Sound due diligence aids compliance, say industry officials ahead of Hong Kong's new IPO sponsor regulations

Financial institutions in Hong Kong should take swift action to prepare for tougher legislation that imposes criminal penalties for sponsors of initial public offering (IPO) that fail in their due diligence, industry officials said. With the new rules just two months away, the use of investigation and risk management consultancies is quickly becoming a popular route to help institutions be compliant and avert scandals.

Under new regulations planned for Hong Kong listings, sponsors will be held criminally liable for failing to undertake due diligence, in a move that has prompted investment banks hiring investigations firms to check up on listing prospects.

Jack Clode, co-founder of the Blackpeak Group in Hong Kong, told Compliance Complete that there was already a minimum level of investigative due diligence imposed on IPO sponsors by regulators in Hong Kong. He said investigation firms could assist financial institutions to detect and measure risks that are not apparent during the normal course of business discussions or via traditional legal and regulatory compliance procedures

"This work is actively supported by a number of investigative firms and tends to be compliance-driven in nature," he said.

The Securities and Futures Commission (SFC) has set October 1 as the start date for the new rules to take effect. Under the new regime, bankers could be subject to potential penalties of three years' imprisonment and a fine of HK$700,000 ($90,200) for failing in their due diligence of listing candidates.

In a local example, in June 2012, the city's High Court ordered sports fabric maker Hontex International to repay investors over HK$1 billion for overstating profits and revenues in its listing prospectus. The company was delisted in March this year, but had traded for just 64 days when the SFC took action to suspend it in March 2010. The SFC also revoked the licence of Mega Capital — Hontex's sponsor — in April last year. Mega Capital was fined HK$42 million.

Following the SFC's announcement of the reforms, investment banks began asking investigative firms for more help with pre-listing investigations, said Steve Vickers, chief executive of Steve Vickers and Associates (SVA), a political and corporate risk consultancy in Hong Kong. He said the new regulations had strengthened the compliance culture amongst sponsors that needed to meet the new requirements — which would help them manage their regulatory, operational and perhaps most importantly, reputational risks.

Vickers added that while detailed checks were conducted by legal and accounting firms into the information provided by listing candidates, a wider, more holistic approach was more useful in pinpointing practical or off-balance sheet risk. Vickers said that his firm's focus was to delve into individuals and organisations in great depth and to compare their findings to IPO documents and in the process, raise material issues and other potential risks.

This approach checked the 'real' corporate structure to see if it was anything different from that described in the draft prospectus, he said. Company comments would also be collected from former employees, distributors and vendors. Additionally, the integrity of key stakeholders would be probed to determine whether they had criminal ties.

"Clear and accurate information is critical to successful IPOs … especially given the increasing requirement for disclosure and more transparency in exchanges around the world," Vickers told Compliance Complete. "This requirement is more difficult in the emerging markets of China and Southeast Asia. High profile disclosure in the U.S. of financial irregularities in Chinese-based but U.S.-listed companies has illustrated the need for in-depth investigative due diligence prior to the listing of these entities," he said.

Yet in the last decade, there have been many more IPOs for companies whose core operations are in mainland China rather than in Hong Kong.

"Regulators have upped the ante and underwriters are now more responsible for the companies they bring to market," said Violet Ho, Kroll's managing director for Greater China in Beijing. "Chinese companies have gained a controversial reputation in the U.S. market with recent [accounting] scandals, so it is not as easy for them to list there. Hong Kong has, therefore, become an ideal place for [mainland] Chinese companies looking for capital," she said.

Verifying the veracity of a party's claims is therefore critically important.

"They [counterparties] may give you information, but you may have doubts as to the whole picture of [what they disclose]. There may be a shadow of truth to what they are saying, but you still need an independent check to see if you are dealing with trustworthy individuals so that they do not embarrass or hurt you," said Ho.

While the territory's new regulation is expected to improve the quality of listings, but is also seen as raising costs, as greater due diligence is required.

Compliance implications

Given that the compliance divisions of many banking and financial institutions are understaffed and at times, not located in the same jurisdiction as the transactions at issue, the use of third parties in conducting IPO due diligence is, for all practical purposes, necessary because there are limits to what can be done in-house.

"Banks have many divisions, but their compliance and legal divisions are typically understaffed. They are also [generally] housed in financial centres, rather than where transactions take place," said Ho. "For Asia, compliance [staff] or legal counsel are typically based in Hong Kong or Singapore. They often do not have an on-the-ground presence in mainland China or where transactions take place," she said.

Likewise, corporate investigators who do due diligence research have international networks of professionals with expertise in a wide range of disciplines that enhance the in-house professional services of their clients.

A typical corporate investigation team will have backgrounds ranging from international affairs to engineering, and are also able to be critical of business plans in a wide range of areas since they have seen many cases of failure when working on projects for 'the other side of the house' when businesses start to fall apart, said Julian Russell, director of Pacific Risk, a boutique political and business risk advisory in Hong Kong.

"For this reason corporate investigators are also alert to the various means of exaggerating capabilities and even deception by the subjects of their investigation. The international connections of corporate investigators also bring in the international expertise of foreign environments that may not be available to local in-house researchers," he told Compliance Complete.

Russell said the ability to operate discreetly without obvious connections to the client is also sometimes an advantage. "Environmental and social compliance issues are typical of issues addressed by corporate investigators," he said. "For example the ability to discreetly approach factory workers and discuss their working conditions may result in learning potential liabilities that investors may not be aware of."

While law firms and accountancies can check on quantitative data provided by companies seeking to list, on-site visits by investigators are also necessary for proper due diligence. It is usually through such a hands-on approach that banks can gauge whether companies are providing accurate information.

"Experience has shown that whilst 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," said Vickers. He added that such efforts complemented professional services provided by lawyers and accountants.

For example, investigators can visit companies' places of business to determine if representations regarding revenues and turnover bore any resemblance to what was actually observed, or if profits and sales were being exaggerated.

Such issues can impinge on a financial institution or a corporation's reputation, but there are also business-centric issues for compliance and legal professionals to grapple with.

"Compliance and legal know that they are the custodians of their bank's risk management and reputation," said Kroll's Ho. "But they have to keep a balance between internal risk management and diplomacy with other departments."

This, she said, was because for any financial institution, compliance was a cost centre.

"They are not bringing in the business; other teams in sales and operations do that. But the investment banking environment is now more competitive with more players pursuing the same deals," she said.

There is an inherent conflict of interest between compliance and the business people at any financial institution — whether stated or hidden. "Those guys [investment bankers] want to close a deal because their compensation and careers are tied to that. Compliance is there to save a bank from reputational loss and sometimes, they need to say 'we want to stop a deal because there are certain risks'," Ho said.

Yet, it is still prudent to begin investigative due diligence (IVDD) as early in the process as possible.

"IVDD is a critical part of any major transaction but is especially important in the pre-listing process. A huge amount of material is generated in support of the offering document, but much of this important documentation is often unverified, incomplete and on occasion downright misleading," said Vickers. The goal, he said, was to provide a detailed understanding of the actual circumstances of the company to be listed and to highlight, at an early stage, any material or important issue. "IVDD conducted early in the IPO process can save time, money and potential embarrassment, in that the investigative process will swiftly throw up key issues or potential 'show stoppers'."

Doing so can either facilitate a complete disengagement from the listing or help deal with such matters before they adversely impact a potential listing.

"It makes a difference as to when you start your due diligence. If you start when you are so invested in a deal and so much time, effort and resources have gone into it, it can be quite challenging," said Ho.

Since legal and financial due diligence are labour-intensive and costly, institutions tend not to want to undertake it until they are sure that they want to go ahead with a transaction.

"By that point, it is hard to put a plug on it. With investigative due diligence, you look at people [involved in a deal] early on and by doing so, you find more red flags and it ends up costing less," said Ho. "Early on in a deal, you can walk away and face fewer obstacles. The key is to identify the issues you need to focus on early enough in the process," she added.

Being an independent third party matters

An independent, outside investigator can also strengthen the hand of compliance and legal departments in internal debates with their investment banker colleagues.

"The way we help them is that they can say to their sales colleagues, 'look, this information comes from an independent, third party," Ho said. "In that sense, we make the lives of compliance and legal people easier."

Similarly, Blackpeak's Clode said his firm worked with financial institutions that understood the value of investigative research and due diligence as a risk mitigation tool to protect their brands and reputations.

"These institutions typically go way beyond minimum requirements stipulated by regulators and appreciate the value that this kind of work brings to their operation," he said.

Like all consultants, being external helps one be objective to any project, being free of internal politics and vested interests, some said.

"The ultimate objective of the corporate investigator is however to give clients a holistic view of the potential risks of any investment, so these risks may be managed and everybody succeeds," Russell said.