The SFC complained yesterday about deteriorating standards of sponsors' work in listing applications. Some of the blame lies with the SFC for abandoning in 2006 proposals to reform the law on prospectus liability. Until investors can effectively sue for a fraudulent prospectus, creating a stronger deterrent, the situation is unlikely to improve.

The SFC and prospectus liability
27 July 2010

The SFC yesterday announced its latest dual filing update, complaining about a deterioration in the standard of draft prospectuses submitted in listing applications. If the SFC is picking up a deterioration on the drafts, then it is a fair bet that the overall standard of final prospectuses has been declining too - because we can't expect regulators to detect every piece of sloppy due diligence by sponsors or every questionable piece of accounting.

However, some of the blame for the deterioration must lie at the SFC's door, for failing to reform the laws on prospectus liability to increase the deterrent for bad work by sponsors, reporting accountants, valuers and everyone else involved in the prospectus, including not least the applicant and its directors, of course. In Aug-2005 the SFC proposed reforms to the law on prospectus liability, but in 2006 these were abandoned under pressure from the industry.

Prospectus liability

On 22-Sep-06 the SFC announced that it had abandoned a proposal (Proposal 9 in the Consultation Paper on reforms to the prospectus regime) to allow secondary market purchasers to bring claims for fraud in IPO prospectuses. The entire price discovery process in the secondary market relies on the truth of the prospectus, and subscribers in the IPO have a right of recourse (subject to the limitation below), but anyone who purchases shares in the market from that subscriber, even on the first day of trading, is on their own, as if the prospectus did not exist. The subscriber who sells on day 1 is of course free and clear, and will not claim if the issuer subsequently collapses in a smoking heap of fraud, while the secondary buyer can't sue the seller because no representation was made by him in the market when he sold.

Another SFC proposal that was abandoned was Proposal 10, to remove the requirement for subscribers to prove that they actually read and relied on the prospectus when making a claim for fraud. Now, how many people can prove what they read yesterday, let alone what they read months or years ago? Do they have any witnesses? Of course not. Again, the relevant fact is that the IPO was priced on the basis of the prospectus and nothing else, and enough people read enough of it for the market to set that price. If the prospectus then turns out to be fraudulent, no victim should have to prove that he himself read it. It should be enough to show that if the document had been known to be false, then the shares would not have fetched the price they did in the primary or secondary market. The SFC could not find any such "prove that you read it" requirement in Australia, Singapore or the UK.

For these reasons, plus the lack of a class action system, no IPO sponsor has ever been sued by an investor in HK, as far as we know,

Currently the only deterrent to poor due diligence work comes from the SFC, which may fine or discipline sponsors, or reach no-fault settlements with them. The largest to date is the HK$30m no-fault settlement in 2005 with ICEA Capital Ltd in the case of Euro-Asia Agricultural (Holdings) Co Ltd. Another case involved Deloitte & Touche Corporate Finance Ltd, which "voluntarily refrained" from sponsoring listings for 9 months after a no-fault no-payment settlement in 2006 relating to its work on the listing of Codebank Ltd, which still holds the record for the shortest listing before imploding.

If the SFC is serious about improving the quality of sponsor's work, then it needs to improve the deterrent by moving ahead with the proposals it abandoned in 2006, and the Government must table legislative amendments to achieve this. Secondly, the Government must move ahead with the proposals of the Law Reform Commission for a class action system in HK, otherwise most investors will never be able to afford to go to court, as each individual claim is too small to justify the millions in potential costs for a battle which could go the Court of Final Appeal.

Auditors have no duty of care to shareholders

Apart from reforming prospectus liability, there is also the problem of the unreliability of audit reports after the company has listed.

In Jul-06, a brave individual investor attempted to bring a court action against Ernst & Young, the auditors of Gold Wo. The Court of First Instance had no choice but to quote the House of Lords case Caparo Industries plc v Dickman and Ors (1990), in which the auditors were held not to owe a duty of care to shareholders of the company, let alone to future shareholders who may buy in the market. Their only duty was to the company itself. The HK case was accordingly "doomed to fail" and was struck out in its entirety.

It is frankly ridiculous that no investor can rely on the audit report in the annual report when deciding to invest, or to remain invested. Only legislation can change this, as Deputy Judge Ian Carlson said:

"What [the plaintiff] seeks is the sort of consumer protection which is available in some of the state jurisdictions of the United States...That position has not been arrived at in Hong Kong."

Again, the Government should legislate on this, so that auditors carry the can for sloppy work. That doesn't escape the directors who are responsible for financial statements, but it would also impose a duty of care on auditors to do their job properly, and if they knew that they had that duty, they might be a bit more careful in their work.

©, 2010

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