The Securities and Futures Commission (SFC) has issued a guidance note to directors of Hong Kong listed companies on their duties in respect of corporate transactions. The guidance note focuses on ensuring that deals done by listed companies are fair and reasonable and in the best interests of the company and its shareholders as a whole. Emphasis is put on the need for adequate due diligence on transactions and guidance on when independent valuations and other professional advice should be obtained. Directors who fail to follow the guidance may face regulatory enforcement action if future deals go wrong. This is particularly likely where a company announces a substantial decline in the value of an acquired asset shortly after completion.
The guidance note has been prompted by the SFC's concerns over a number of unreasonably highly-priced acquisitions and undervalued disposals by listed companies which suggest that directors may have failed to properly diligence deals or to obtain valuations in appropriate circumstances with resulting losses for shareholders. The guidance note sets out a reminder to listed company directors of their obligations and the steps they should take in assessing whether to proceed with any corporate acquisition and disposal.
In this bulletin we highlight the key aspects of the guidance note.
Expected level of due diligence for corporate transactions
The guidance note sets out the SFC's expectations on the due diligence that directors should carry out prior to proceeding with any corporate transactions. It also highlights certain areas which, where relevant, will require additional due diligence focus. In relation to a proposed transaction to buy or sell a business or asset, the directors must:
- understand the nature of the business or asset to enable informed deliberations about the transaction;
- carefully consider all information relevant to assessing the merits of the transaction;
- take all reasonable steps to verify the accuracy and reasonableness of material information likely to impact the valuation. This requires directors to be satisfied that financial forecasts and assumptions are reasonably justified. Directors cannot simply rely on the forecasts, assumptions and business plans provided and must understand, question and, where necessary, verify these as far as reasonably possible. Relevant factors to be considered in assessing forecasts and assumptions include the financial status of the asset or business, its historical performance and prospects, peer companies and macro-economic factors such as economic, political and industry conditions and relevant markets;
- if appropriate, engage professional valuers and other advisers (see below as to the guidance on when a valuer or other adviser should be engaged); and
- pay particular attention where certain higher-risk areas are present. These include where:(i) the business or asset has a limited track record, is loss-making or only makes a small profit or has minimal or negative net assets;(ii) valuations are based on forecasts with no historical basis or assume aggressive growth;(iii) sales contracts are non-binding or recently signed, calling sales projections into question; and(iv) any recent previous transfers of the asset or business have been at different valuations.
Appointing an independent valuer - when, who, how and why
The guidance note sets out a series of factors to help directors assess when it is necessary to appoint an independent valuer and whether the valuer is suitably qualified, together with guidance on their engagement terms. In relying on a valuation report, directors must have acted reasonably. Carefully selecting and instructing the valuer, and critically assessing and testing the valuation report will be important factors in demonstrating whether directors have acted reasonably in relying on a valuation report.
- When? – Factors that directors should consider is assessing whether to appoint an independent valuer include:(i) where the directors themselves lack sufficient experience to assess the business or asset or its valuation;(ii) where the business or asset is new, or information about the business or asset requires professional advice or scrutiny to properly assess its merits;(iii) the transactions relative size and significance to the listed company;(iv) the level of risk and the transaction's complexity; and(v) if any of the directors have any conflicts of interest.
- Who? – Any valuer appointment must:(i) be independent (of the listed company, the counterparties and their connected persons) with no personal interest in the outcome of the transactions;(ii) be suitably qualified and reputable such that the valuer's opinion can withstand challenge; and(iii) have relevant expertise and adequate resources to perform the role.
- How? – The valuation report will be used by the directors to assess the transaction and whether the price is fair and reasonable. The scope of the mandate with the valuer must, therefore, be sufficiently broad to ensure the report provides meaningful information for that assessment. A mandate to prepare a valuation based solely on projections or forecasts provided, without further testing, is unlikely to be sufficient. When instructing a valuer, directors must provide all material information likely to affect the valuation.
- Why? – In exercising their duties, it is not sufficient for directors to simply obtain and rely, exclusively and without question, on a valuation report. Such reliance must be reasonable. A valuation report should be used as a tool to assist directors in assessing the merits of a proposed transaction, based on their own judgement, The guidance note stresses the directors must make an "informed decision" which will involve analysing the full valuation report and making follow up enquiries of the valuer. Directors should be engaged and critical in their review with more complex, higher-risk or significant transactions meriting greater director involvement.
Appointing financial advisers and other professionals
Listed companies should also follow the above guidance applicable to valuers (with appropriate modifications) when appointing financial advisers and other professionals.
In relation to financial advisers, the guidance note specifies that the appointment mandate should require the financial adviser to review the reasonableness of any relevant assumptions in respect of the valuation. Where a valuer (other than a property valuer) is also engaged, the mandate should specifically require the financial adviser to comply with its obligations under the Corporate Finance Adviser Code of Conduct (CFA Code) in respect of reliance on work by experts or other professionals.
The CFA Code requires financial advisers to undertake reasonableness checks on the experience and expertise of the experts and professionals appointed. In addition, save for certain categories of professionals (such as property valuers and legal advisers), a financial adviser is required to review and discuss with their clients and the relevant expert, the qualifications, bases and assumptions the expert has adopted.
The SFC has issued a circular to financial advisers to remind them of their obligations to clients when advising on corporate transactions.
Accuracy of disclosures in announcements and circulars
There has also been heightened scrutiny by the regulators over the accuracy of disclosures made by listed companies concerning their acquisition targets. It is important that disclosures made by a listed company over its proposed acquisition contain all relevant and material information concerning the target, including its value, prospects and known risks. Careful consideration should be given to the need for, and the extent of, disclosure of information which is known to the listed company and its board that might suggest that the prospects or value of the target differs from that suggested by the purchase price or the other disclosures. Inaccurate or misleading disclosures can lead to disciplinary actions and penalties under the Securities and Futures Ordinance and Listing Rules.
Amid concerns about certain transactions in the market, the SFC is keen to ensure listed companies, their directors and advisers act diligently in analysing corporate transactions. The SFC warns that those who breach the Securities and Futures Ordinance risk regulatory enforcement action. A directors' breach of duties in the context of assessing a corporate transaction could amount to an offence of misfeasance or other misconduct.
The SFC has stated that it is more likely to investigate and pursue enforcement action against those who do not comply with the guidance note. Listed company directors must, therefore, consider the guidance note in every corporate transaction to ensure they fulfil their duties as regards the assessment of the transaction and the expert help required in doing so.