The Securities and Futures Commission (SFC) customarily prioritizes enforcement actions of high deterrence value. In capital markets, SFC has aimed enforcement firepower at sponsors of big initial public offerings (IPOs) – not because those institutions are necessarily the worst, but because their public disgrace is the most newsworthy. 

Sponsors punished in 2019 for a spate of disastrous listings ten years earlier were subsidiaries of international banks. In the last few years, SFC has shifted its enforcement focus. The change is not deliberate, and still does not hold the true perpetrators of the worst misconduct accountable. Instead, SFC has settled for trophy hunting among a less glamorous subset of the sponsor community. Having bagged the big deep-pocketed sponsor firms, SFC turned to small impecunious ones. There are plenty of those. 

There has been a step down, also, in the quality of the frauds: from sensational swindles of tycoons who vanished with millions, to the sideshow hustles of small-time grifters. Yet it remains the reality that sponsors bear most of the punishment for the sins of company insiders who abscond with investors’ money. 

Aside from regulatory risk, sponsors face stiff competition for fees. New sponsor coupling requirements are intended to redress imbalances between sponsors’ commercial power versus that of underwriters, but will render some boutique sponsors obsolete.

The IPO sausage factory 

The SFC’s most recent disciplinary action against sponsors concerned an unprosperous firm called Changjiang Corporate Finance. CJCF churned out a string of six failed listing applications, oblivious to regulatory requirements and specific risks threatening each company’s business. SFC fined CJCF HK$20 million and suspended its sponsor license. 

China Candy

An earlier case concerned TC Capital International, for its sponsorship of China Candy. While the IPO raised just HK$57 million, expenses burned through HK$21 million, meaning over a third of the cash was lost to underwriters and other service providers. Most of the rest was supposedly for expanding production. According to the prospectus: 

“With an increasingly sophisticated consumer base, an increasing number of young and fashionable people are attracted by exotic sugar confectionery in first and second tier cities. … As China gradually eases its restriction on birth control, birth rates are estimated to pick up in the years to come. A larger population of children, who are the primary target market of confectionery products will translate into a larger customer base and bolster sales of pastilles, gums, jellies and chews. … Functional pastilles, gums, jellies and chews, added with vitamin C, vitamin E, calcium or DHA, claim to provide consumers with nutritional supplements in addition to being just a snack food. Such products are gaining in popularity due to their claimed health benefits.”

If that wasn’t fanciful enough, investors might have guessed China Candy was doomed if they read in its 2016 Annual Report: “To enhance the value for the Shareholders, the Company decided to expand its business into investment business, mainly in listed shares.” Worse, this random pivot was financed by a loan from the company’s co-founder and CEO, Hong Yinzhi. 

The stock was suspended two years after listing, when it emerged that RMB178 million had been transferred from company bank accounts to personal accounts of its senior managers. Recipients included Hong and her husband, China Candy’s chairman. Some of the money was eventually recovered or accounted for, but the disappearance of RMB12 million remains a mystery. While Hong resigned as CEO in 2019, her daughter was then appointed deputy.

The company allegedly also falsified accounting records and overstated its 2016 cash balance by 97%. SFC has not attempted prosecution of key perpetrators (in the mainland beyond its jurisdiction) but merely sought their disqualification as directors. Meanwhile, SFC punished the sponsor for failing to properly investigate China Candy’s purported pre-IPO revenue. SFC fined TC Capital $3 million, saying the fine would have been heavier “but for the firm’s financial position”.

Two failed frauds 

SFC’s action against TC Capital echoed its earlier punishment of two sponsor firms for inadequate due diligence of listing applicants’ purported revenues. Those cases were significant for another reason: they demonstrated that sponsors can face serious penalties even if the application fails and no harm is done to the investing public. 

In the madcap goldrush of Hong Kong’s listing industry, applications sponsored by smaller firms are often launched speculatively then abandoned before their approval. A change in HKEX protocols has facilitated SFC’s ability to build enforcement cases against sponsors involved in those assignments. Previously, regulatory action in response to complaints against applicants ceased if the application terminated before approval. SFC now expects HKEX to consider whether further action is warranted, such as a referral to SFC. 

Ample Capital was one of the first sponsors disciplined for an abandoned listing application. The applicant, COCCI International, claimed to receive much of its revenue from one distributor, in bags of cash at rendezvous points in Hong Kong. Various individuals, who were not COCCI employees, then carried the cash to the mainland. 

The SFC said: “Settlement of payments through third parties by a customer is a red flag as third-party payments might be used to disguise the original source of funds and facilitate a fraudulent scheme.” 

The implication is that COCCI conspired with its purported distributor and supplier to generate bogus transactions, creating a circular flow of funds to inflate revenue artificially. After SFC’s second rejection of the draft prospectus, Ample Capital did not respond, and the application lapsed. SFC reprimanded Ample Capital and fined it HK$5.5 million. 

Similarly, SFC disciplined Yi Shun Da Capital (YSD Capital) for its sponsorship of Imperial Sierra Group. The application was under consideration when unknown persons, calling themselves “Blazing Research”, reported that major customers’ purchases were “most likely to be fabricated”. They presented evidence that Imperial Sierra’s young founder, Aric Yip Wik, was the son of Michael Yip, who in 2010 was jailed for stealing HK$180 million from Ocean Grand Holdings. Michael founded Ocean Grand with his father in 1990, took it public in 1997, and then promptly foundered it, siphoning off assets by making bogus purchases from his family’s other companies.

Blazing Research concluded:

“Imperial Sierra is just another fraud designed by Mr. Yip Kim Po after his release from jail, so as to earn the ‘shell’ price of Hong Kong listed companies. … Due to the high premium of ‘shell’ price in Hong Kong listed market, some companies collude with sponsors to conduct fraudulent IPO and earn huge profits by selling the company’s shares after lock-up period. Although many companies merely use accounting tricks to meet the profit test requirement, some companies use transaction without any commercial substance to fabricate revenue and net income to pass profit test. We believe the fraudulent extent of Imperial Sierra is the most serious among these companies, since Imperial Sierra does not have any operation with commercial substance at all.”

After the application lapsed, SFC concluded YSD Capital had failed to perform all reasonable due diligence. Appealing to SFAT, YSD Capital asserted it was entitled to rely on the accountant’s confirmation of the financial statements. SFAT held that YSD Capital could not use the accountant’s report to “wash its hands of the matter”. 

With respect to SFC’s $4.5 million fine, although considerably less than the $14 million originally proposed, YSD Capital lamented it would still suffer a significant loss. Its fee for the listing assignment had been a pitiable HK$2.5 million. Noting that a firm cannot be entitled to make a profit on work that “has been undermined by its own culpability”, SFAT nonetheless further reduced the fine to HK$3 million in view of YSD Capital’s “financial straits”.

It is not apparent that Yip family members who allegedly conceived the scheme suffered any regulatory consequences, though creditors sued Aric Yip Wik regarding an unpaid debt and a bond issued to raise money for the listing attempt. 

Sponsor coupling

Last year, 75 companies completed IPOs on HKEX − an annual total that has been declining in recent years. The applications were shared, unevenly, between 130 licensed sponsor firms. While the potential rewards of listing are enormous for pre-IPO shareholders, especially if they disappear with the proceeds, sponsorship is a competitive business with thin margins. Commercial pressures may encourage sponsors to offer a cut-priced service so that a group company can head the underwriting syndicate, which enjoys higher fees. In effect, sponsors provide loss-leaders for more lucrative underwriting work. 

An analysis of IPOs in 2020 revealed average underwriting fees of HK$49 million, versus sponsor fees of HK$6 million. SFC said this indicated “misalignment between fees and sponsor costs and responsibilities.” This doesn’t elucidate the problem, which is that misalignment of fees creates misalignment of incentives. When the economic incentive of its corporate group is to complete an IPO, a sponsor doesn’t simply face a temptation to offer a cursory and inexpensive service, but to actively ignore red flags. Discovery of fraud or falsity, through assiduous performance of their duties, could imperil underwriting fees. 

In response to sponsors’ commercial weakness, SFC in 2022 introduced a “sponsor coupling” requirement. Main Board applicants must now appoint at least one sponsor which is also part of the underwriting syndicate, or related to one of the underwriters. Also, an underwriter must be appointed when it (or its group company) is appointed sponsor. 

The SFC stated, “it appears that the sponsors presently have too little bargaining power. The ‘sponsor coupling’ requirement is aimed at redressing that”. It is intended to ensure sponsors are not incentivized to compromise due diligence to secure the underwriting appointment. When sponsors also act as underwriters, “total fees may properly compensate the additional sponsor resource commitments and responsibilities.” In effect, SFC hopes underwriting will cross-subsidize sponsor work.

It is not logical to hope that tying sponsors’ remuneration to underwriting will advance sponsors’ independence and performance. On the contrary, it will exacerbate conflicts of interest and entrench misaligned incentives. If an applicant’s share issue is underpriced, underwriters assume minimal risks and potentially gain huge profits at the applicant’s expense. Applicants cannot receive impartial pricing advice from sponsors also acting as their underwriters. 

Additionally, sponsor coupling has an anti-competitive effect, with underwriters locked in long before they would usually be appointed. So, it is questionable whether the requirement is consistent with SFC’s objectives, anchored in legislation, which include promotion of the security industry’s competitiveness. Moreover, the requirements prejudice sponsors which are not part of a corporate group that includes underwriters. Although underwriting involves completely different capabilities, firms that cannot offer underwriting will only be able to sponsor Main Board listings as co-sponsors with firms that can. This severely limits their opportunities because most listing applicants appoint only one sponsor. Responding to objections on this point, SFC concluded, “The impact on small boutique sponsors should be limited” because 72% of all sponsors (or their group companies) are also engaged in underwriting. Presumably the logic was that the changes will, at most, put only 28% of sponsors out of business.

A corollary of requiring at least one sponsor with underwriting capabilities is that at least one underwriter must have a sponsor in its corporate group. Underwriters thereby face pressure to participate in relatively unprofitable sponsor work. Or, at least, be appointed as a sponsor and accept the regulatory risk, even if most of the work is done by another sponsor. This increases the likelihood that for each IPO there will be a sponsor that is part of a highly capitalized financial group. That reinforces the allure of scapegoating sponsors for frauds committed by others.

Conclusion

While seeking to unlock the treasure chest of public capital markets, some company insiders fall to the temptation of falsifying disclosures. Whether the charades unravel before listing or after, regulators usually now focus on finding fault with the due diligence performed by sponsors. More than ever, sponsors face significant regulatory risks for limited financial gain.

This article first appeared in the October 2023 issue of Hong Kong Lawyer, the official journal of The Law Society of Hong Kong.

Regulators struggle to prevent listing fraud and hold fraudsters accountable. So they found a softer target: licensed sponsors. Once a mere quirk of Hong Kong’s listing regime, sponsors became the primary enforcement focus, from which the Securities and Futures Commission (SFC) has extracted substantial fines. While SFC still hasn’t found a way to penalize the actual perpetrators of listing fraud, sponsors know they’ll now be blamed for it. 

That’s peculiar, because sponsors have limited commercial bargaining power and no responsibilities at all under legislation. Disciplinary action against them is useless for investor compensation, because fines are paid to the government. It might discourage poor due diligence but can’t deter fraud.

HKEX’s annus horribilis

SFC’s sentiment, that a campaign against sponsors is the solution to cleaning up HKEX, emerged after a blizzard of fraudulent IPOs in 2009: 

• Trading in Hontex was suspended just three months after listing, following allegations it massively overstated profits. SFC secured a share buyback requiring the return of funds raised in the IPO, but never attempted proceedings against the insiders who committed the fraud. Instead, SFC fined the sponsor, Mega Capital, HK$42 million and revoked its licence. This was only the second time in over a decade that SFC fined a sponsor, and the first time ever it revoked a sponsor’s licence. 

• Two years after listing, Real Gold Mining confessed to secretly transferring HK$1.4 billion to its founder, Wu Ruilin. Although SFC sought court orders that Wu and others compensate minority shareholders, it appears that no writ was ever served and no particulars ever pleaded, meaning the defendants had no case to answer. To punish the sponsor, Citigroup Global Markets Asia, SFC had to identify deficiencies occurring before the IPO. SFC found Citigroup’s due diligence of Real Gold’s customers was inadequate. Citigroup argued that, gold being a commodity with a ready market, it was reasonable to focus on the company’s production, rather than its customers. SFC disagreed, and fined it HK$57 million. 

• China Metal Recycling was suspended after short-sellers called its growth “suspiciously amazing”, return on capital “Madoffian” and revenue per employee “absurd”. They asked, “How many suspicious metrics do investors and regulators need to realize that the only explanation for the Company’s unusually strong performance is that [it’s] dabbling in the dark arts of accounting?” Liquidators chased founder Chun Chi Wai for HK$822,900,000 he milked from China Metal after the IPO. While Chun’s wife and a manager were jailed, Chun escaped prosecution, having fled to mainland China. 

• China Forestry was suspended after KPMG belatedly flagged massive accounting irregularities. While the IPO prospectus claimed a book value of RMB7.4 billion, the true figure was a net liability of RMB323 million. SFC litigation seeking compensation for public shareholders is on hold pending Market Misconduct Tribunal proceedings, in which SFC alleged insider dealing and false or misleading disclosures. Hearings concluded in 2020 but no report was released. Three years later MMT ordered a rehearing, the judge having become unable to discharge his duties.

Another horrible year

Two IPO scams in 2014 further exposed SFC’s difficulties bringing perpetrators to justice:

• Tianhe Chemicals was suspended after a “hacker collective” alleged Tianhe’s sales were fictitious. Associated Press said Tianhe’s chairman, Wei Qi, founded Tianhe with assets he transferred to himself for free from a state-owned company. Also, a supposed key customer’s office was “an unoccupied room containing broken furniture and old mattresses in a dilapidated apartment building”. 

SFC sued Tianhe and its CEO, Wei Xuan (Qi’s brother), and instituted MMT proceedings. It is unclear whether any IPO funds will be recovered. Moreover, while MMT can order disgorgement of profits it cannot impose prison terms. In practice, commencement of MMT proceedings precludes prosecution. MMT found Tianhe and Xuan committed market misconduct, and barred Xuan from managing listed companies for four years. The finding exposes defendants to civil liability but might be futile, considering Tianhe declined to participate in proceedings and Xuan vanished before they even started. 

• Fujian Nuoqi was suspended after Ding Hui (chairman and CEO) disappeared with HK$292 million (over 90% of IPO funds). No-one has been held to account, through criminal conviction, administrative sanction or restitution. Ding joined a long list of “pao lu lao ban” (runaway bosses) who, in the absence of extradition agreements with mainland China, would not face rendition to Hong Kong. 

SFC never disciplined CCB International Capital (CCBIC) for its sponsorship of Fujian Nuoqi, but disciplined it for an unsuccessful listing application of Fujian Dongya Aquatic Products. Leery about punishing the subsidiary of a state-owned mainland bank, SFC fined CCBIC HK$24 million but noted “no evidence [of] systemic failure in CCBIC’s policies, procedures and practices”.

The law

Pre-IPO shareholders maximize their returns by persuading public investors of their company’s financial prospects. To protect the integrity of this process, legislation and listing rules prescribe disclosure requirements. Company directors must accept responsibility for the accuracy of a prospectus and confirm it contains no untrue statement or omission of material fact. 

The Securities and Futures Ordinance imposes civil and criminal liability on anyone who discloses or disseminates false or misleading information likely to induce another person to subscribe for or deal in securities. 

The Companies (Winding Up and Miscellaneous Provisions) Ordinance (CWUMPO) provides that directors, promoters and persons who “authorized the issue of a prospectus” have civil liability to persons who subscribe for shares on the faith of the prospectus and who sustain a loss due to any untrue statement therein. Experts, such as accountants, who consented to the issue of a prospectus containing their professional statements, are liable in respect of their own untrue statements. A person is not liable if they prove they had reasonable grounds to believe the untrue statement or, in relation to untrue statements by an expert, had reasonable grounds to believe the expert was competent.

CWUMPO also imposes criminal liability on any person who authorized the issue of the prospectus containing an untrue statement, unless they prove the statement was immaterial or they had reasonable grounds to believe the statement was true. 

This legal framework gives regulators a range of options for taking action against a listing applicant, its directors and auditors. 

Sponsors

Unlike most jurisdictions, Hong Kong also requires applicants to engage a sponsor to assist with the listing process, despite IPO sponsors not even being mentioned in legislation. Their role is codified only in HKEX listing rules and SFC conduct codes. 

SFC asserts that persons who “authorized the issue of a prospectus” include sponsors. However, the legislation is ambiguous and no case law confirms that interpretation. In 2005, and again in 2012, SFC proposed statutory amendment to include sponsors explicitly within the scope of liability. On both occasions, SFC quietly dropped the proposals, claiming CWUMPO already covers sponsors and no revision is necessary.

In SFC’s view, “investors rely on sponsors to act as key gatekeepers of market quality and, at the heart of this is the expectation that sponsors have conducted sufficient due diligence to properly understand and assess a company aspiring to join the stock market.” From a rules-based perspective, however, it is not for sponsors to police “market quality”. Their responsibilities are less lofty, and include:

• being “closely involved” in preparation of the prospectus;
• conducting “reasonable due diligence”; and
• using “reasonable endeavours” to address all matters raised by HKEX. 

Decisions of the Securities and Futures Appeals Tribunal confirm that sponsors must ensure listing applicants issue a good quality prospectus. SFAT said sponsors “must act with independent professionalism in ensuring that all information placed before [HKEX] and investors generally is fully, fairly and accurately presented.” But sponsors are not required to “chase every rabbit down every hole”, nor to ensure the applicant is a good quality company. Case law does not support SFC’s implication that sponsors’ duties extend to rejecting any applicant that offers a poor investment opportunity. 

Moreover, there is no public policy rationale for requiring sponsors to assume greater responsibility than accountants for accuracy of financial statements. A note buried in SFC’s licensee Code of Conduct acknowledges: “As a reporting accountant performs audit procedures on information received from a listing applicant under applicable professional standards, a sponsor is not expected to carry out any further due diligence on this information.” However, SFC disciplinary announcements give no hint of this.

In fact, when listings go awry, sponsors risk being the first parties SFC pursues, and possibly the only parties pursued successfully. Being licensed, sponsors can be fined, reprimanded, suspended and stripped of their licences by SFC – in effect wielding disciplinary powers as prosecutor, judge and jury – without any need to make its case in court. 

Outsourcing

When disciplining CCBIC, SFC complained the sponsor commissioned a due diligence plan from lawyers but didn’t follow it. The finding is perverse because sponsors, not their service providers, are responsible for determining due diligence plans. A plan’s adequacy should be assessed objectively, not against whatever some lawyers happen to propose. SFC has itself warned of sponsors’ habitual delegation of responsibilities, and insisted, “Sponsors remain ultimately responsible for the quality and substance of the due diligence undertaken by agents they appoint.” 

Problematically, some sponsors lack the competence to fulfil that responsibility. With lawyers and accountants cutting fees to compete for work, cutting the quality of services correspondingly, outsourcing might fail to fill the competency gap.

Reliance on accountants is inescapable, because prospectuses must include an auditor’s report. IPO fraud usually involves paying accountants to sign off false financial statements. That begs the question whether accountants were negligent in failing to detect the fraud, which should expose them to prosecution. Invariably, however, accounting firms escape SFC’s attention.

Punishment

In 2013, SFC introduced a new regime seeking to make sponsors explicitly accountable. Two previous attempts at statutory reform having failed, the regime was implemented by inserting a new paragraph into the Code of Conduct. It is arguable whether the change amounted to new regulatory standards, or simply a more detailed expression of SFC’s expectations. In any case, SFC codes do not have force of law. They serve legitimately only as tools of statutory interpretation. However, SFC staff seldom appreciate the difference, so codes are commonly regarded unquestioningly. 

Further clues to SFC’s expectations are found in circulars, regulatory bulletins and thematic reviews. Typically, SFC alleges failure by sponsors to:

• conduct reasonable due diligence, confirm material customers and conduct face-to-face interviews;
• investigate red flags;
• properly supervise team members;
• keep proper records; and
• ensure that information submitted to the regulators is complete and accurate.

Initially, SFC took little regulatory action reinforcing its rhetoric. Perceptions lingered that SFC was struggling to figure out how to use coercive powers without tainting Hong Kong’s reputation as an attractive listing venue. HKEX has become increasingly reliant on mainland companies, which account for 80% of market capitalization and 90% of turnover. A crackdown on fraud might scare some of them off. 

Any doubt that SFC would act was dispelled in 2019, when SFC fined sponsor subsidiaries of four international banks: 

• UBS AG and UBS Securities Hong Kong − HK$375 million, and 12 months licence suspension (for sponsorship of China Forestry, China Metal and Tianhe);
• Morgan Stanley Asia − HK$224 million (Tianhe);
• Merrill Lynch Far East − HK$128 million (Tianhe);
• Standard Chartered Securities (Hong Kong) − HK$59.7 million (China Forestry).

SFC later fined China Merchants Securities HK$27 million for neglecting “a number of unusual facts and findings on China Metal and its customers”. China Merchants had only a token involvement in the listing, being appointed just a few months before China Metal’s second application. Strangely, SFC’s summation of China Merchants’ failings focused almost entirely on activities of its co-sponsor, UBS. This suggests co-sponsors might be unable to mitigate risks by contractually delineating the extent of their responsibilities. SFC might consider all the sponsors culpable for any supposed shortcomings in the whole sponsorship process. 

Conclusion

Hong Kong’s absorption into China over recent decades has been a bonanza for HKEX but the scourge of many investors, introducing a slew of scams to public markets. SFC has limited success holding fraudsters accountable, and has shown no inclination to pursue auditors who sign off false company accounts. Instead, enforcement efforts are primarily focused on sponsors. As licensees, sponsors are attractive candidates for punishment.

In next month’s issue, the author will review recent regulatory and enforcement developments concerning sponsors. 

***

A version of this article first appeared in the September 2023 issue of Hong Kong Lawyer, the official journal of The Law Society of Hong Kong.

Prologue

The costs of a conventional initial public offering (“IPO”), principally underwriting fees, can amount to over 20% of the money raised. Some private companies, rather than taking the time and expense of going through the listing process themselves, essentially buy a listing off the shelf by merging with a listed shell company. The listing industry has developed various ways to do this – some legitimate, others fraudulent.

Last year, Hong Kong formalized the practice of shell manufacturing with the introduction of a SPAC regime, largely basing its provisions on current US market practice. Problematically, analyses of US markets show that SPAC mergers tend to significantly underperform typical IPOs, with the proportion of investors’ funds that are consumed by service providers being much higher even than in a conventional IPO. As a result, although service providers and fundraisers may profit handsomely, SPACs are a toxic product for retail and professional investors alike, often sparing only those who dump their holdings at the first opportunity.

Act I, Scene I: An ill-omened pedigree

Listed shells have plagued the Hong Kong stock exchange (“HKEX”) for decades, long before the vehicles were re-branded as SPACs. Shell manufacturing typically involves the listing of a company without any genuine intention of raising capital for existing operations. Usually, it is a relatively small business, such as a family-owned trading firm, with barely sufficient turnover (real or fabricated) to satisfy the minimum listing criteria. Controlling shareholders sell their shares after the IPO and expiry of a regulatory lock-up period, and the directors have a change of heart regarding the business plan disclosed in the prospectus. Sometimes, they sell the company’s business back to its original owners, who walk away with a profit, leaving a listed shell with no operations.

Shareholders of the shell can usually sell at a premium to book value. At best, this premium represents the opportunity for quick access to public capital markets without the inconvenience of jumping through the regulatory hoops of an IPO. At worst, the premium is speculative froth arising from illegal market activity. Listed companies with few assets tend to have low revenue and few shareholders. The shares are likely to have a low trading volume, making them especially vulnerable to market manipulation and price volatility. A classic “penny stock fraud” involves the quiet accumulation of such shares, then noisy promotion by boiler room brokers through spam emails and cold calls. New demand drives up the price, allowing scammers to sell their shares at a profit before the demand and price again collapses.

The directors of the shell company, having divested the original business, later buy another. That business thereby becomes a public company via a “backdoor listing”, circumventing the regulatory vetting of the usual listing process. Backdoor listings are susceptible to fraud. This is because directors of the listed shell can make an acquisition with relatively little disclosure and oversight. In an IPO, key information must be disclosed in a prospectus, and underwriters mitigate their risk by undertaking due diligence. Without this independent verification, it is easier for the business that is going public to falsify its earnings and inflate its stock price. The directors of the listed company acquiring that business might be misled by the falsification, indifferent to it, or complicit in it.

Previously, the Securities and Futures Commission (“SFC”) and HKEX tried clamping down on shell manufacturing and backdoor listings. They increased their scrutiny of suspicious listing applications, such as those with assets consisting substantially of cash, and threatened to suspend or de-list companies with insufficient business operations. With backdoor listings attracting unwelcome regulatory attention, however, the scions of at least two Hong Kong billionaires turned away from Hong Kong markets to list SPACs in the US instead. This development, two or three years ago, spurred Hong Kong authorities to rethink their regulatory approach.

Act I, Scene II: A peek behind the curtain

As investment vehicles without any existing business, SPACs are simply listed shell companies in a different costume. Many are launched by high-profile financiers, known as “founders”, “sponsors”, or “promoters”. After raising capital through an IPO, the SPAC swallows one or more private companies (“de-SPAC targets”), a process known as “de-SPACing”. Although sometimes referred to as an “acquisition”, the deal is usually structured as a reverse merger, in which shareholders and management of the target gain control of the SPAC. The merged “successor company” is listed, and the target thereby becomes publicly owned and traded.

For investors, one of the purported benefits of SPACs is that they provide an opportunity to exploit a valuation arbitrage between private and public equity markets by participating in private equity-like investment. However, that benefit has usually proven illusory, with the structure of SPACs creating substantial costs, misaligned incentives between promoters and other shareholders and, ultimately, losses for investors who continue to hold shares after de-SPACing.

Theoretically, investigation and analysis by promoters should enable them to identify promising targets among private companies that might struggle to go public through a conventional IPO. An IPO may be problematic, for example, because the company’s business is unusual or complicated, making it difficult for the company and its underwriters to agree on an IPO price. Another potential advantage of SPACs is that, within basic regulatory parameters, there is great scope for customization of the commercial terms governing each structure. In practice, however, SPACs have proven resistant to commercial innovation and have become quite standardized.

For promoters, the irresistible attraction is that they acquire equity in the SPAC on far more favourable terms than investors in the IPO or subsequent investors on the open market. The standard arrangement is that promoters are issued 20% of the post-IPO shares for mere nominal consideration. For example, if IPO investors buy 80 million shares for $10 each, the promoters receive 20 million shares essentially for free, resulting in a total issue of 100 million shares with $8 underlying each of them. Those 20 million shares, referred to as “the promote”, are the promoters’ reward for their efforts and risking their capital to set up the SPAC and complete a de-SPAC transaction. Promoters may also receive earn-out rights, entitling them to additional free shares if the successor company achieves specified revenue, profit or share price targets.

In most cases, SPAC promoters cannot use any IPO proceeds to pay the costs of the IPO and of finding a de-SPAC target. Instead, promoters themselves fund the SPAC’s working capital. For example, a SPAC may use a loan facility from its promoters, and also sell “promoter warrants” for $1 each. Each warrant may entitle the promoters, one year after de-SPACing, to purchase one share for $11.50. Warrants are typically exercisable on a cashless basis, meaning the promoters, in this example, can surrender their warrants in exchange for shares of equivalent value to the amount by which the market price of the shares exceeds $11.50. Although used primarily as a mechanism to pay the SPAC’s expenses, rather than as compensation for the promoters, the warrants will yield a profit if the successor company’s share price exceeds the exercise price by more than $1.

IPO investors, meanwhile, are customarily issued free warrants alongside the shares, similarly entitling the warrant holder to purchase newly issued shares in the future at a certain price. This compensates IPO investors for using their cash, like underwriters, to help launch the SPAC.

A proposed SPAC merger can only proceed after receiving majority shareholder approval. Shareholders rarely withhold approval because their warrants become worthless if no merger is completed. If the promoters fail to finalize a merger within a predetermined period, usually two years, all shares (other than the promote) are redeemed at the IPO price plus interest. The SPAC’s net asset value – consisting chiefly of the IPO proceeds, until then held in trust – then falls to zero, so the promote and all debt of the company become worthless. Consequently, promoters have an overwhelming incentive to ensure de-SPACing occurs, even if the terms are unfavourable to other investors. Given the costs they incur versus the equity received, promoters can enjoy very fat returns. This is possible even if the SPAC acquires targets for more than they are worth and the successor company’s share price subsequently tumbles.

While promote shares are locked-up, other shareholders are entitled to cash out, at the IPO price plus interest, after a merger is announced and before it is completed. Consequently, until de-SPACing, IPO shareholders enjoy a capital-guaranteed investment with potentially attractive returns, plus a free “equity kicker” in the form of warrants. If shares are trading above the IPO price, these investors typically sell them. Otherwise they typically redeem them after the merger announcement. According to a study published in 2022 (Klausner, Ohlrogge and Ruan), the investors in SPAC IPOs in the US are predominantly hedge funds and “nearly all” of them sell their shares before de-SPACing. However, most retain their warrants until they become exercisable, usually 30 days after de-SPACing. The authors found that the warrants delivered average annualized returns from the IPO until de-SPACing of 11.6%. While this may be an attractive low-risk return, it is a potential trap for retail investors. If an investor misses a notice of redemption and fails to exercise the warrants, they become worthless. The inattentive or inexperienced investors’ loss is the other investors’ windfall.

Some of the equity lost to redemptions before de-SPACing is offset with private investments in public equity (“PIPE”) by independent institutional investors. The promoters and the target undertake a promotional roadshow, much like a company going public through a conventional IPO. Although shares are typically issued to PIPE investors at a discount, the funds raised at this stage often exceed non-redeemed equity from the SPAC IPO. PIPE financing therefore can sharply reduce SPAC costs as a percentage of net cash delivered to the successor company.

Even with significant PIPE financing, the costs of the SPAC process are typically “more than twice as high” as a conventional IPO. The promote, earn-outs and warrants, which substantially dilute other shareholders’ share of the underlying cash, are the most eviscerating expense. Further costs include underwriting fees, typically charged at 5.5% of the IPO proceeds, without adjustment even if most of the shares are redeemed before de-SPACing. The underwriter and other service providers may also tap the SPAC for advisory fees. Redemptions then deplete the amount of underlying cash, thereby amplifying the costs for each remaining shareholder.

Klausner et al’s study of 47 de-SPAC transactions occurring from January 2019 to June 2020 found that the average net cash underlying each SPAC share (issued at $10) was just $4.10. This means that more than half of the value per share was dissipated through fees and other compensation.

Until a merger is announced, SPAC shares tend to trade at roughly their IPO price of $10, because the redemption right creates a price floor. A year after de-SPACing, however, most successor companies’ share prices have underperformed by an amount roughly comparable to the cash per share that has been extracted by service providers, “with the remaining value [on a market-adjusted basis] roughly equal to the net cash a SPAC contributes to a merger.” While SPACs might be dazzling upon first appearance, they typically bomb at the box office. 

Act II, Scene I: SPACs bomb in America

SPACs were the hottest thing on Wall Street in 2020, a financial fad accounting for more than half of all US IPOs. Many SPACs included celebrities in their management teams, and investors were captivated. SPACs raised a record US$83 billion that year, and a further US$162 billion in 2021.

The hype soured with a succession of high profile failures. For example:

• Rapper Jay-Z became “chief visionary officer” of The Parent Company, “the largest, most socially responsible and culturally impactful cannabis company in California,” with a market capitalization over US$1 billion after a de-SPAC merger. Two years later, its share price has fallen 98%.

• Two decades ago when asked on TV about her alleged involvement in securities fraud, Martha Stewart famously replied, “I want to focus on my salad.” Now embracing a “secular shift to vegetable-based diets”, Stewart is a director of AppHarvest Inc – “an applied technology company that could integrate a wide range of systems for the common purpose of providing a much-needed resource” and that, at the end of the day, grows tomatoes in a greenhouse. It went public through a SPAC deal in 2021 with a valuation over US$1 billion. Its share price has fallen 99%.

• Basketballer Shaquille O’Neal was “special advisor” to the SPAC that took WeWork Inc public. The merger valued WeWork at about one fifth of its US$47 billion valuation preceding a failed IPO attempt two years earlier, when the company was panned as “a real estate arbitrage startup that thinks [it’s] disrupting consciousness by making secondary leases and giving out beer.” Twenty months after going public, its share price has fallen a further 98%.

• Car sharing company Getaround Inc listed through a SPAC merger in December 2022. Its share price has fallen 97%.

• When Donald Trump’s media company announced a merger with Digital World Acquisition Corp, the SPAC’s share price jumped from $10 to $175, giving the proposed successor company an implied market valuation over US$19 billion. It then emerged that the parties signed a “letter of intent” less than three weeks after the SPAC’s IPO, raising suspicions they had secretly discussed the merger months earlier. While the SPAC shares are now trading around $13, the possibility of fraud charges could further dampen investors’ enthusiasm.

Overall in 2021, while the S&P 500 rallied 27%, a share price index of de-SPACed companies (DESPACTR) tumbled 45%. In 2022, DESPACTR fell another 71%.

SPACs’ popularity has contributed to their decline. This is because they compete with each other in the hunt for target companies, while under pressure to de-SPAC before deadlines otherwise requiring money be returned to investors. Deals get riskier or more expensive as promoters get desperate. A surge of lawsuits has emerged from the wreckage, with investors and regulators suing SPAC promoters, directors and advisers for allegedly making misleading disclosures, failing to vet deals properly, or committing fraud.

Act II, Scene II: Hong Kong arrives late to the festival

On HKEX in 2021, the amount of money raised in IPOs shrank 18% from the previous year. In contrast, global IPO fundraising jumped 87%, having enjoyed a major boost from another record year of SPAC listings in New York. With the progeny of Hong Kong’s four (plus) big families eager to join the SPAC stampede, the Hong Kong government wished to help them do it at home. In March 2021, Financial Secretary Paul Chan cued SFC and HKEX to explore new listing regimes, including SPACs. The regulators obliged, in December that year publishing consultation conclusions and announcing that SPAC listing applications would be welcomed from the following month.

Standard features of SPACs that developed as a matter of market practice in the US were in Hong Kong codified in listing rules, with the addition of some convoluted and apparently arbitrary restrictions. For one thing, only professional investors may subscribe, and at least 75% of shares must be subscribed by institutions. Retail investors can buy the company’s shares on HKEX only after it has de-SPACed. HKEX concluded SPACs are not suitable for retail investors because, “As a SPAC is a cash shell without any operations, the price of its securities is much more likely, relative to an operating company, to be driven by speculation and rumour.” This assertion was contradicted by another, in HKEX’s consultation paper, that “Prior to a De-SPAC Transaction, the volatility in the share prices of most US listed SPACs is similar to that of a bond, with low volatility at a constant valuation around their IPO share price.”

Although SPAC share prices sometimes increase (like an “IPO pop”) on the announcement or completion of a de-SPAC transaction, prices typically start deflating immediately thereafter – the very time retail investors will be allowed in. The floor of around $10 disappears, and subsequent issues of free or discounted shares from earn-outs and warrants exert downward price pressure. In other words, Hong Kong regulators have decided to reserve a potentially lucrative risk-free asset class exclusively for professional investors, while allowing retail investors the opportunity to pay higher prices, without downside protection, in the secondary market after de-SPACing.

Another dubious requirement is that SPACs in Hong Kong must have a net asset value of at least HK$1 billion upon listing. This is intended “to ensure high quality Successor Companies are listed.” Without any evidence of correlation between size and quality (HKEX’s consultation referred only to “high quality” promoters), by whatever metric that might be measured, it was a weak justification. Coupling a small SPAC with a big PIPE decreases the severity of a SPAC’s dilution, with a lower proportion of the total amount being pocketed by promoters and underwriters. So the minimum SPAC IPO requirement is likely detrimental to SPAC investors.

While the US has no regulatory requirement for PIPE investment, Hong Kong rules stipulate that PIPE must amount to at least 25% of the target’s value, declining to a minimum of 7.5% for targets over HK$7 billion. On application, HKEX may permit a lower percentage for targets over HK$10 billion. At least half of the PIPE must come from at least three institutional investors with assets under management of at least HK$8 billion. Although these appear to be arbitrary arithmetic criteria with no empirical justification, the implication is that regulators consider these to be the thresholds necessary for ensuring that PIPE investors perform sufficient due diligence on target companies. Regulators hope PIPE will provide a price validation mechanism, preventing SPAC promoters from shortchanging the other SPAC shareholders by acquiring targets at an excessive valuation.

Hong Kong has a further regulatory overlay to the due diligence process, requiring every listing applicant to engage at least one licensed IPO sponsor. Under the new SPAC regime, that requirement applies both to the SPAC and later to its successor company. The intention is that successor companies’ sponsors will perform due diligence on target companies “to the same extent as is performed for an IPO”.

As well as one or more IPO sponsors, each Hong Kong SPAC will almost inevitably have one or more SFC-licensed firms among its promoters. For one thing, some of the functions undertaken by promoters might constitute regulated activity. HKEX’s consultation conclusions dodged this issue, merely reminding promoters to consider whether there are any licensing implications. Also, listing rules now impose an eligibility or suitability test on promoters, in that HKEX “must be satisfied as to the character, experience and integrity of all SPAC Promoters and that each is capable of meeting a standard of competence commensurate with its position.” The intention is to exert tighter regulatory control over promoters than in the US, where endorsements by celebrities became so common that the Securities and Exchange Commission issued an alert cautioning investors not to make decisions based solely on celebrity involvement.

Supposedly, HKEX adopts a “holistic approach” in conducting the suitability assessment, taking into account “all relevant circumstances”. These include a listing rule that at least one of the SPAC’s promoters must be a firm licensed by SFC to provide corporate finance advice or asset management services. HKEX says promoters may seek a waiver of the requirement, for example on the basis that they have equivalent overseas accreditation. However, this guidance is inconsistent with listing rules requiring that the SPAC’s board include at least two SFC-licensed individuals, at least one of whom must be a director representing the SFC-licensed promoter. In view of the inconsistency (in which the rules should take precedence over the guidance), and the fact that SFC licensees are subject to SFC disciplinary proceedings (meaning they can easily be held accountable for perceived breaches of standards), it seems unlikely that regulatory authorities will readily allow the waiver. Consequently, in practice, suitability assessment will likely be left largely to SFC’s Licensing Department, which performs the task formulaically based on granular criteria (solvency, regulatory history, qualifications and years of experience) set out in its Guidelines on Competence.

HKEX’s first SPAC – Hong Kong’s off-Broadway SPAC premiere – listed on 17 March 2022, by which time the SPAC mania in America had already long turned rotten. Hong Kong’s stricter suitability requirements for promoters notwithstanding, the first SPACs to file listing applications were peppered with local personalities better known for their wealth or their political connections than their asset management experience. They included Kenneth Lau (hereditary legislator and Heung Yee Kuk chief) and his sisters; Norman Chan (former head of the Monetary Authority); Katherine Tsang (sister of Hong Kong’s second chief executive); and Li Ning (Olympic medalist).

Despite an initial flurry of applications, only five SPACs have listed, none raised more than the minimum HK$1 billion, and none have announced a de-SPAC transaction. The SPAC regime has failed to arrest the decline in equity fundraising on HKEX, with total IPO funds raised in 2022 plunging a further 68% from the previous year.

Denouement

Regulators in Hong Kong historically have seen prevention, suspension and delisting of shell companies as one way to improve market quality. So it is ironic that, with the introduction of a SPAC regime, they have now formalized the practice of shell manufacturing. In a further irony, seemingly to protect society’s grassroots from the more rapacious urges of the monied class, retail investors are excluded from this asset class altogether. They will be permitted to buy only after the shell becomes an operating company – precisely the moment that the smart money knows it’s time to sell.

While a honeypot to some celebrities, tycoons and their professional advisors, SPACs have by and large been disastrous for everybody else. A preponderance of failed SPACs in America suggests it is a deeply flawed structure. There is nothing yet to indicate that the experience in Hong Kong will be much brighter. 

A version of this article first appeared in the April and May 2023 issues of the Hong Kong Lawyer, the official journal of The Law Society of Hong Kong.