s advice does not turn on the correctness of that advice, but is rather a question of looking into the extent of that advice – Does it answer the questions that had been asked? Is it of any benefit in the due diligence process? The Appeals Tribunal was of the view that the advice from the Taiwanese lawyers was blinkered and that the probabilities suggested that SHKI knew that they were being “stonewalled” by Sino-Life. The Appeals Tribunal was satisfied that there was a significant failure of due diligence on the part of SHKI for not having fully investigated the owner’s true financial history (other than the initial and limited discovery of one court action), despite that SHKI was aware of the need to do so.
Lesson 5: Critically assess statements and representations made by the company and be alert to information that contradicts or questions their reliability.
The SFC found that the various financial projections and breakdowns concerning the financial viability of the columbarium project were materially problematic and that the failure to recognise this and to ensure rectification in an acceptable form cast serious doubts on the quality of the relevant due diligence conducted by SHKI. The problematic areas included, among others, ambiguous or contradictory information disclosed in the forecasts and the prospectus as to Sino-Life’s intention vis-à-vis ability to commence sales of repositories immediately upon listing; non-reconciliation of figures of the estimated sales growth rate and sales forecast; and inconsistency in the number of other columbarium facilities disclosed in the information provided to the Stock Exchange with that based on SHKI’s research and Sino-Life’s own earlier estimate.
With one exception, the Appeals Tribunal agreed with the SFC’s findings and found that SHKI failed to satisfy itself that the forecasts had been made after due and careful enquiry and to put a clearer and more accurate picture before the Stock Exchange.
Lesson 6: Keep adequate records of due diligence work, especially in respect of matters that may be contentious or material.
The Appeals Tribunal had given a general remark in its determination that a ‘bare bones’ outline setting out only broad and entirely expected areas of due diligence is insufficient and that the SFC must be able, by a study of the sponsor’s records, to see how that sponsor has discharged its duties (including the manner in which each area of investigation was pursued, the nature of the material decisions made in pursuit of that investigation and the reasons for, and nature of, conclusions reached) and there is a special need for details in respect of issues that are, or are likely to be, contentious. The Appeals Tribunal also stressed that the keeping of proper records is not merely an aid to investigation by the SFC, but equally a protection for sponsors.
SHKI’s counsel claimed that the SFC had given no consideration to the overall adequacy of SHKI’s documentation outside of the three instances identified by the SFC. In response to such an argument, the Appeals Tribunal remarked that common sense dictates that matters that may be contentious or material in some way be recorded and that a failure to record such matters may in the eyes of the reasonable observer suggest an intention to disguise. The Appeals Tribunal was of the view that “while obviously the adequacy of the record-keeping generally is an important consideration, an abundance of information in respect of the obviously mundane is not to be taken as excusing a lack of information in respect of matters of particular importance or contention.”
This recent ruling against SHKI sends a clear message to all sponsors that they should be mindful of their duties in carrying out proper due diligence and maintaining adequate records, or otherwise they may face a range of severe sanctions.
This case was decided on the basis of the then applicable rules prior to the new sponsors regulatory regime becoming effective on 1 October 2013. Some of the points discussed in this case regarding the rules and standards of sponsors’ due diligence and record-keeping obligations are now set out in clearer terms in paragraph 17 of the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission currently in force (the “Code”) as part of the new sponsors regulatory regime. In addition to bearing in mind the lessons learned from this case, sponsors should also ensure due compliance with the other more stringent requirements under paragraph 17 of the Code when discharging their functions as sponsors.