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Jane Moir

A little white lie over market share. A slightly embellished growth story. Creative profit figures. In a hot market for initial public offerings comes the risk of dressing up a listing. Style over substance.

But if the company or its directors decide to take a more rosy view of its financial affairs, should its IPO sponsor shoulder the blame for having been hoodwinked?

Such is the dilemma an unusual alliance of 14 investment banks claim to have found themselves in.

The banks - including Goldman Sachs, ING Bank, Merrill Lynch, Nomura International and Morgan Stanley - have baulked at a proposal to tighten rules on IPO sponsors, saying it forces them to take front-line responsibility for incomplete or inaccurate disclosure by issuers and their directors.

In short, they will have to stand in the shoes of shonky companies when it comes to laying blame.

The picture being painted by regulators is  less draconian. In fact, the investment banks have got it all wrong.

All that is expected is that the sponsors do proper due diligence. In a nutshell, 'know your client'.

In the next few months, Hong Kong Exchanges and Clearing and the Securities and Futures Commission (SFC) will set out a revamp to the listing rules concerning IPO sponsors, the aim being to bridge an 'expectation gap' between investors, sponsors and regulators.

A number of corporate scandals and large failures have put the spotlight on those responsible for bringing companies to the market. Mainland corporations in particular are using Hong Kong's stock market to raise capital. This poses 'particular challenges' to sponsors which have to verify information.

In the case of Euro-Asia Agricultural (Holdings) for example, its flamboyant chairman Yang Bin  allegedly inflated revenues by 20 times over a four-year period. The company  crashed in 2002.

The main thrust of the regulators' proposal that has drawn fire from the investment banks is that sponsors sign a declaration in a prospectus attesting to the due diligence work carried out.

To the investment banks this translates as putting the sponsors in the front line of liability.

Not only is this impractical in terms of the due diligence required, it is 'legislation by the backdoor', stretching liability beyond the law as it stands, and pre-empting a review of the Companies Ordinance in relation to prospectuses which should take place towards the end of the year.

Ultimately, the proposal would  diminish the responsibility of the main offenders. 'One of the big points we were trying to make is the person who stands at the front of the responsibility line is the issuer and its directors,' says Stephen Fletcher, a partner at Linklaters who acts on behalf of the 14 investment banks.

He uses the IPO of a supermarket as an example. The grocer perhaps has 150 outlets and dairy does particularly well.

'[The investment bank] can go visit all 150 supermarkets. How does the investment bank pick? How do you test whether the dairy products are doing well? Please understand the world is not perfect and we don't have a million hours to  check every supermarket.'

The regulators seem almost perplexed by the alliance's argument.

'I think they have misunderstood,' says Ashley Alder,  an executive director of the SFC.

'A lot of what they have said is that 'it's not fair for us to stand in the shoes of management'. That's not what we are asking them to do. We are not asking them to be a guarantee for management default.

'What we are doing is saying in terms of due diligence you need to be doing a proper job up to international standards.'

A set of due diligence criteria has been set out by the regulators in the proposal.

'What it boils down to is know your client,' Mr Alder stresses.

It is astonishing the extent to which some investment banks do not know their clients, he adds.

This becomes apparent in some applications for listing where a sponsor will rely on the vetting process to meet the criteria needed for an IPO in Hong Kong. Instead of getting the IPO in order, they rely on the regulators to return the application with a check-list of what  is needed to meet the listing rules. In other words, they let the regulators do all the work.

The other danger is that in a bull market for IPOs, the opportunity is there to churn out offerings to generate fees. The companies would then be set up for manipulation after listing on the exchange.

Ultimately, however, there is a fundamental need to assess the business case.

'Does it stack up in the context of the industry in which it operates?' Mr Alder says. 'For example, if a company has a history which is largely dependent on related party transactions, we need to get to the bottom of it.'

How does the company's story fit with the industry background?

The SFC, however, already has powers under the Securities and Futures Ordinance to punish sponsors for being negligent where false or misleading information is disseminated. Amending the listing rules, the investment banks may argue, is superfluous.

It begs the question as to just how lax some sponsors are when they apply for an IPO and how much work the regulators do in the vetting process. It was noted in the consultation paper that other jurisdictions have moved to a system of post-vetting: with enforcement taken against the issuer, directors and sponsors in relation to  defects.

This is not being advocated for Hong Kong now, but 'the ground should be prepared', the regulators stress.

NO MORE MAGIC TRICKS

Main proposals to include in the listing rules relating to sponsors:

- A list of acceptable sponsors to be set out

- Sponsors should have at least four senior staff as eligible supervisors who give a personal undertaking to comply with listing rules

- Sponsors sign a declaration in the prospectus about due diligence work they have performed

- Sponsors should have paid-up capital of at least $10 million

- A code of conduct for sponsors and independent financial advisers to be incorporated into listing rules

- Further guidance on independence requirements of sponsor or independent financial adviser



Rules revamp targets sponsor culpability