HONG KONG SFC CONTINUES TO IDENTIFY DEFICIENCIES IN SPONSOR WORK IN SECOND THEMATIC REVIEW

On 26 March 2018, the Securities and Futures Commission (SFC) published a circular and a report following its second thematic review of sponsors. As with its first thematic review, the SFC found deficiencies in standards of conduct, due diligence practices, and internal systems and controls. Particularly serious deficiencies and instances of non-compliance were found to be prevalent in the sponsor work done for Growth Enterprise Market (GEM) listings.

This second thematic review covered the work undertaken by 31 sponsors from October 2013 (when the new sponsor regime was introduced) to 31 December 2017. The first thematic review was completed in 2011.

In the report, the SFC sets out its observations on non-compliance of the requirements under:

• the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Comission (Main Code);
• the Corporate Finance Adviser Code of Conduct (CFA Code);
• the Main Board and GEM listing rules (Listing Rules).

The report also highlights some practices observed during the review which met the SFC's expected standards. Both the report and the circular set out the relevant requirements and the SFC's expectations on the areas highlighted.

The SFC has made it clear that sponsors with a checkered history in discharging its obligations may expect more frequent inspection visits and supervisory actions, and that future listing applications submitted by them may be subject to closer regulatory scrutiny. The SFC emphasises that it will not hesitate to take enforcement action against those responsible for non-compliance.

THE SFC'S OBSERVATIONS REGARDING NON-COMPLIANCE

The following are the SFC's key observations relating to non-compliance with the relevant requirements.

1. Main Code requirements

•  Reasonable judgement and professional scepticism
  • Failing to take reasonable steps to follow up on due diligence despite obvious red flags;
  • Following standard due diligence checklists without adapting them to the circumstances of specific listing applications.
• Interview practices
  • Scheduling important interviews with business stakeholders at a very late stage;
  • Failing to confirm the bona fides of the interviewees and that the interviewees had the appropriate authority and knowledge;
  • Failing to follow up on questions which were not answered during interviews.
• Record keeping
  • Being unable to provide relevant records to demonstrate that major issues were properly considered and disposed of;
  • Failing to maintain a proper due diligence plan and documentation of certain due diligence conducted.
• Corporate governance, systems and controls
  • Insufficient management supervision over sponsor work;
  • Being unable to demonstrate management’s involvement in the consideration of key concerns;
  • Failure by transaction teams to escalate critical matters to management (or its designated committees);
  • Insufficient training and guidance for staff;
  • Insufficient resources to undertake sponsor work, eg, sponsor principals lacking capacity to adequately supervise transaction team

2. CFA Code requirements 

• Chinese walls
  • Failing to maintain effective Chinese walls to prevent the flow of confidential information between corporate finance activities and other business activities. 
• Receipt or provision of benefits
  • Lack of written company policy governing the provision of benefits to clients;
  • Failing to comply with company policy on the receipt of benefits from clients;

3. Listing Rules requirements

The majority of sponsors had poor internal control procedures for independence checks, which are required to support their declarations of independence to the Stock Exchange.

THE SFC'S OTHER OBSERVATIONS

The SFC observed that during the period from October 2013 (start of the second thematic review) to 26 March 2018 (the issue of the report), 44 listing applications (except those relating to transfers of listing from GEM to Main Board) were returned or rejected due to sufficiently serious concerns. In a number of these applications, the sponsors' work or the application materials were below the SFC's expected standard. Further, some individual sponsors handled a relatively large number of these applications.

The SFC has also noted that 17 new sponsors had joined the industry since Jan 2016. They generally operate with fewer staff but undertake a large number of smaller transactions. The SFC is concerned that some sponsors, particularly the recent entrants, may not have sufficient experience in resolving difficult issues.

CONCLUDING REMARKS

In light of the SFC's circular and report, licensed or registered persons who engage in sponsor work are strongly advised to review the SFC's guidance and observations (of both deficiencies and good practices) and assess whether any enhancements are required to their systems and procedures.

Sponsor misconduct has been a priority of the SFC for a number of years and continues to be a key enforcement priority in 2018 (see the SFC's Enforcement Reporter Issue No. 3 of February 2018, page 2). The SFC has set up a number of specialised teams under the Enforcement Division, including a team which focuses on sponsor misconduct during listings. The SFC considers the sponsorship regime to be one of the risk management tools that are essential for preventing corporate fraud – hence, sponsors play a crucial gatekeeping function.

In the above issue of the Enforcement Reporter, the SFC indicated that it had investigated 15 sponsor firms and issued notices of proposed disciplinary actions against 8 firms and 4 sponsor principals. As of February 2018, the SFC was considering similar disciplinary notices and other enforcement actions against other firms and at least 5 sponsor principals.

Aside from enforcement, the SFC will continue to conduct onsite inspections of sponsors to monitor their compliance. It will also employ real-time regulatory tools when necessary "to supplement its ongoing supervisory and enforcement efforts to pursue wrongdoers, seek remediation and deter misconduct", such as objecting to listing applications in serious cases under the Securities and Futures (Stock market Listing) Rules (see the SFC Regulatory Bulletin: Listed Corporations Issue No. 1 of July 2017).