A new regulation that will hold listing sponsors criminally liable for failing to perform due diligence has led to investment banks hiring investigators to check up on listing prospects.
Bankers said the new rule, to come into force soon, would help prevent listing scandals but would also make many firms unwilling to sponsor small offerings.
The Securities and Futures Commission said last year it would tighten the regulation of sponsors from October this year. Under the new rule, bankers may face up to three years in jail and a fine of HK$700,000 if they fail in their due diligence of listing candidates.
The criminal liability reform for sponsors follows problems that emerged with several firms soon after listing.
In June last year, the High Court ordered sports fabric maker Hontex International to repay investors more than HK$1 billion for overstating its revenue and profit in its listing prospectus. The company had traded for only 64 days when the SFC suspended it in March 2010. It was delisted in March this year. The SFC revoked Hontex's sponsor Mega Capital's licence in April last year and fined it a record HK$42 million.
Steve Vickers, a Hong Kong policeman turned commercial investigator and now the chief executive of Steve Vickers and Associates, said that after the SFC announced the reform, his company had found more investment banks asking for help with pre-listing investigations.
"The new regulation has established a culture among the sponsors where they want to do more to comply with the new rules," Vickers said.
"While detailed efforts are conducted by law firms and accountants into the information provided by listing candidates, a wider, more holistic approach is beneficial in identifying practical or off-balance sheet risk.
"Our focus is to look at people and organisations in great depth and then compare this to the documented IPO material. We will compare our analysis with the contents of the listing documentation available and will highlight potential risks or other material issues."
Vickers said his company would check the "real" corporate structure to see if was different from that provided in the draft prospectus. Comments about the company would also be collected from former employees, distributors and vendors.
Vickers would also check on the integrity of key stakeholders, such as determining whether they were linked to criminal organisations.
Kelvin Ko, the managing director of Verity Consulting, said more sponsors were also hiring his commercial investigation firm for due diligence checks.
"The accountants and investment banks can check on the numbers and figures provided by the listing candidates, but we conduct on-site surveillance to see if the companies are providing accurate information," Ko said.
As an example, he said his staff would visit shops to check if turnover was as good as it was made out to be in financial statements.
Ko said in one case, a mainland company selling winter clothes claimed it had strong sales in the summer, which made the listing sponsor suspicious and hired his firm to investigate.
"We found that the company's shops were very small and not many people were buying its clothes during our surveillance period," he said. "The stocks at the shops were also limited. This meant the company may have inflated the sales figures."
The listing plan was abandoned after the investigation.
Ko said investigators could help uncover hidden risks, such as whether the company hired child labour or had poor fire-safety precautions.
"An accidental fire that causes the death of a child worker would be a big scandal for a company, which is a type of hidden risk for a new listing," he said.
Besides conducting investigations, Ko said his firm also trained investment bank staff on how to comply with the new SFC rule.
Joseph Tong Tang, an executive director of Sun Hung Kai Financial, said the new regulation would improve the quality of listings.
"But it also adds to the cost as we have to do more due diligence by either hiring more staff to do the checks or hire independent firms to do the job for us," Tong said. "Eventually, the costs will pass on to the clients.
"The new regulation has also led sponsors to be more selective in choosing listing hopefuls, which means small players may find it harder to get listed."