SFC Raises Concerns on IPO Sponsor's Due Diligence

April 12, 2011

In the latest of a series of reports on sponsorship work in Hong Kong initial public offerings (IPOs), the Securities and Futures Commission (SFC) has again raised concerns about the quality of the due diligence performed by sponsor firms in recent IPOs and listing applications on the Hong Kong Stock Exchange.


In its Report on Sponsor Theme Inspection Findings issued on 29 March 2011 (Report), the SFC set out a number of deficiencies in sponsors' work identified in the course of regulatory reviews.


Areas of Deficiency


The SFC highlighted a number of key areas of deficiency, including:

  • Insufficient Due Diligence
  • Undue Reliance on Lawyers' Confirmations
  • Questionable Disclosure to the Regulators
  • Record Keeping and Internal Controls Failures

Lessons Learned

The Report reveals some issues often overlooked in the due diligence process. These are particularly important in our market where due diligence work is often performed by professionals who may be relatively inexperienced as "business people". A few key themes can be drawn:

  • Have the right respondents been identified for the specific due diligence enquiries?

The SFC mentioned a sponsor firm failing to verify the identities of the interviewees. If the sponsor firm did not meet the relevant individuals (or worse, did not know who they were talking to), it would naturally be difficult to justify the quality of their due diligence work.

  • Is the sponsor's representative alert to the key issues on the transaction before him?

The SFC mentioned a sponsor firm's failure to follow up on key information missing from the due diligence questionnaire. This highlights the problem of following a written "script" (in a questionnaire or checklist). There may be great temptation in practice for representatives of sponsor firms, particularly junior members of staff, to go through a due diligence checklist as no more than a box-ticking exercise.


The point was hammered home in the case of the sponsor failing to perform due diligence on a new and very important customer who emerged late in the listing process. Failure to spot the commercial impact of this customer on the listing applicant's business model points to gaps in the business acumen on the part of the sponsor's representative.

  • Is the sponsor's representative confident and flexible enough to react appropriately to specific issues?

The SFC expressed concern in one example of an incomplete due diligence response from a third party, that the missing parts were not followed up on and the interview questionnaires were not sent back directly by the interviewee, giving the listing applicant a chance to intercept and "taint" it. This illustrates the high standard of independent investigations that a sponsor's representative is expected to perform, and plainly calls for a culture of independent thinking, flexibility and confidence in sponsor firms.  

  • How should sponsors extract the best value from lawyers?

The complaint against undue reliance on lawyer's advice points to the need for some sponsor firms to consider carefully their co-operation with legal advisers. Although lawyers' input on such as questionnaires and confirmations are crucial to IPO due diligence, the sponsor firm must bear in mind that lawyers' input are not always the panacea for all ills.


Lawyers are generally unable to give any meaningful assurance on questions of fact. There should be alarm bells for sponsors where questions of fact and law are mixed, where different legal systems overlap on the same issue, or where an issue seems to fall into a "no-man's land" between different legal systems. It is crucial for the sponsor firm to agree with the lawyers beforehand precisely which areas can or should be covered by which legal teams, and work out ways together to address any "gap" issues.


If their input is not used wisely, the lawyers may turn out to have provided no more than a false sense of security.

  • How important are records, documentary evidence and audits?

The Report also highlights the importance of complying with institutional requirements such as maintaining proper records of IPO work and conducting annual reviews of internal systems and controls. IPO sponsor work is a specialist area of a securities intermediary's profession with attendant compliance burdens. Failure to discharge these duties raise professional conduct issues and will impact directly on a firm's fitness and properness to remain registered with the regulators for the relevant type of work.


See a copy of Report on Sponsor Theme Inspection Findings.



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