Jurisdiction - Hong Kong
Reports and Analysis
Hong Kong – SFC Notes Poor Quality Listing Applications.

19 Juy, 2012

In July 2012, the SFC published its Dual Filing Update, which continued to note that listing application materials were not up to the expected standard. 
The areas of concern noted were:
1.  Assertions of critical importance were based on assumptions apparently at odds with observable facts
The SFC noted that liquidity problems and potential insolvency pose significant risks to the sustainability of a listing applicant. Where an applicant has experienced serious cash strains or continuing operating losses, the listing application materials should provide a balanced analysis of pertinent facts relating to the applicant’s business and industry environment to demonstrate that the applicant and its business can continue as a going concern.
Example 1
A property developer submitted a forecast predicting strong cash flows from its property sales based on forecast average selling prices that were approximately 30% higher than the historical average. Regulators’ enquiries revealed the 
  • actual cash flows for the first two months of the forecast period were much lower than the forecast because of exceptionally poor property sales in the traditional peak season; and
  • the applicant subsequently initiated a substantial price cut for one of its property projects.
Despite the material adverse changes, the applicant revised upwards the forecast cash flows without offering any plausible explanation. It was questionable whether the forecasts were prepared on reasonable grounds and after careful consideration.
Example 2
A media products distributor had never reported any operating profit despite its long operating history of over ten years and was expected to continue to have negative equity after listing. To justify its viability, the applicant asserted that it would be profitable within two years, assuming it managed to acquire and distribute more media products, but then provided no objective information to demonstrate how it would be able to turn around in practice. 
Regulators’ enquiries revealed the following:
  • a patchy track record in acquiring commercially successful media products; and
  • gross profits from some of its products could not even cover the corresponding amortization and distribution costs.
2.  Listing application materials were incomplete and not ready for regulators’ review
Submission of incomplete or inaccurate listing applications prolongs the vetting process at the expense of applicants. In order to facilitate efficient vetting, a listing application should comprise a substantially complete draft of the listing document and all other requisite supplementary documents under the relevant listing requirements.
Example 1
A listing application by an applicant established in a newly recognized overseas jurisdiction lacked a number of documents expressly required under the listing requirements. In the absence of further submissions, the application ultimately did not proceed.
Example 2
There were two cases where the listing applicants relied on external investment managers to manage their investment portfolios. They were required under the relevant listing eligibility requirements to demonstrate that their investment managers had the relevant investment experience. 
However, the draft listing document in one case did not contain the required disclosure, whereas the draft in the other case stated that the proposed investment manager did not have any relevant experience in the field of the applicant’s target investment. Both applications did not proceed after the regulators expressed concern on the qualifications of the investment managers.
Example 3
Draft listing documents were submitted which contained not only due diligence questions requesting information from the listing applicants regarding their customers or directors, but also obvious errors and inconsistencies that were attributed to “inadvertent typos” when queried. 
3.  Failure to provide meaningful disclosures on the risks, historical financialperformance and future plans 
Investors rely on disclosures related to risks, management’s discussion and analysis of financial performance (MD&A) and future plans in order to understand the specific events or factors driving the changes in a listing applicant’s financial performance historically and going forward. The listing document should provide sufficient information tailored to the specific circumstances of the applicant for investors to make an informed assessment of the applicant.
Risk Factors
Many draft listing documents contain only boiler-plate risk warnings, which fail to explain clearly the relevance, significance and likelihood of the risks disclosed. A common risk factor is that an applicant might not be able to obtain necessary government approvals for its development projects. However, the risk disclosures often failed to explain the risk in the context of the applicant’s business, such as the materiality and nature of the applicant’s projects that were pending government approvals at the time of listing.
Example 1
A draft listing document disclosed that the applicant might incur significant losses because it had agreed to provide very high guaranteed rates of return to its clients. However, it failed to disclose a meaningful analysis of the possible losses, such as a comparison of the market rent trend and the guaranteed returns for the various properties under the entrustment arrangements.
Example 2
A listing applicant operated various nonprofit entities that were prohibited by law from distributing dividends. To allow for dividend distribution, the entities must be converted into for-profit enterprises, which would operate under a different business model and tax regime. However, the initial draft listing document failed to disclose clearly the risks associated with such conversion and the different business model following conversion. 
Historical Financial Performance
The MD&A sections, particularly in the discussion of changes in gross profit margins and fair value gains, frequently merely recited figures from the financial statements in narrative form with little or no meaningful explanation of the events causing the fluctuations in the applicants’ financial performance. 
(a) Decrease in gross profit margins
Examples of unacceptable explanations for a decrease included:
  • “the rate of increase in cost of sales was faster than the rate of increase in revenue”; and
  • “differences in product varieties caused by changes in customer preferences”.
(b) Significant fair value gains
Sufficient information must be provided for investors to understand the reasons for the significant fair value gains during the track record period and the bases and assumptions used in the estimation of the gains.
Example 1
The estimated fair value of the applicant’s investment properties was said to have more than doubled over the track record period, although the applicant failed to lease out a substantial portion of the units and an industry report suggested that there was a severe over-supply of similar units in the market. There was no meaningful explanation for the significant appreciation in the estimated capital value of the applicant’s properties notwithstanding the unfavorable market conditions. 
Example 2
An applicant recorded a gain on certain biological assets acquired in the latest financial year but omitted the fact that some of the biological assets had been infected with disease and that the fair value was estimated based on a “constant yield” assumption, contrary to the decreasing yield of the biological assets in reality. 
Example 3
The draft listing document disclosed that the fair value of the applicant’s biological assets was estimated by an independent expert. The regulators’ enquiries revealed that the expert had not conducted any physical count to ascertain the condition or quantity of an entire class of biological assets, which accounted for over 30% of the total fair value of the applicant’s biological assets. 
Future Plans
Very limited disclosures on the applicants’ future plans make it difficult to understand the justifications for and the feasibility of the plans, which might use up a significant portion of the listing proceeds. 
Example 1
The use of proceeds was substantially revised after the regulators enquired about the details of the future plans, which raised concern on whether the original future plans were determined after careful consideration. 
Example 2
An applicant intended to use most of the listing proceeds to almost double its production capacity on the directors’ belief that market demand would grow rapidly, but did not reconcile the directors’ belief with the widespread media reports about weakening market demand nor provide meaningful justifications for the aggressive expansion plan given the historically low utilization rates of its production facilities 
and over-supply in the industry.


For further information, please contact:
Venantius Tan, Partner, Morrison & Foerster


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