SFC imposed first revocation of IPO sponsor's licence to advise on corporate finance for due diligence failings

On 22 April 2012, the Securities and Futures Commission ("SFC") announced that it revoked Mega Capital (Asia) Company Limited's ("Mega Capital") licence to advise on corporate finance and fined it HK$42 million for failing to discharge its duties as a sponsor in the listing of Hontex International Holdings Company Limited ("Hontex"). This is the first time the SFC has revoked an IPO sponsor's licence over due diligence failings. The fine represents the highest financial penalty to date that the SFC has imposed on a sponsor.

The SFC's findings against Mega Capital provide an important indication about the SFC's expectations of sponsors' due diligence work, and the consequences of failing to meet those expectations. This case should be considered with the issues that the SFC identified in its March 2011 "Report on Sponsor Theme Inspection Findings". Mark Johnson, Gavin Lewis and Andrew Tortoishell analyse the decision below.  

Background

Hontex is a Mainland China-based company. Its business focuses on fabric sales and garment manufacturing. It was listed on the Main Board of the Hong Kong Stock Exchange ("SEHK") on 24 December 2009. However, the SFC issued a direction to the SEHK to suspend trading in Hontex shares just over three months after the listing, amid allegations that the IPO prospectus contained materially false or misleading information that overstated Hontex's financial position. Mega Capital was Hontex's sole sponsor, bookrunner, and lead manager.

Following the commencement of High Court proceedings by the SFC against Hontex for allegedly disclosing materially false or misleading information in its prospectus, the SFC investigated the practices and procedures adopted by Mega Capital in acting as the sponsor of Hontex's listing. 

The SFC's findings against Mega Capital

The SFC was of the view that Mega Capital had failed to discharge its duties as a sponsor, based on deficiencies in the following areas: 

• Inadequate and sub-standard due diligence work
• Failure to act independently and impartially
• Inadequate due diligence audit trail
• Inadequate supervision of staff
• Breach of sponsor's undertaking and filing untrue declarations with the SEHK

Inadequate and sub-standard due diligence work

The SFC considers that Mega Capital failed to conduct proper due diligence on the customers, suppliers and franchisees of Hontex and its subsidiaries ("the Group"). The due diligence was important for a proper assessment of the authenticity of the Group’s business performance. For example: 

• Material information such as transaction figures with the Group was missing from the questionnaires that suppliers and customers filled in during due diligence, but Mega Capital failed to follow-up on the missing information. 
• It rushed certain telephone interviews with suppliers and customers on the day that the listing application was filed. 
• It did not verify franchisees' information provided by Hontex, or obtain transaction records between franchisees and the Group.  

Failure to act independently and impartially  

The SFC considers that Mega Capital placed undue reliance on Hontex for important aspects of the due diligence work. For example, it agreed to Hontex’s request not to approach the Group’s customers, suppliers and franchisees directly, and instead conducted all the relevant interviews (which Hontex arranged) in the presence of Hontex’s representatives. 

Mega Capital also accepted at face value and without question Hontex’s claim that some of the customers and suppliers "refused to have face-to-face interviews with Mega Capital". It then attended Hontex-arranged telephone interviews with those customers and suppliers. 

Mega Capital also obtained through Hontex written confirmations from franchisees confirming that they were independent from Hontex. 

Inadequate due diligence audit trail

The SFC considers that Mega Capital failed to adequately document its due diligence planning and significant aspects of its due diligence work. For example, there were no records to prove what background or other searches it had conducted on the Group's customers, suppliers and franchisees. 

Inadequate supervision of staff

The SFC found that most of the due diligence work was handled by junior and inexperienced Mega Capital staff, without adequate supervision. Further, Mega Capital's responsible officers who were the sponsor principals for the IPO denied that they were responsible for the listing application. 

Breach of sponsor's undertaking and filing untrue declarations with the SEHK

The SFC found that Mega Capital breached its sponsor's undertaking to use reasonable endeavours to ensure that all the information provided to the SEHK during the listing process (including the information in the prospectus) was true in all material respects and did not omit any material information. It also appears to the SFC that certain of Mega Capital's declarations to the SEHK, for example that it had made reasonable due diligence enquiries, were untrue. 

Comment

Although the SFC found no evidence that Mega Capital was involved in any fraud, and took into account Mega Capital's otherwise clean disciplinary record, the SFC nevertheless considered a revocation of its Type 6 licence and a record fine appropriate. This is a clear signal that the SFC has sponsors' responsibilities high on its regulatory agenda. 

This disciplinary action also precedes a widely-anticipated SFC consultation on tightening sponsor's liability which is expected to commence shortly, and a hearing scheduled for 4 June 2012 at which the SFC will ask the court for an order to require Hontex to return its IPO proceeds to the relevant investors. In light of these developments, we can expect greater regulatory scrutiny of sponsors and the integrity of the listing process going forward. Financial institutions which undertake sponsorship work should examine / revisit relevant systems, controls and supervision covering such work, in particular due diligence work. If you require assistance in that regard, we would be happy to discuss this with you.