Enforcement cases highlight HK SFC's expectations of sponsor due diligence in IPOs with red flags

Two separate disciplinary actions reported last week against IPO sponsors in Hong Kong provide important reminders as to the regulatory due diligence expectations on sponsors, particularly when red flags are found during the IPO process. Both cases, which were taken by the Securities and Futures Commission, involved unusual, third party payment arrangements during the track record period. The sponsor firms were reprimanded for, among other things, failing to conduct adequate due diligence on these arrangements which should have raised red flags.

One of the disciplinary actions also involved a listing applicant with significant sales to a distributor. Distributorship business models can lead to regulatory concerns that sales to distributors may be used to artificially inflate demand for products and manipulate the track record. The sponsor firm was found to have failed to adequately diligence the background and independence of the distributor as well as the reasonableness of the sales to the distributor. It also failed to identify red flags in the supporting shipping documents relied on as evidence of the sales.

In this blog post, we draw out from the enforcement cases the regulatory expectations on sponsors where red flags, such as third-party payments and documentary irregularities, are discovered during the IPO process or where there are heightened risks due to material distributorships.

Third party payments

Third party payments raise red flags as they could be used to disguise the true source of funds and could potentially facilitate a fraudulent scheme, particularly if the third party is connected, for instance, to a supplier.

In one of the recent disciplinary actions, cash payments were deposited into the listing applicant’s Mainland bank accounts by five different third parties on behalf of a distributor. The sponsor understood that the listing applicant had nominated the third parties to obtain cash settlements from the distributor, convert the sums received into Renminbi and physically carry the funds in cash to the Mainland, depositing it into the listing applicant’s bank account. Reasons given for the arrangement were that the listing applicant’s Mainland branch did not maintain bank accounts in Hong Kong for receiving payments. Additionally, settlements from the distributor were subject to foreign exchange control regulations in the Mainland.

In the other case, the listing applicant received payments from customers through third parties which amounted to a significant portion of the payments it received during the track record period. The prospectus indicated that such third-party payments were not uncommon in the Mainland and were, on occasion, a matter of expediency. The sponsor did not, however, carry out verification on the relationship between the customers and the third-party payers and relied solely on statements made by representatives from the listing applicant as to the reasons for the arrangements without conducting independent due diligence.

In both disciplinary actions, the sponsors were found to have failed to perform all reasonable due diligence in respect of the third party payment arrangements. Based on the regulatory expectations set out in the disciplinary actions, where unusual third-party payments are discovered, a sponsor should:

• critically assess the reasons behind any third party cash settlement arrangements – sponsors should not merely accept at face value assurances that the arrangements were for convenience or a private arrangement;
• conduct independent due diligence to ascertain the truth and completeness of the reasoning;
• ascertain how the third-party payment practice had arisen, why it was in place, and why it is a legitimate practice and not one designed to give a false impression to the market;
• conduct due diligence to understand the relationships between the third-party payers and the customers;
• carry out sufficient due diligence to be comfortable that the payment arrangements do not raise concerns as to a circular flow of funds or similar scheme, having regard to the flow of financing arrangements. In the disciplinary case, for instance, it was not sufficient to get comfortable that the loan withdrawals had been properly booked in the necessary accounts – looking at the overall picture, all relevant matters needed to be considered to determine if there had been a circular flow of funds;
• interview customers and third-party payers to find out why such payments were necessary and why they had cooperated in the arrangements;
• if a third-party payer, when interviewed, does not know the reason for the payments, this should raise further red flags requiring follow-up enquiries;
• follow up on unwilling or untraceable interviewees; and
• maintain records to demonstrate the due diligence carried out, including discussions with the listing applicant’s directors and reporting accountants.

Distributors

Where a listing applicant sells to a distributor, there are heightened regulatory concerns that such sales may be used to inflate sales numbers during the track record period or give an unsustainable impression of demand. The Stock Exchange guidance for listing applicants with distributorship business models (GL36-12) requires sponsors to have performed sufficient due diligence on the fairness and reasonableness of sales to distributors during the track record period.

In one of the disciplinary actions, the listing applicant’s revenue increased significantly during the track record period due to sales to its distributor. However, the sponsor was found to have failed to assess the reasonableness of such sales. It also failed to ascertain the background and independence of the distributor. Based on the statement of disciplinary action, when a listing applicant adopts a distributorship model, a sponsor should:

• carry out due diligence on the ownership structure, management and employees of the distributors to ascertain if any is connected with the listing applicant, its directors, shareholders or suppliers;
• carry out follow up diligence on possible connections to ascertain the involvement of any connected person in the business of the distributor and the extent of the influence;
• conduct adequate due diligence to assess the reasonableness of the sales to distributors;
• interview major customers of the distributor to verify end-customer demand and the market; and
• conduct further independent assessments, for instance on the ultimate customers’ background and scale of operations (including arranging site visits as required).

Documentary irregularities

Irregularities in due diligence and verification documents raise red flags which cast doubt on whether those documents can be relied upon.

In one of the disciplinary actions, the sponsor failed to pick up on irregularities in the shipping documents which were being relied upon to verify the sales to the distributor. Based on the statement of disciplinary action, in carrying out due diligence a sponsor should:

• critically assess the reliability of documents relied upon;
• watch out for red flags which cast doubt on a document’s reliability and follow up on any issues identified;
• look out for incomplete identification documents or documents marked with the same number or “TBA”. For instance, in the disciplinary action, bills of lading were all marked with identical numbers/TBA;
• ensure dates of documents are consistent with other related documents or other supporting information; and
• where possible, verify documents against publicly available sources, for instance compare bills of lading with publicly available sailing schedules for the relevant vessels.

Principles guiding sponsor duties where potential red flags raised

One of the disciplinary actions was a review by the Securities and Futures Appeals Tribunal and the published Determination on the case sets out useful general principles guiding the duties of sponsors. It notes that a sponsor is required to examine the accuracy and completeness of representations made to it by the listing applicant’s representatives with the necessary degree of professional scepticism. This requires sponsors to make critical assessments of information with a questioning mind, being alert to information that may bring into question the reliability of statements or representations made. The Tribunal sets out some key general points worth noting in its Determination:

• Where a sponsor becomes aware of circumstances that may cast doubt on any information provided or may indicate a potential problem or a risk, the sponsor has an obligation to undertake additional due diligence to reach an accurate understanding.
• Undue reliance must not be placed on management representations, particularly where they lack detail or are bland. This is especially so when seeking to verify problematic information.
• Sponsors have a dual obligation to both the listing applicant and to the Stock Exchange and investors. In discharging its obligation, a sponsor must employ “due skill and care, tempered always with a healthy but rational degree of scepticism, doing so in the best interest of its client and – importantly – the integrity of the market”.