Don't pass the buck to bankers
There has been much talk over the past few weeks about the proposal by the Securities and Futures Commission to strengthen the regulation of sponsors of initial public offerings.
Such sponsors - investment banks or brokers - oversee a firm's application to list on the exchange.
The SFC wants these sponsors to be accountable for the contents of listing documents. This ensures that the information in IPO prospectuses is true, accurate and complete. So far, so good - what's not to like?
The catch is that the SFC has also proposed holding sponsors criminally liable for false statements (including important omissions) made in offering circulars.
In other words, bankers involved in the offer documentation for IPOs could be sent to jail if a firm manages to list using false information.
Certainly, Hong Kong has had its share of fraudulent IPO issuers. But under the current rules, the worst that can happen to a sponsor of such a listing is the loss of its licence, as well as a hefty fine.
This recently happened to broker Mega Capital. Its licence was revoked last month after the commission found it had performed substandard due diligence on the listing of Fujian-based garment maker Hontex International. Mega Capital was also fined the not inconsiderable sum of HK$42 million.
To understand why the proposal by the SFC is such a big deal, it is important to know how a prospectus is generally drafted. And here, size matters.
For a smaller IPO, the sponsor generally holds the pen; while the company, its legal advisers, accountants and other experts, such as property valuers, chip in to ensure the accuracy of the prospectus. This due diligence includes inquiries with suppliers and customers, as well as site visits to inspect a firm's production facilities.
Lawyers (usually hired by the issuer) hold the main responsibility for drafting the prospectus of a larger deal.
The prospectus is then revised while each statement in it is verified through lengthy drafting and verification meetings that address the hundreds of questions that Hong Kong Exchanges and Clearing (HKEx) throws at the team.
The truth, however, is that while sponsors are required to submit a declaration to the HKEx, at the end of the day the prospectus remains the issuer's document. The board of directors has to sign off on its contents.
The lawyers also issue opinions on what has been described. Meanwhile, the accountants sign comfort letters that trace financial information to the company's accounts.
But for the international version of the prospectus, the banks themselves take very little responsibility. They will generally confirm that their names and addresses appear as they are, and that the short statement on price stabilisation has been appropriately worded. By and large, that's it.
If something goes badly wrong with the company, investors will sue the issuer, who in turn will sue the lawyers and the accountants. Everyone will sue everyone else. And, let's face it, this is likely to happen in the United States more than in any other jurisdiction - which is why the banks want to minimise their accountability there.
There is some sense in the SFC's consultation paper. Sponsor banks should be held responsible when issuers clearly defraud investors in a public offer.
But there are practical problems with the proposals. For example, the regulator wants to limit the number of sponsors on an IPO, to focus responsibility on just one or perhaps two banks. But in my experience as a former IPO banker, it's better for several sponsors to be involved.
The jockeying and outwitting of each other that goes on between the various houses working on a prospectus often results in tricky issues being covered from various angles - that's surely better than relying on advice from a single firm. And what if the advice from the sole sponsor is wrong?
Laying the blame for fraud so prominently at the sponsors' door also risks deflecting from issuers' responsibilities.
The regulator might also focus on other matters, such as issuers' common habit of appointing independent directors just ahead the filing for an IPO. Independent directors should really be fully on board (no pun intended) long before a prospectus is wheeled in front of investors for the marketing push.
The SFC might also want to tighten up the screening of independent directors, to make sure they are not silent partners of the chairman or CEO, as is, on occasion, the case.
A little more accountability is in order when aiding and abetting is invoked. But ultimately, issuers remain the source of fraud - and that is where the focus should be.
Philippe Espinasse, a former investment banker, is the author of IPO: A Global Guide (HKU Press)