On 26 March 2018, the Securities and Futures Commission (“SFC”) issued a Circular urging licensed corporations carrying out sponsor work to critically review and enhance their due diligence practices as well as internal systems and controls to comply with the expected standards set out in the Circular. This follows the SFC’s findings of deficiencies and instances of non-compliance with relevant provisions in the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission, Corporate Finance Adviser Code of Conduct and the Listing Rules from a thematic inspection of sponsors detailed in a Report issued by the SFC on the same day.

I. Certain sponsor firms’ deficiencies and non-compliance identified in the thematic inspection

The thematic inspection, which covered the work undertaken by 31 sponsors from October 2013, when the new sponsor regime was introduced, to December 2017, found that some sponsors, when conducting due diligence, failed to follow up on obvious red flags, only followed standard checklists without adapting them to the circumstances of specific listing applications and did not confirm that interviewees had the appropriate authority and knowledge to provide the information requested. The SFC also observed that serious deficiencies and instances of non-compliance were prevalent in the sponsor work done for GEM IPOs.

Some of deficiencies and instances of non-compliance discussed in the Report are highlighted below:

  • failed to conduct reasonable follow-up due diligence despite obvious red flags;

Examples of red flags:

    • involvement of third parties in the shipment and settlement processes among the listing applicant and its largest customers
    • material discrepancies between the sales amounts stated in the invoices obtained by the sponsor and the payments made, which could not be reconciled
    • significant discrepancies in the weights of goods reported in the bills of lading and the export forms
    • inaccurate descriptions of the goods shipped in the bill of lading
    • inconsistency between the amounts spent by the top users of the listing applicant’s online services set out in a summary table provided by the listing applicant and those in the raw data generated from the listing applicant’s internal system
    • the sales to certain customers provided by the listing applicant were significantly larger than these customers’ sales and purchases according to the local government's figures obtained from a background research report on the listing applicant’s customers
    • irregular arrangement whereby most customers were understood to have liaised with the listing applicant through representatives and to have paid it through third parties from different countries
    • one share of a major supplier was purportedly held by the controlling shareholder on trust for a third party, but many inconsistencies, backdating and other errors were noted in the documentation obtained by the sponsor in support of this trust arrangement (P.S. It would not be adequate for sponsor to only rely on a statutory declaration of the controlling shareholder and a confirmation provided by the listing applicant)
  • merely followed standard due diligence checklists without adapting them to the circumstances of specific listing applications;
  • unsatisfactory practices in due diligence interview with major business stakeholders:
    • important interviews with business stakeholders were scheduled at a very late stage of the due diligence process;
    • failed to follow up on questions which were not answered during the interviews; and
    • failed to confirm the bona fides of the interviewees and that they had the appropriate authority and knowledge;

Example:

Interviews were conducted at the listing applicant’s office premises or by ringing the interviewees’ telephone numbers provided by the listing applicant without any further verification.

  • failed to provide relevant records to demonstrate that major issues were properly considered and disposed of;
  • failed to maintain a proper due diligence plan and documentation of certain due diligence conducted;
  • insufficient management supervision over sponsor work:
    • failed to demonstrate Management’s involvement in the consideration of key concerns; and
    • Transaction Team failed to escalate critical matters to the Management or its designated committee for consideration;

Example of critical matter not escalated to the Management:

The listing applicant refused to accept some of the sponsor’s due diligence measures and threatened to change sponsors if it insisted on carrying them out.

  • insufficient training and guidance provided by some sponsors to their staff;
  • insufficient resources to undertake sponsor work;

Example:

A sponsor Principal was reported to be simultaneously overseeing six active listing applications, while most survey respondents reported that their sponsor Principals and their staff would handle, on average, only two to three IPOs simultaneously.

  • failed to perform any annual assessments of their systems and controls;
  • annual assessment was based solely on the attestation by the sponsor Principals, without detailing the work done or samples reviewed to ensure that key policies and procedures are effectively implemented
  • failed to maintain effective Chinese walls to prevent the flow of confidential information between the sponsors and related licenced corporations;
  • failed to have a written company policy governing the provision of benefits to clients or failed to comply with the company policy on the receipt of benefits from clients (or could not demonstrate their compliance due to the lack of documentation);
  • poor internal control procedures for independence checks - many sponsors did not confirm the independence of Transaction Team members, directors of the sponsor groups or their close associates.

II. Highlights of expected standards for sponsor work set out in the Circular

A. Due diligence

Exercising reasonable judgement and applying professional skepticism:

Understanding the listing applicant:

  • Obtain sales walkthrough documents to verify if the listing applicant’s business operations are accurately described in the listing application, and identify key issues
  • Conduct reasonable due diligence on the listing applicant’s major retail or online customers, especially where certain customers account for a materially larger portion of sales than others
  • Conduct reasonable due diligence on the volume of business at the listing applicant’s major retail stores, especially where particular stores account for a materially larger portion of sales than other stores or industry peers
  • Perform background research on the listing applicant and update it regularly, especially if the listing application process is expected to continue for some time or if the listing applicant operates in a fast-evolving industry or regulatory environment

Due diligence plan and checklist:

  • Keep records of due diligence plans, which should include the factors considered in planning the due diligence and the specific due diligence conducted as well as the issues identified and the steps taken to resolve them
  • Develop robust, comprehensive and customised due diligence plans and checklists at the start of each engagement
  • Plans, checklists and subsequent updates should be approved by designated senior members of the Transaction Team and properly recorded
  • Keep proper records documenting the breadth and depth of their due diligence and the results, including the specific issues identified and how they were resolved. All material risks and issues identified should be properly logged and accompanied by stand-alone due diligence notes as appropriate
  • For site visits to the listing applicant’s main business locations or customer premises, sponsors should document the criteria for selecting these sites (such as the percentage of sales covered), the names of the sites inspected as well as those participating in the site visits, any verification work conducted and all instructions or guidance provided to participating staff

Relying on third parties:

  • Sponsors should be able to explain:
    • why they decided to rely on a particular third party to discharge their due diligence obligations, giving due consideration to the qualification and competence of the third party
    • whether they communicated to the third party the scope and extent of the due diligence to be conducted
    • whether the work of the third party provided a sufficient basis to determine that reasonable due diligence had been conducted and whether further due diligence was required, taking into consideration:

- whether the work was conducted as contemplated by the sponsors - whether the due diligence was commensurate with the standards expected of sponsors - whether the sponsors considered the bases and assumptions for the reports or opinions to be fair, reasonable and completeRelying on experts:

  • Critically review the expert’s opinion and conduct follow-up work to resolve any material discrepancies, irregularities or inconsistencies
  • When dealing with specific due diligence issues, sponsors should be able to demonstrate that they have considered how an expert's report could form the basis for them to discharge their due diligence obligations and whether additional due diligence is required

Identifying and following up on red flags:

  • Take reasonable steps to identify red flags and cross-check information obtained from different sources. Any material irregularities should be properly followed-up and resolved
  • Be especially skeptical of claims that an abnormal practice or unusual business conduct is the industry norm or a common practice. Focus on whether such practice or business conduct cast doubt on the genuineness of the financials of the listing applicant, its legality and commercial rationale, and further seek to understand the potential liability and other implications of such practice or business conduct

Interview practices:

  • Exercise due care in confirming the bona fides of interviewees in order to be satisfied that they have the appropriate authority and knowledge:
    • as far as possible, conduct interviews at interviewees’ business premises and conduct further cross-reference checks of more than one type of proof of identity. If this protocol is not adopted, ensure any irregularities are adequately explained and resolved, and take reasonable alternative steps to verify the interviewee’s bona fides
    • where interviews are conducted by telephone, verify the telephone numbers and identities of the interviewees - should not rely solely on telephone numbers provided by the listing applicant to verify an interviewee’s identity. For example, they could call the general line of the interviewee’s company obtained from a reliable public source (such as a telephone directory) to verify the interviewee’s position and confirm that the individual participated in the interview
  • Document:
    • the criteria for selecting interviewees
    • if any persons selected refused to attend the interview, what were the reasons and how this was followed up (for example by trying to fix another interview or performing other due diligence)
    • the name and position of any other person present during the interview, especially if representatives of the listing applicant insisted on attending the interview
  • Ensure that the representations made by the interviewees reflect the position of their respective companies. For example, sponsors may request telephone interview notes to be validated by the interviewees’ companies with copies of the interviewees’ identity documents attached

B. Proper records

  • Maintain sufficient records to demonstrate that proper due diligence were conducted and contentious issues were adequately investigated as well as how sponsors’ conclusions were reached
  • Maintain comprehensive records of due diligence in relation to matters which are material to the listing applicant’s business
  • Ensure that sponsors can locate and retrieve records after Transaction Team members depart

C. Resources, systems and controls

Corporate governance:

  • The sponsor firm’s organisational structure should be documented and approved by the board of directors (“Board”), clearly setting out, among other things, the Managers-In-Charge (“MICs”) responsible for overall management oversight of the firm and the MICs specifically responsible for directing and overseeing the sponsor business, as well as their reporting lines
  • Have clear policies requiring critical matters to be escalated to its Board, responsible MICs or its designated committee for consideration
  • Management of sponsors should ensure the appropriateness of the team structure for each sponsor engagement
  • Sponsor Principals should maintain an effective reporting line as well as communication among their Transaction Teams and other members of Management regarding the sponsor work undertaken
  • Sponsors should be able to demonstrate the involvement of Management in the consideration of key issues

Other aspects:

  • Ensure that sufficient resources are allocated to each engagement
  • Provide sufficient training, guidance and management supervision over sponsor work. Scenario-based training for identifying and resolving material issues should be provided to staff, supplemented by on-the-job training by the sponsor Principal or other more senior staff
  • Escalation policies should, among other things, cite examples of material risks and issues and specify an appropriate threshold for internal escalation. Records should be maintained of the escalation of critical matters to Management and their final resolution
  • Sponsor Principals should adequately supervise their Transaction Teams at all times. They should attend key due diligence interviews together with junior team members to be better informed about the listing applicants and provide timely guidance to the Transaction Team when needed

Annual assessment of systems and controls:

  • Reviews of policies and procedures should be conducted to ensure compliance with the relevant codes, rules and regulations. Review of samples of listing applications should be conducted to ensure that key policies and procedures are effectively implemented

III. Concluding remarks

The SFC emphasises that sponsors with a history of returned or rejected listing applications or which are found to have had serious deficiencies and instances of non-compliance may expect more frequent inspection visits and supervisory actions. These factors may cast doubt on a sponsor's capability to discharge its responsibilities as well as potential compliance risk. Future listing applications submitted by them may also be subject to closer regulatory scrutiny. The SFC will not hesitate to take enforcement action against sponsors and their senior executives responsible for failure to comply with the expected standards in sponsor work.

Sponsors must therefore pay attention to the areas of concerns discussed in the Circular and the Report, and critically review and enhance their due diligence practices as well as internal systems and controls to ensure that they comply with the expected standards set out in the Circular.