Acting as a sponsor for Chinese companies listing in Hong Kong has become a high-stakes game. Danielle Myles looks at the obstacles along the road, and how to get mainland listing applicants over the line.

HKEX embedded

Sponsors in Hong Kong may have the toughest gig in the initial public offering (IPO) universe today. They are the most senior advisers on listings in Asia’s financial centre, and while the role is typically performed by one of the bookrunners, they face pressures and obligations that are a world away from those of a lead underwriter.

For one thing, it is a fiercely competitive market. In addition to the US and European bulge brackets that dominate other listing centres, there are Australian and Chinese banks, plus a whole raft of smaller specialist firms competing for work. On top of that, Dealogic data reveals that 85.17% of flotations on Hong Kong Exchanges and Clearing (HKEx) between 2013 and June 2016 were out of mainland China, a category of issuer with a tarnished reputation since a series of accounting scandals and a lack of transparency in their home market.

Scepticism over the quality of HKEx’s issuer pipeline is only increased by the China Securities Regulatory Commission, which, given the long queue to IPO on its A-share market, is perceived simply to be rubber-stamping requests to list overseas without the substantial checks it undertook in the past.

Checks and balances

The mainland’s dominance of HKEx’s issuer pool – and the fact retail investors conduct up to one-third of trading on the exchange – has created a regulatory snowball that makes sponsors increasingly responsible for which companies come to market, and how much investors know about them. It starts with regulators not being in a position to check an applicant’s background, meaning sponsors are best placed to make sure a company’s business, prospects and balance sheet are on the level. As such, they are required by law to authorise the issuance of a prospectus, including via a written declaration to HKEx that the prospectus is regulation-compliant. In turn, Hong Kong’s Securities and Futures Commission (SFC) has insisted that sponsors can be held liable for misstatements or omissions. The SFC declined a request for comment on this article.

Sponsors’ gatekeeper function, and the liability and accountability that entails, now overshadows every other aspect of their role.

“Years ago, bankers wouldn’t take responsibility for anything other than the way their name appeared in the prospectus, and a statement saying they may conduct price stabilisation. Everything else was the responsibility of the issuer and/or selling shareholders,” says Philippe Espinasse, a former regional head of equity capital markets with Macquarie and Nomura in Asia. “But, working as a principal now on an IPO in Hong Kong, if there’s an issue with disclosure, it’s your name and, possibly, your job on the line.”

Revamping the rulebook 

This is a reality that JPMorgan knows all too well. In March, it became the first global investment bank to appear on HKEx’s so-called ‘name and shame list’ for its work on Shenhua Health Holdings’ draft prospectus (known locally as an A1 filing). The policy of publishing the names of sponsors on A1 filings rejected by the exchange for incompleteness is part of a package of reforms from 2013.

HKEx’s policy was a result of the emergence of a two-tier sponsor market, in which the bigger banks maintained a high standard of due diligence and execution, while some smaller local firms took a less stringent approach. The changes were designed to clamp down on listing indiscretions involving the latter, many of which were formally reprimanded by the SFC. They include Mega Capital, whose licence was revoked in 2012 for false and misleading information included in fabric manufacturer Hontex’s prospectus, and Sun Hung Kai International, which was suspended and fined in 2014 for due diligence failings regarding the IPO of Sino-Life Group.

The JPMorgan incident reveals that even the most reputable of sponsors can be ensnared by the revamped rulebook. A consultation launched three months later proposing that the SFC’s chief become more deeply involved with listing policies and decisions means both overseers, in their own way, have signalled their intentions loud and clear. “The SFC has definitely taken a tough stance on [diligence] and I think it is trying to get a message across to sponsor banks,” says Robert Cleaver, partner and head of corporate Asia at law firm Linklaters. “And I suspect the exchange had been waiting to make an example of an international bank to show they aren’t immune.”

Mr Espinasse does not believe the incident will have a significant or long-term impact on JPMorgan’s sponsor business. But, naturally, competitors are making the most of it and have received client queries on the US bank’s merits as a sponsor. JPMorgan did not respond to a request for comment for this article. The reputational damage it has sustained is, arguably, unjust, not only because it is unknown how many other bulge brackets worked on A1 filings returned before the publishing policy took effect, but also because a number have worked on the long list of IPOs that were approved, only to be later scrutinised by regulators and short-sellers for pre-listing issues.

For example, UBS acted as sponsor in the 2009 IPO of China Metal Recycling, which was delisted in February after regulators found the company had inflated its performance, revenue and profit in its listing application. Tianhe Chemicals Group – brought to market in June 2014 by UBS, Morgan Stanley and Bank of America Merrill Lynch – suspended its shares three months after listing following allegations (which it denied) by research firm Anonymous Analytics that the prospectus vastly overstated the company’s profits. As of June 28, 2016, its shares were suspended again after a failure to publish its 2014 annual results and 2015 interim results. (In March, Tianhe appointed an independent forensic specialist to investigate issues identified by its previous auditor, a condition for the resumption of trading in its shares.) UBS and Morgan Stanley declined to comment; Bank of America Merrill Lynch did not respond to requests for comment on this point.

A question of suitability

None of these sponsors have been formally implicated, but situations such as this raise questions as to which companies on HKEx were suitable for listing in the first place and would have passed muster if subjected to the post-2013 rulebook. What is more, according to HKEx’s website, as of the end of May, Tianhe is just one of 24 companies whose shares have been suspended for more than three months due to irregularities, regulatory investigations or failing to publish financial results. Some of this is down to the SFC’s increased focus on due diligence; if it appears that profit forecasts or other disclosures in a prospectus could be inadequate or mis-stated, the regulator, or the company at the regulator’s request, will investigate the pre-listing diligence that leads to a suspension.

“There have been dozens of such cases in Hong Kong over the past three or four years,” says Mr Espinasse, who co-authors the manual for Hong Kong’s sponsor exams. “I think that’s much worse than a draft prospectus being rejected – before shares have even been distributed – and bankers being told to do more work.” Yet these investigations are not public, and the sponsors on these deals are not subject to the same disclosure policy that applies if the issue was discovered pre-listing.  

Irrespective of whether the publishing policy is fair, it raises the stakes when vetting mainland listing candidates. They are raised still further by the fact that the strongest private companies and biggest state-owned enterprises have already come to market, meaning the Chinese issuer pool is dominated by second-tier financial institutions, a number of which Mr Espinasse says have performed poorly on the investment side or have balance sheets significantly affected by non-performing loans. “If you’re held accountable for due diligence, and what you’re working on is not a great product to start with, it means that you must scrutinise the issuer even more,” he says.   

The summaries periodically published by HKEx on why it has knocked back A1 filings are instructive. The reasons why three applications were returned (meaning they can be reworked and resubmitted after eight weeks) during 2015 included material omissions regarding loans guaranteed by connected persons, and a compulsory winding-up order against a company overseen by one of the applicant’s directors. Eight prospectuses were rejected outright for reasons including unlicensed operations and principal assets in a high-risk jurisdiction.

Revamping the rulebook 

However, it is anecdotal evidence from those who know the market best that reveals the golden rules and best lines of inquiry when vetting China listing applicants. “Sometimes it’s really obvious stuff,” says Mark Dickens, HKEx’s former head of listings and former SFC executive director of market supervision. “Are its relationships with customers and suppliers genuine? Does the company own its own property and plants? Sometimes it goes to whether the business exists at all.” Examples exist of sponsors being given the wrong address for a counterparty, with the imposter being paid to respond as instructed.  

Accounting frauds follow a similar pattern. There have been instances where an auditor is given an inflated bank statement, which is later confirmed by a bank officer who has a close relationship with an executive at the company. “Of course there are more sophisticated versions of that, but in effect, it has proved very easy to circumvent the processes, especially if they know what the process will be,” says Paul Gillis, professor of accounting at the Guanghua School of Management. That leads to a more fundamental discrepancy regarding the use of written contracts. “The main difference in the West [is that] business practices rely heavily on documentation and internal controls, whereas in China business is done more through personal relationships and individual trust,” says Mr Gillis.

Understanding this can make or break a vetting process. Indeed, the situation of China Media Express Holdings and China Yingxia listing on Nasdaq via reverse mergers between 2005 and 2011 only to delist following fraud allegations can partly be attributed to the fact that some US advisers and intermediaries did not know how to apply due diligence to mainland applicants.

In private hands

Unpicking accounting issues is further complicated by the prevalence of related-party transactions and inter-company loans. “Unlike in Europe, across most of the exchanges in Asia you commonly have founder-owned and controlled groups, particularly among the multi-business, multi-industry conglomerates. That can mean getting to the bottom of a complex web of information, which is often not straightforward,” says Claire Suddens-Spiers, head of Rothschild Equity Advisory, Asia. The job is made harder still by legitimate businesses often working in very different industries.

Because most companies now looking to list are privately owned, their relationship with the government must also be investigated, particularly if their history pre-dates China’s first rounds of privatisation. “If they have been around that long, they must have been taken out of the state,” says Mr Gillis. “That is a story that has been widely under-reported, how some of these companies ended up in private hands.” 

A controller’s involvement in a criminal investigation, even just as a witness, must be probed, but obtaining background checks on people in China can be extraordinarily difficult. Regulatory breaches so severe that they suggest a lack of respect for law enforcement also warrant close attention. Greater vigilance is now needed when assessing applicants in sunset industries and those looking to raise a relatively small amount of capital compared with the fees involved. These factors can indicate a company is not listing to expand its business, but rather plans to dispose of its assets and sell the shell – the going rate is reputedly HK$500m ($64.45m) – to an entity looking to go public via a back-door listing. An HKEx guidance letter issued in June states that because these companies affect the quality of the market, it will take a more focused review when reviewing listing applicants with these characteristics. In short, sponsors must try to spot ulterior motives for listing.

The number of returned applications was much higher before the new regime took effect; 15.8% in 2012 compared with 6% and 1.2% in 2014 and 2015. An HKEx spokesperson says there is no doubt that the policy of naming those sponsors has helped improve the quality of A1 filings, alongside a new Paragraph 17 in the SFC’s Code of Conduct which sets out a lengthy and prescriptive due diligence checklist that sponsors must complete. This is a laborious process and some feared it would encourage a box-ticking mentality, but in practice it has removed any excuse for falling foul of the rules. “Paragraph 17 is a big step forward as it’s very hard to say you didn’t know what you had to do, whereas it was somewhat easier beforehand,” says Mr Dickens.

Dodging liabilities

But no set of guidelines can make auditing and accounting issues easier to spot. “It’s an incredibly difficult job to do and I think it’s really hard to get that right,” says Mr Gillis. “It’s a high-risk business.” So much so that some sponsors have changed the cost-benefit analysis of taking on a mandate.

Historically, the sponsor role was the most sought after on an IPO, not only because it is the most lucrative, but also because it set the bank up for an ongoing relationship with the client. But the size of companies listing in Hong Kong today means this is less important. Some principals are opting for the bookrunner role on certain deals to avoid the liabilities that come with being a sponsor. One banker recalls a situation in which he identified, and subsequently cleared, a potential issue regarding a mainland client. While his bank felt it could deal with the issue via disclosures and brought the company to market, the other sponsor was uncomfortable and dropped out of the deal. 

The bigger banks, in particular, are now much more selective when taking on mandates, yet some deals are still killed after being cleared by the first stage of a bank’s due diligence. What makes these decisions so difficult goes to the heart of the sponsor concept.

“The role does come with potential conflicts. On the one hand, banks are trying to make money by bringing these companies to listing. On the other, they are required to act as gatekeepers on behalf of the regulators and tell applicants they can’t list if they are not suitable,” says Mr Cleaver of Linklaters.

As a result, the gatekeeper function can suffer, with some sponsors being less scrupulous than others. “It’s such a ferociously competitive market that those struggling to get the right mandates might take on deals that maybe aren’t that great, and might feel some pressure to take a lighter touch to the due diligence in order to get those companies to listing,” adds Mr Cleaver. 

Regulatory tightening may have improved listing processes, but it is powerless to improve the issuer pool or end the two-tier sponsor market. It has prompted some bankers to query whether a stricter licensing regime for sponsors might have been a better approach. If JPMorgan remains the only bulge bracket on HKEx’s list, perhaps the regulators will start to ask the same thing.

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