The territory's banks and corporate finance firms have successfully lobbied for years that they should not be held culpable if a company they helped bring public in Hong Kong is later found to have misled investors about its finances or business operations. That argument will be more difficult to sell now.
A slew of scandals at North American-listed Chinese companies is putting Hong Kong's market regulator, the Securities and Futures Commission (SFC), under intense pressure to bring in sponsor liability at an upcoming review.
"The idea that a bank's responsibility should end the moment a company IPOs makes little sense," said Jamie Allen, Secretary General of Hong Kong-based Asian Corporate Governance Association.
"If you are introducing a company to a market, then you are giving some degree of assurance. If that assurance doesn't last even one day beyond the IPO, then surely it must be worth less than we are led to believe."
With Hong Kong being the world's biggest IPO market for the past two years, banks and other local sponsors have made millions in fees by picking up a small part of the IPO proceeds for every company they bring to market.
The SFC estimates that the total income derived from IPO sponsorship in Hong Kong was HK$4.8 billion ($616.2 million) and HK$2.2 billion for the years ended September 30, 2008 and 2009, respectively.
The SFC argues that the rush of listings has sometimes favored quickness over quality.
While lawyers and auditors share in the due diligence, it is the investment banks -- in this case known as IPO sponsors -- who study the company, pitch their services and ultimately underwrite and sell the offering to investors.
In March, the SFC said an inspection of 17 sponsors found a range of deficiencies including inadequate due diligence and making questionable disclosures to the Hong Kong stock exchange during the application process.
The Hong Kong Monetary Authority said in April that it made recommendations to JPMorgan (JPM.N), UBS AG (UBSN.VX), HSBC Holdings (HSBA.L) (0005.HK), Royal Bank of Scotland (RBS.L) and Deutsche Bank (DBKGn.DE) on how to improve their IPO work.
The perception that standards are not improving prompted SFC's former Chief Executive Martin Wheatley to announce last month that the regulator will start a new consultation on sponsor liability this summer.
"The SFC has expressed repeated concern at the scrutiny of IPO applications so they feel there needs to be more teeth in the process," said James Wadham, a partner in Clifford Chance's litigation practice in Hong Kong.
FIERCE RESISTANCE
Banks will not cave in without a fight. They say there's only so much they can do to stop a company misleading investors.
"As a bank, you're not the one committing the fraud. No matter how much we check, there's always going to be someone clever trying to cover something up," said a Hong Kong-based investment banker who did not want to be identified because he is not authorized to talk to the media.
The banker cited examples where IPO sponsors had verified money flows with a company's bank-- only to find out later that the bank itself was fudging the numbers.
Some lawyers are doubtful whether bringing in sponsor liability on its own will really solve the problem. They say Hong Kong lacks the U.S.-style class-action system that would facilitate legal action by investors.
"In Hong Kong there is no class action, so there's a strong discouragement for investors as if they lose a case they have to pay the other side's cost -- lawyers can't take on cases on a contingency fee basis," said Bonnie Chan, a partner at Davis Polk & Wardwell and former head of Hong Kong Exchange's IPO transactions department.
"If you try to impose more serious liability for the sponsors, the sponsors will be more careful but at the end of the day if a company really wants to engage in fraudulent behavior there will always be ways they can trick the sponsors so really it just shifts the risk around."
SHADY DEALS
Those arguments may not be strong enough to wash with the SFC.
"The situation in the U.S. along with publicity about China Forestry and Hontex does mean it may be more difficult for IPO sponsors to push back against the introduction of prospectus liability," said Ashley Alder, partner at law firm Herbert Smith and former director of corporate finance at the SFC.
Chinese textile firm Hontex International Holdings Co Ltd (0946.HK) was listed in December 2009 and just three months later, its shares were suspended after the SFC alleged its IPO prospectus had "materially overstated" its financial position.
The SFC has successfully managed to freeze the assets equivalent to the sum Hontex raised in its IPO. Yet investors are still to get their money returned, with a debate continuing in the courts about the methods the SFC is using to reclaim the money.
China Forestry Holdings Co (0930.HK) also listed in December 2009 and had its shares suspended in January this year after auditor KPMG informed the board of possible irregularities in the books.
Its CEO is now the subject of court proceedings for alleged insider dealings. But a wider question investors are now asking is whether the IPO, which raised $216 million, should ever have gone ahead.
While it's unclear when the alleged fraud started, the company's prospectus said the previous three years' profits were driven by "fair value gains" derived from a revaluation of its forest holdings.
Without those gains, experts question, whether the company would ever have made it on to the market.
"It's shone a light on a dark aspect of the IPO process in Hong Kong -- should a company like China Forestry be able to list when its "profits" are based on fair value gains? Without those paper gains, the company registered losses for the 3.5 years prior to listing," said Asian Corporate Governance Association's Allen.
MAINTAINING STANDARDS
Accounting scandals at Chinese firms in North America have also mounted the pressure on Hong Kong authorities and its exchange to make sure that their desire to act as a gateway to the mainland doesn't come at a cost to quality.
Hong Kong Exchanges and Clearing (0388.HK) prides itself on having tougher entry requirements than its North American counterparts -- that image hinges on taking every possible measure to keep fraudulent companies out of its market.
"Hong Kong is positioning itself as an international Exchange, attracting listings from a range of overseas jurisdictions," said Adler at Herbert Smith.
"Because it is undoubtedly harder to exercise the same regulatory oversight over these companies as domestic companies, there may be a greater emphasis on sponsors as gatekeepers."
The SFC looked at bringing in prospectus liability for sponsors during a 2005 consultation, but decided in 2006 that it would be "premature" to impose such a measure.
In the SFC's consultation report, arguments some respondents gave against the idea included that it would "encourage litigation" and misrepresent sponsors' role which is to assist with listing applications, "not to guarantee the accuracy of the information provided."
Those responses are unlikely to win the debate this time round. "It would look pretty bad if they proposed it for a second time and abandoned it for a second time, so I hope this time they have learnt from their mistake and will press ahead with it," said David Webb, an activist shareholder in Hong Kong.
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