Despite an otherwise difficult year, Hong Kong has again solidified its position as one of the prime finance centers of the world, and tops the world's IPO fund-raising list in 2019 for the sixth time in the last 10 years. Hong Kong's success in fund raising is built upon the stellar reputation of its regulatory authorities, which finished a busy year with many high profile enforcement actions and new regulatory requirements. This article looks at the enforcement trends in 2019 and provides an outlook of what is to come for 2020.
2019 in review – Enforcement related to listed companies
The enforcement divisions of the Stock Exchange (SEHK) and the Securities and Futures Commission (SFC) were again very active in 2019. And as already recognizable in 2018, the SFC in 2019 has been increasingly focusing on substantive cases which affect a larger pool of market participants, and is sending a clear message to the market about the regulators' enforcement priorities which include:
- Misconduct / fraud in relation to corporate acquisitions and disposals – the SFC's focus is on the conduct of directors of listed companies, particularly as to whether a deal was negotiated at arm's length; and whether independent judgment was exercised in scrutinizing the consideration for such deal and the valuers' projections, assumptions and selection of comparable companies, and the impact a deal would have on the listed company's financial position. The SEHK has also regularly investigated and sanctioned directors of listed companies for the failure to consider any of these factors.
- The SFC has focused on tackling backdoor listings by seeking to detect red flags such as a new shareholder acquiring significant interest in a listed company, suspicions regarding the true nature of a listed company's business and affairs, a series of acquisitions of a new business with no connection with a listed company's original business, and the deferred disposal of the original business to an outgoing controlling shareholder. The SEHK has, in turn, amended the Listing Rules so as to inter alia restrict a listed company from proposing a disposal of a material part of its existing business within 36 months after a change in control, and to disallow large scale issue of securities for cash which will result in a change in control and where the proceeds will be applied to acquire a new business.
Focus on IPO Sponsors
Given the SFC's apparent focus on high profile cases, it is not surprising that in 2019, the SFC continued its enforcement against IPO sponsors which due to the substantial fines and high profile targets involved generated a lot of publicity for the SFC's work. Over the course of the last three years, the SFC imposed substantive fines of over HK$900 million (US$115 million) in disciplinary actions against eight sponsor firms and three sponsor principals. Some of the most high profile enforcement actions involving such sponsors were published in the first half of 2019 and targeted well-known banks and financial service providers. The SFC based its enforcement actions on findings that these sponsors failed to discharge their duties in relation to several listing applications by failing to conduct thorough due diligence and properly assess the business of the companies applying for listing. Apart from substantial fines, the SFC also obtained voluntary undertakings from the sponsors to enhance internal corporate governance and internal controls going forward. In certain cases these undertakings have also included the requirement to appoint independent directors to the board or to engage a sponsor principal independent of the transaction team to achieve an extra layer of independent review within the IPO due diligence process.
Such enforcement actions against IPO sponsors sent a clear message to the market that the SFC will hold so-called gatekeepers responsible for any failure to conduct proper due diligence which in turn will put investors at risk and affect market integrity.
2019 in review – New trends
In conjunction with its enforcement focus on IPO sponsors, the SFC in 2019 has also targeted other gate keepers specifically asset managers in terms of transactional due diligence and listed companies in terms of their announcements and public disclosures.
In November 2019, the SFC issued a statement emphasizing the importance for listed companies to ensure that announcements, statements, circulars and other documents issued by them do not include materially false, incomplete or misleading information regarding their counterparties in a transaction. At the same time, the SFC issued a circular requiring asset managers to ensure that the identities of counterparties in transactions are properly checked and disclosed. As in the case of IPO sponsors responsible for vetting companies seeking a listing, the SFC also requires listed companies and asset managers to properly vet and disclose relevant information about counterparties to transactions so that its investors / shareholders can make informed investment decisions. As part of this initiative, the SFC confirmed that it had conducted inspections into the conduct of asset managers through which it identified this lack of proper due diligence and the risk of market misconduct.
Virtual Asset Trading Platforms
As in the years before, the SFC confirmed in 2019 that it continues to focus on new trends and innovation in the financial services industry. At Hong Kong FinTech Week in late 2019, the SFC's CEO Ashley Alder confirmed that the SFC is closely monitoring the digitization of assets and the change in the way financial products are being traded. In embracing such change, the SFC is now for the first time offering licenses to virtual asset trading platforms. However, the SFC's approach is not to regulate crypto currencies (which in most cases are not securities) directly but rather to create an opt-in scheme for virtual asset trading platforms to get licensed; the SFC will only offer licenses to those platforms which decide to trade at least one security crypto-asset or digital token, upon which the SFC's new rules will apply to all operations of the platform, even if a majority of other virtual assets traded on the platform are not securities.
In order to get licensed, the platforms will have to demonstrate that they meet robust regulatory standards, comparable to those which apply to licensed securities brokers and automated trading venues. In addition, the platforms have to meet specific requirements for risks associated with virtual asset trading, including to undertake to only offer their services to professional investors and maintain stringent criteria for the inclusion of virtual assets on their platforms. Once licensed, such virtual asset trading platforms will be placed in a confined regulatory environment, the so-called SFC Regulatory Sandbox, for a period of close and intensive supervision. Finally, to obtain a license, platforms must maintain sufficient insurance coverage to manage the risk of virtual assets being stolen. While obtaining a license could be attractive to some platforms (for instance in gaining investors' confidence), other operators may find the SFC's requirements too burdensome and decide to continue operating without a license.
The SFC also acknowledged the growing trend of storing data in the cloud with physical locations of such data being more difficult to ascertain and potentially being outside of Hong Kong. Such practice, however, sits at odds with the regulatory requirement for licensed corporations to have their premises for record keeping approved by the SFC. The SFC clarified that even if data is stored online the SFC must still be able to access regulatory records without delay in discharge of its regulatory functions. Such records must also be properly protected to avoid any data breach.
The SFC issued a circular which requires licensed corporations to
- obtain the SFC's approval if they plan to store regulatory records exclusively electronically and with an outside provider.
- conduct proper due diligence on any service provider for electronic or cloud storage which includes checking the security of the storage solutions offered.
- ensure that such data storage is either provided by a company with staff in Hong Kong and where the relevant data centers hosting the data are located in Hong Kong, or, if such data is hosted by a foreign service provider in overseas data centers, that such service provider enters into an undertaking under which it will render assistance to the SFC should retrieval of regulatory records be required.
- ensure that regulatory records stored electronically can be uniquely identified and that metadata detailing access, modification or deletion of such records is kept.
Increased Cooperation among Regulators
The SFC announced that it will work more closely together with other regulators in Hong Kong to bring enforcement actions, in particular the Independent Commission Against Corruption (ICAC). The SFC and the ICAC signed an MOU in 2019 under which they agree to engage in the cross-referral of cases, joint investigations, exchange and use of information, and mutual provision of investigative assistance among others. This closer cooperation between the ICAC and the SFC has already been put into practice as both regulators announced a joint investigation into two sponsor firms, which involved the regulators' search of the offices of the sponsors and the companies they helped to list. The investigation also involved allegations against members of the SEHK for possible bribery in connection with the vetting of listing applications.
Outlook for 2020
It is expected that the SFC's selective approach to enforcement will continue in 2020 with a focus on large cases that attract public interest, in particular on so-called gatekeepers. The SFC disclosed in 2019 that it is in the process of conducting a thematic review of IPO processes and 2020 could therefore see more cases focused on any improper conduct during the IPO process, for example where the SFC may have reason to believe that underwriters generated orders to inflate share prices for an IPO or to give more control to certain shareholders.
Similarly, the SFC's scrutiny will likely extend to other gatekeepers, including asset managers and their role in ascertaining the identities of all parties involved in an investment transaction. In 2019, the SFC conducted reviews that identified problems with existing transactional due diligence, which could pave the way for enforcement actions in 2020.
For listed companies, the SFC has already on various occasions based enforcement action on a failure to maintain proper internal controls and it is expected that the maintenance of proper internal controls will remain an enforcement focus for 2020. For boards this means that internal policies and procedures should be assessed periodically and any identified risk or event of non-compliance should be properly remediated by for example updating relevant policies and training staff accordingly. Should the SFC identify internal control failures during any of its investigations which were previously highlighted by internal reports without proper remedial measures being taken then the board would have difficulties convincing the SFC that it maintained proper oversight and had a culture of good corporate governance and proper internal controls.
Finally, with the financial services industry embracing technology it remains to be seen how the SFC will react to the challenges arising from the gradual transformation of trading and financial products being offered online. While currently the SFC does not regulate virtual asset trading directly and only started to offer an opt-in licensing scheme for virtual asset trading platforms, the SFC is likely monitoring this space closely and paying attention to what other jurisdictions are doing. The question of whether the SFC will take more of an active role will likely also depend on the success of its opt-in scheme – SFC CEO Alder himself acknowledged that the scheme can only be an interim measure and that the rapid evolution of the virtual asset sector may require a more comprehensive legislation in the future. As such, further developments in the FinTech sector, whether in form of binding legislation, guidelines/circulars or illustrative enforcement action appears likely for 2020.
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