Hong Kong’s regulator has a tough job.
On the one hand, their primary mandate – like other regulators – demands the preservation of financial-market integrity and trustworthiness.
On the other, they tow a fine line in ensuring their actions don’t tie free-flowing markets in regulatory straitjackets.
But sometimes, market players intentionally breach the rules. When that happens, the onus falls on the regulator to crack the whip and set them back on the straight and narrow.
This is because a reluctance to act often perpetuates further questionable behaviour by other players, which could lead to a spiralling decline in overall investor confidence, spurring capital flight.
Incurring the Wrath of Hong Kong’s Securities Regulator
The clear and present danger of meeting this undesirable fate should explain why Hong Kong’s Securities and Futures Commission (SFC) handed its harshest fines ever to three internationally renowned investment banks on 14 March.
The reason: Investigations by the SFC had revealed severe due diligence failings on past IPOs undertaken by them.
Swiss bank UBS received the heftiest penalty at US$375 million, “for failing to discharge their obligations as one of the joint sponsors of three listing applications.”
Next in line for the whip was Morgan Stanley (US$224 million), followed by Merrill Lynch (US$128 million). But unlike UBS’s three applications, the SFC reprimanded these two entities for just one listing: Tianhe Chemicals (2014) – the common thread tying all three banks together.
To get a sense of stewardship failings at play with Tianhe’s case, see the excerpt below from the SFC’s official statement:
Failure to address red flags in an interview
[UBS, Morgan Stanley, and Merrill Lynch] had initially requested to interview the largest customer of Tianhe, Customer X, at its office, but eventually accepted Tianhe’s explanation that since an anti-corruption campaign in Mainland China was underway, Customer X, a large state-owned enterprise, would normally turn down any third-party request to visit its premises.
[UBS, Morgan Stanley, and Merrill Lynch] then agreed to interview Customer X at Tianhe’s office. At the end of the interview, the representative of Customer X refused to produce his identity and business cards and stormed out of the meeting room. He told UBS and other parties that he would not have agreed to be interviewed under Customer X’s internal procedure, and he only attended the interview to help the family of Tianhe’s chief executive officer.
Nonetheless, [UBS, Morgan Stanley, and Merrill Lynch] did not conduct any follow-up inquiries to ascertain that the person it interviewed was the representative of Customer X and that he had the appropriate authority and knowledge for the interview.
The apparent lack of governance was plain for all to see.
Companies that score well on corporate governance tend to perform better in IPOs. Read more: What a Popular Hollywood Film Tells Us About the Symbiotic Link Between IPO Performance and Corporate Governance
Identified: Clear Correlation Found Between Sponsor Selection and IPO Performance
Independently, this latest imposition of fines by the SFC could be easily viewed as a one-off event. As to whether it materially impacts future deal-making business, though, is another question altogether.
If only companies with intentions of listing on the Hong Kong Stock Exchange had a reliable way of benchmarking sponsors.
But, they do!
Deep analysis conducted by Aequitas Research has found a distinct link between the average share returns of Hong Kong-listed companies and the sponsors of their listings.
In the First Week After Listing
“In terms of one-week deal performance post-listing, Bank of America Merrill Lynch (BAML) ranked best overall, as a sponsor, with… an average return on 17.2 percent,” according to Aequitas. “The next-best sponsor was Credit Suisse (CS), with an average return of 11.4 percent.”
Three Months After Listing
BAML and CS maintained their top two positions in this time frame, averaging deal gains of 22 percent and 11.6 percent respectively.
The irony: It appears that, based on these findings, Merrill Lynch’s latest run-in with the SFC might be a mere statistical outlier after all.
Sign up or sign in to read the full study: IPO Analytics: Corporate Governance – Alpha Generator, Shortlist of Bookrunners to Avoid/Keep Happy
Uprooting the Root Cause
Studies like the one above undoubtedly go a long way to help inform sponsor selection.
But that’s not the point.
Slapping those massive fines on the guilty three – UBS, Morgan Stanley, and Merrill Lynch – was still a reaction to grave wrongs that had already run their course.
Even though “the sanctions send a strong and clear message to the market,” the misconduct shouldn’t have occurred in the first place, not least in one of Asia’s premier financial capitals.
Yet somehow they did. And that’s because conflicts of interest persistently exist in the due diligence process: Sponsors stand to gain financially and in reputation if their IPOs perform well.
Perhaps the SFC could learn a best practice or two from the UK’s Financial Conduct Authority to nip these failings at the bud.
For a start, why not consider adopting the new UK regime for equity IPOs that allows independent analysts to scrutinise soon-to-be-listed companies?
Smartkarma covered the first listing (Aston Martin) under the UK’s new disclosure rules. Read the Insight: Aston Martin Lagonda Pre-IPO Under the New IPO Process – Lots to like Apart from R&D Capitalisation
That introduces vital checks and balances at the pre-listing phase, which could pressure the sell-side to conduct proper due diligence, or risk losing credibility.
Something for the SFC to think about, eh?