Bankers may face prison for misleading information in share-sale documents under a proposal by Hong Kong regulators that could raise the cost and risk of arranging initial public offerings in the city.
The Securities and Futures Commission said yesterday it will seek feedback on a proposal to impose criminal penalties on bankers or firms who fail to ensure proper due diligence in IPOs. Some senior bankers in Hong Kong are already devoting more time to examining companies they take public in anticipation of tougher rules, said two executives at securities firms who requested anonymity because the matter is sensitive.
The SFC said tougher legislation is needed to protect investors, after a string of accounting scandals involving Chinese companies that were listed in recent years eroded confidence in IPOs. Bankers said the risk of criminal penalties that may include prison means they may steer clear of arranging smaller offerings.
“You have to wonder with the smaller deals, whether the economics will really support them,” said Dominic Tsun, a Hong Kong-based capital markets lawyer and partner at Kirkland & Ellis. “The due diligence standards are exactly the same for smaller deals.”
Under the SFC’s proposal, bankers would face fines of as much as HK$700,000 ($90,300) and prison terms of as long as three years. SFC Chief Executive Officer Ashley Alder said during a press conference that the regulator will mainly target sponsor firms, and individual bankers would only be criminally liable for “serious” cases.
Hong Kong is proposing legislation that’s tougher than in major IPO markets like the U.S. and London. In Singapore, underwriters may be criminally liable for information in prospectuses, though only if they acted “intentionally or recklessly,” according to a statement on the Monetary Authority of Singapore’s website.
The territory, which reverted to Chinese rule in 1997, has benefited as $159 billion of IPOs by companies from the mainland in the past decade swelled the value of its stock market. First-time sales peaked at $58 billion in 2010 before dropping by more than half last year, data compiled by Bloomberg show.
In 2007, the SFC introduced a system where one or several investment banks arranging an IPO would act as a so-called sponsor and be responsible for due diligence. The sponsors on a deal are typically identified on the front page of the prospectus.
“Bankers want to be sponsors because they play a key role that involves lots of communication with the company,” said Tsun who regularly works with issuers and underwriters. “This may result in better commissions as well as future mandates for block trades and the like.”
State to Private
Another proposal in the SFC’s consultation paper is to restrict the number of sponsors on any single IPO, since having too many “can lead to fragmentation of work, gaps and overlaps,” according to the document.
As the state-owned companies that dominated IPOs in Hong Kong over the past decade give way to smaller, privately owned businesses, accounting issues are more common, said Winnie Cheung, chief executive officer of Hong Kong Institute of Certified Public Accountants.
“Because the market is moving from the mature area, the state-owned enterprises, to the private sector, we are seeing problems there,” Cheung said in a May 8 interview. “For a lot of these small enterprises from China, there’s the question: are they ready to go public?”
The average size of a Hong Kong IPO fell to $136 million this year, the lowest in nine years, according to data compiled by Bloomberg. That compares with $301 million last year and $609 million in 2010.
Four Hong Kong-listed Chinese firms, including Boshiwa International Holding Ltd., a Shanghai-based Harry Potter apparel licensee, said their auditors resigned this year because of disputes over financial data or other key information. That’s four times the number in the same period last year and in the first quarter of 2010. Two other companies reported that their auditors needed more time to verify earnings.
Large investment banks operating in Hong Kong typically employ about five executives each who are licensed to act as sponsors on IPOs, said one banker. In total, there are about 100 such people in Hong Kong, this person said.
“It’s in everyone’s interest that we maintain integrity of the market,” said Bonnie Chan, a lawyer at Davis Polk & Wardwell, who is coordinating the response from the “most active” investment banks sponsoring Hong Kong IPOs. “The banks will certainly help the SFC in a constructive manner to analyze these issues to assist with the consultation.”
The SFC reviewed deal work by underwriters in 2010, when the city rose to become the world’s biggest IPO market as companies including AIA Group Ltd. went public. In March last year, the regulator published findings from the review, saying due diligence had been “inadequate” at times.
In some cases, the sponsors failed to keep proper records of their checks on the businesses of listing applicants, according to the report. In others, inadequate manpower and resources were used by sponsors during IPOs, the SFC said.
“The SFC has noticed and we have noticed there have been instances when sponsors do not appear to have taken their duties seriously enough,” said Mark Dickens, head of listing at the Hong Kong bourse, in a May 2 interview.
The regulator in April fined Mega Capital (Asia) Co. a record HK$42 million for failing to highlight misleading information in the share sale prospectus of Hontex International Holdings Co. Mega Capital, the sole sponsor on the deal, was also stripped of its corporate finance license -- an unprecedented penalty.
The rising cost and risk of sponsoring IPOs would add to pressures for underwriters already stung by falling fees and tougher competition. Banks earned 2.24 percent of IPO proceeds as fees last year, down from 2.94 percent in 2007, according to data compiled by Bloomberg. At the same time, the average number of underwriters on each deal increased to a record. Fees in the U.S. were 3.4 percent of proceeds last year, the data show.
“Hong Kong is the toughest market in the world to list in,” said Jeff Maddox, a capital markets lawyer at Cadwalader, Wickersham & Taft LLP. “More liability will make it even more expensive. Everybody will need to up their game.”