The SFC launched this week a much-anticipated consultation on proposals aimed at enhancing the regulatory regime of sponsors. The consultation follows concerns expressed by the SFC that standards of work carried out by sponsors have fallen short of reasonable expectations, particularly in light of the reliance investors place on sponsors as key gatekeepers of market quality.
According to the SFC, these proposals are not intended to affect those sponsors who are already fulfilling their role thoroughly and properly. However, that may not necessarily be the case as there are a number of proposals which introduce new or more onerous obligations on all sponsors. We await with interest the market response from sponsors, as the proposals could, if implemented, have a number of commercial, legal and practical implications.
The public consultation period will close on 6 July 2012.
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How could the proposals affect sponsors commercially?
- SFC Proposal: a single sponsor, who must be independent, should be appointed for each listing transaction
The SFC rationale for this is that where there is more than one sponsor there is an increased chance of key issues being missed. The SFC has also gone so far as to question whether there are any benefits in appointing more than one sponsor.
We expect this proposal to be met with resistance from investment banks and other non bank sponsors who may well argue that there can be benefits in having more than one sponsor. For example, different sponsors might bring different areas of expertise to the deal (e.g. country familiarity and industry sector expertise).
The SFC seems to acknowledge that it may not be successful in implementing this proposal, and as an alternative has suggested there be a limit on the number of sponsors, all of whom should be independent. Nevertheless, this proposal may well affect, in particular, how investment banks structure the provision of services to a potential listing applicant pre-IPO, and whether the bank invests on a pre-IPO basis, as the bank may not want to rule itself out from acting as sponsor.
- SFC Proposal: the SFC has stated that “no deal; no fee” arrangements, whether implicit or explicit, can lead to a misalignment of incentives for staff and should be avoided
It does not appear that the SFC are suggesting a ban of such fee arrangements but rather expressing disapproval. They also suggest sponsors’ fees, as opposed to underwriting commissions, should better reflect the amount of work involved in sponsorship. Since this suggestion bucks the trend for how fees are typically structured, sponsors may seek clarification that having its fees built in to the underwriting commission will not be held against them in assessing the quality of due diligence carried out.
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How could the proposals increase legal risk?
- SFC Proposal: it will be made clear in relevant legislation that sponsors have civil and criminal liability for untrue statements (including material omissions) in a prospectus
This is perhaps one of the more controversial items of the consultation; to date it has been unclear in law whether sponsors have civil and criminal liability under the relevant legislation. This proposal is also an indication that the SFC may become more active in taking enforcement action against sponsors. One view is that sponsors’ liability could make prospectuses even more legalistic, which would exacerbate one of the existing problems identified by the SFC with many prospectuses - i.e. their content being driven by a desire to avoid liability.
- SFC Proposal: a sponsor should not submit a listing application unless it has completed all reasonable due diligence on a listing applicant
There are a number of related issues which the SFC now wants a sponsor to confirm at the time of the “A1” listing application, such as the applicant having established adequate systems and procedures to ensure compliance with the Listing Rules.
This proposal, together with the proposed publication of the prospectus submitted with a listing application (discussed below), may result in sponsors seeking greater documentary assurances from listing applicants and advisers prior to submission, and accordingly the “A1” listing application process becoming much more cumbersome.
- SFC Proposal: a sponsor should demonstrate that it is reasonable for it to rely on the expert sections of the listing document, that assumptions are reasonable and that factual information is verified
The SFC notes that sponsors should not place uncritical reliance on experts’ work, including accountants’ and valuers’ reports. Accordingly, the SFC proposes that sponsors should be in a position to demonstrate that it is reasonable for it to rely on experts and their reports.
We expect some push-back from sponsors on this proposal, particularly in so far as it relates to accountants’ reports, which are based on an audit standard and prepared under well-established processes. Sponsors may argue that it may not always be possible for them to determine whether the bases and assumptions used by an expert are appropriate nor to determine exactly what factual information has been relied upon.
- SFC Proposal: the SFC has expressed concerns that sponsors may be over-delegating their responsibilities to conduct due diligence to legal counsel
The SFC also notes the growing practice of sponsors asking Hong Kong legal counsel to provide comfort letters relating to Hong Kong due diligence requirements, similar to “10-b-5” letters provided in connection with offerings into the US. The SFC states that in some cases such comfort letters might give rise to concerns that a sponsor has over-relied on legal counsel during the due diligence process and as a result has not met its own obligations to conduct reasonable due diligence.
Accordingly, it seems for the time being that such non-US comfort letters might not be beneficial. Certainly, the consultation paper is an indication that sponsors should keep extensive internal documentation to evidence the due diligence steps they have themselves taken. Such an emphasis on record keeping is by no means new, and is an ongoing theme in the SFC’s guidelines and approach to regulation.
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How could the proposals affect IPOs practically?
- SFC Proposal: the prospectus proof submitted with an “A1” listing application should be made publicly available
This proposal, which is similar to the process in the US, is intended to encourage the submission of high quality and substantially complete first submission proofs as it has been suggested that some sponsors over-rely on the regulatory commenting process to identify issues with prospectuses. However, if implemented, the proposal will have an interesting effect on the market because any changes to the prospectus after “A1” (including those arising from the Exchange’s review) will also be publicly available, giving issuers potentially less flexibility in responding to investor sentiment before they launch their offering. Also details of the issuer and its plans will be publicly available for an extended period, which may be unsettling both for the issuer and its advisory team.
- SFC Proposal: a sponsor’s management should ensure sufficient resources are allocated to an IPO; oversee the progress and the standard of due diligence; and be closely involved in resolving difficult issues
The SFC are increasingly looking at the internal organisation of teams undertaking sponsor mandates, and the amount of senior resource devoted to those mandates. This will be of particular concern to risk functions at banks, since the definition of “management” includes the sponsor firm’s board of directors, CEO, executive officers, responsible offers and other senior management.
More welcome to sponsors will be the SFC’s proposal to liberalise the regime requiring each sponsor to have two “Principals”, by contemplating that experience outside Hong Kong in a comparable jurisdiction can be taken into account in qualifying as a Principal.
- SFC Proposal: sponsors should report to the Exchange any non-compliance by listing applicants with relevant regulatory or legal requirements
This proposal is a change to the current position where sponsors are only required to report non-compliance concerns to the listing applicant itself, and only to comment upon non-compliance to the regulators when requested by them. It is unlikely to be welcomed by sponsors as it could potentially put them in a difficult position with their clients.
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