Introduction

In mid-2017, Mr Ashley Alder, Chief Executive Officer of the Securities of Futures Commission (“SFC”) announced its relative new “front-loaded, transparent and direct” approach to market regulation. As it happens, in or around March 2019, the SFC made its landmark and stern decision in reprimanding top investment banks, namely UBS, Morgan Stanley, Merrill Lynch and Standard Chartered and imposing on them record-breaking fines of HK$786.7 million in total, for failing to carry out their respective responsibilities as IPO sponsors for listing applications of China Forestry Holdings Company Limited (“China Forestry”) and Tianhe Chemicals Group Limited (“Tianhe”)[1].

It has been four years since the SFC implemented its front-loaded regulation and we have now entered the post-China Forestry and Tianhe era, it presents to us the appropriate time to review, re-visit and even reacquaint with the SFC’s regulatory expectations on the work of sponsors and related reforms.

Recent SFC’s enforcement actions on sponsor failures

Let’s start with the enforcement actions recently taken by the SFC against various sponsors’ deficiency and misconduct in listing process.

Action against Ample Capital Limited

On 18 October 2021, the SFC released a statement of disciplinary action against Ample Capital Limited (“ACL”) in relation to its failure to discharge its due diligence duties as the sole sponsor for the listing application of COCCI International Limited (“COCCI”). In particular, it appeared that COCCI’s major wholesale distributor’s (the “Distributor”) debt owed to COCCI together with its subsidiaries (“COCCI Group”) in the sum of RMB9,715,000 was settled by cash, in which third parties nominated by COCCI’s chairman received cash from the sole shareholder and director of the Distributor in Hong Kong, converted them into Renminbi and physically carried the cash to the Mainland and deposited the same into Mainland bank account of COCCI Group. Payments made in cash, which were then physically carried cross-border to evade Mainland’s foreign exchange control regulations, were clearly highly suspicious but ACL plainly turned a blind eye to them. Further, it was discovered that COCCI Group’s revenue rise was largely attributable to the Distributor and the ultimate customers through the Distributor, and COCCI and the Distributor and COCCI’s ultimate owners appeared to be interlinked; but ACL simply failed to make additional due diligence enquiries. Accordingly, pursuant to section 194 of the Securities and Futures Ordinance (“SFO”), the SFC reprimanded and fined ACL HK$5.5 million.

The SFC also suspended the licence of the responsible officer (“RO”) and sponsor principal for 17 months for his failure to properly supervise the execution of the listing application of COCCI.

Action against Yi Shun Da Capital Limited

On 19 October 2021, the Securities and Futures Appeals Tribunal (“SFAT”) upheld the SFC’s enforcement decision to reprimand and fine Yi Shun Da Capital Limited (“YSD Capital”) for its deficiencies in fulfilling the sponsor duties in the listing application of Imperial Sierra Group Holdings Limited (“Imperial Sierra”) in 2017, in which YSD Capital acted as its sole sponsor, global coordinator, bookrunner and lead manager to guide Imperial Sierra through the listing procedures. The SFC found that, as similar to ACL, instead of receiving direct payments from its customers, Imperial Sierra had been receiving third parties’ payments during the 3-year track record period leading up to the listing application. It is pertinent to note that these payments were highly significant and unusual, amounting to over 50% of Imperial Sierra’s total revenue in the first two years, and came close to 40% of the total revenue in the third year, with the details, reasons, relationships of the third parties being unclear. YSD Capital still failed to conduct adequate verification, interviews and independent enquiries, hence falling short of its sponsor’s obligations. Further, against the backdrop of these unusual and dominant third-party payments, there existed “suspicious transactions” where Imperial Sierra and/or its chairman might have provided “financial support” to some of the customer’s payments. SFAT condemned YSD Capital for its total failure to carry out any effective enquiry, if at all. YSD Capital was fined for HK$3 million.

Action against Fabian Shin Yick

For the sake of completeness, kindly note that SFC also prohibited Mr Fabian Shin Yick, former RO, CEO of YSD Capital and sponsor principal for Imperial Sierra from re-entering the industry for 20 months as he had found to failed to (1) exercise due skill, care and diligence in handling the listing application; (2) diligently supervise his subordinates to carry out the sponsor work undertaken by YSD Capital; and (3) ensure the maintenance of appropriate standards of conduct by YSD Capital[2].

Guidelines for Sponsors

Despite the record high fines imposed to the sponsors during China Forestry and Tianhe era, sponsor and its sponsor principal failures remain commonplace. Whilst the legal principles and expected role of sponsors in the IPO process can be found in ample case law, SFC has time and again published updated guidelines and circulars for sponsors, adapting to the ever-changing business and listing environment, which are definitely worth a read.

In the SFC’s Report on the Thematic Review of Licensed Corporations Engaged in Sponsor Business (“Thematic Report 2018”), SFC conducted thematic inspection covering licensed corporations engaged in sponsor business and identify common serious deficiencies and instances of non-compliances, giving practical guidelines to market participants of what the SFC expects and what qualifies as compliance. For example, indirect payment through third parties and the inter-linkage between different business stakeholders (e.g. supplier, distributor, customer, ultimate controller of the listed applicant and etc.) are expressly categorised as red flags (both red flags appeared in both cases mentioned above), calling for heightened scrutiny. Facing with these obvious red flags, sponsors should execute their due diligence exercise with utmost care, which would include conducting independent, comprehensive interviews and enquiries, maintaining updated search and database and etc, standards and requirements of which are set out in the Thematic Report 2018.

As an active response to the SFC’s front-loaded regulatory approach, the SFC Regulatory Bulletin Issue No. 4 (February 2020) (“Regulatory Bulletin Feb 2020”) was issued. Usefully, one of its aim was to address “recurrent problems in sponsor work include failing to apply professional scepticism and turning a blind eye to obvious red flags uncovered by due diligence”. Apart from sponsor’s response to red flags, the Regulatory Bulletin Feb 2020 touched upon the internal management within the sponsor and ultimately the role of sponsor principals. SFC reminded that for each sponsor engagement and/or task, senior management, who has the requisite experience and skills should effectively and sufficiently co-operate and supervise junior staff for the proper function of a sponsor, whereas sponsor principal are reminded that they are not rubber stamps for signing documents only.[3]

SFC’s proposed reform- sponsor coupling

Back in July 2017, when Mr Alder made his speech, he pinpointed that “…of course, tackling misconduct through traditional enforcement is always vital to send strong deterrent messages to companies, initial public offering (IPO) sponsors and other intermediaries. But we have convinced there was still a gap in regulation…”. This hits the nail on the head. The current commercial and market landscape exists where in an IPO process, the overall coordinator as the head of underwriting syndicate (“OC”) enjoys higher fees than sponsors, though sponsors generally incur more substantial costs and bear the risks of consequences in the event of regulatory breach. This lures sponsors to compromise their due diligence work to win the OC role amongst the fierce competition with the non-sponsors.

Apart from rounds and rounds of enforcement and disciplinary battles against sponsors, aligning with its strong emphasis on “earlier, more targeted intervention”, SFC provides another alternative through its “sponsor coupling” proposal, the consultation of which was issued in February 2021 and then completed and concluded in October 2021. In short, SFC proposes that the listing applicant must appoint at least one sponsor who will also be appointed as an OC for the IPO process. This appointment has to be made two months before filing the listing application. This aims to allow at least one sponsor to be free of potential incentives to limit its due diligence work as the OC role has been secured and this sponsor should be able to give comprehensive advice to the listing applicant.

In the consultation conclusion, after considering feedback from the market stakeholders, SFC has decided to implement the “sponsor coupling” requirement to IPOs on the Main Board of the Hong Kong Stock Exchange within nine months after gazettal.

Conclusion

It goes without saying that sponsors play a unique role in ensuring market quality: they coordinate the IPO process, give advice to directors and are centrally involved in and execute the due diligence exercise on the listing applicant. Hence, the SFC emerges to take a two-pronged approach to maintaining and upholding their standards: the traditional enforcement actions giving deterrent warning; together with the forward-looking and impactful “sponsor coupling” reform. While the reform is underway and the real and practical effects towards the overall market remain to be seen, market practitioners should keep abreast of the latest market and regulatory development to ensure that they can discharge their duties effectively, professionally and up-to-standard.