For over two years, the Securities and Futures Commission (SFC) has been using its powers under the Securities and Futures (Stock Market Listing) Rules (SMLR) and under the Securities and Futures Ordinance (SFO) to intervene at an early stage in serious cases of corporate misconduct. In 2017 and 2018, the SFC issued letters of concern to more than 46 listed issuers about proposed corporate transactions or other actions1. More than 55% of these cases involved proposed corporate acquisitions or disposals.
This statement outlines recurring types of misconduct in relation to corporate acquisitions and disposals that have given rise to concerns and, in some cases, led to intervention by the SFC. Directors and their advisers are reminded to comply with their statutory and other legal duties when evaluating or approving the acquisition or disposal of a company or a business.
Lack of independent professional valuation
Listed issuers are not expressly required by law or under The Stock Exchange of Hong Kong Limited’s Listing Rules to obtain an independent professional valuation in relation to a planned acquisition or disposal. However, it is often the case that obtaining a professional valuation is the obvious and prudent thing for directors to do in order to protect the interests of the company and its shareholders. By not obtaining a professional valuation, directors would have failed to exercise the degree of care, skill and diligence that may be reasonably expected of them.
The SFC has noted that, in a majority of the cases where an independent professional valuation was not obtained, the listed issuers simply announced without further explanation that the consideration was arrived at after arm’s length negotiations, taking into account vaguely described factors such as the target’s business prospects and its alleged leading position in its industry. Often, these bare statements meant that the shareholders of the listed issuer were not being given all the information with respect to its business and affairs that they might reasonably expect.
Lack of independent judgment and accountability
In some cases where an independent professional valuation was obtained, the directors simply relied on the vendors’ forecasts in assessing the consideration for the target businesses. The valuers merely assumed without performing any due diligence or other work that the vendors’ projections would materialise. The profit forecasts often appeared to be baseless and, in some cases, were simply the amounts of the profit guarantees provided by the vendors. Some valuers completely disclaimed their liabilities for the reliability of the projections. In essence, these valuers merely carried out mathematical computations on the vendors’ forecasts and failed to exercise any independent judgment. In most of these cases, the calculations performed by the valuers merely involved applying a profit forecast or guarantee to a multiple derived from a set of allegedly comparable companies “cherry-picked” to justify a pre-determined estimate of the target business (see “Fair presentation of comparables” below).
Such valuation reports do not provide a credible basis for the listed issuer’s assessment of a planned acquisition and it would be highly imprudent for directors to rely on them in approving a transaction. Moreover, any contrivance between corporate insiders and the valuer to use the valuation report as a means to artificially justify a predetermined price estimate could amount to potential fraud on the listed issuer’s shareholders.
Quality of earnings
The SFC noted instances where directors or their advisers performed little or no independent due diligence on the forecasts, assumptions, or business plans which were provided by the vendors or the management of the targets and on which the acquisition prices were based. Analyses of the quality of the target businesses’ earnings were not performed and apparent risk factors, such as historical losses, sudden and unexplained increases in sales, unjustifiably high margins compared to industry peers, suspect non-recurring items and apparently questionable or unsustainable sources of revenue, were largely ignored. For example, in some cases, the listed issuer would agree to pay a hefty acquisition premium to enter a new industry with low entry barriers without explaining why it did not simply start the same business itself at a much lower cost.
Fair presentation of comparables
When performing a valuation based on multiples of publicly traded companies, the selection of appropriate comparable companies is important. Valuers and directors must use their judgment to select companies that have suitably similar characteristics to the target company and ensure that the comparables referred to in the valuation constitute a fair and representative sample. The bases for compiling any comparables must be justifiable and clearly stated in the valuation report. In some cases, the SFC noted that the directors “cherry-picked” companies that had higher trading multiples and disregarded others with poorer performance. Moreover, the companies chosen for comparison had significantly longer and more profitable track records than the target companies; however no adjustments were made to account for the differences between the companies chosen for comparison and the targets.
Impact on financial position
In some cases, the directors did not appear to have assessed the negative impact that the planned acquisition could have on the listed issuer’s resources and financial position. For example, in a number of cases, it appeared that the listed issuer would require substantial additional funds to meet the acquisition costs and the capital investment required by the target company in order to meet the forecasts provided by the vendors. Typically, these cash expenditures would have a substantial impact on the financial position of the listed issuer. In responding to the SFC’s enquiries, the directors failed to demonstrate that they had considered the capital expenditure required to sustain the target business, how such expenditure would be funded and the resultant impact on the listed issuer’s financial position.
Many transactions involved the listed issuer paying consideration up-front based on a profit forecast prepared by the vendor and an undertaking by the vendor to compensate the listed issuer in the event that the projected profits were not met. Often, there was no verification of the vendor’s ability to pay or other safeguards, such as holding funds in escrow, to protect the listed issuer’s interests. In some cases, the maximum compensation amount was substantially lower than the consideration to be paid by the listed issuer, even though the consideration was determined by reference to the profit guarantee given by the vendor.
Suspicious connected parties
The SFC has noted suspicious transactions that suggest an undisclosed relationship or arrangement among purported independent third parties. For example, a listed issuer, who appeared to have safeguarded its interests by obtaining a profit guarantee on the performance of a target from a connected vendor, sold the target shortly before the expiry of the profit guarantee period, when it seemed likely that the profit of the target would fall short of the profit guarantee. The disposal was suspicious because the listed issuer would have recovered a substantially higher compensation amount from the vendor under the profit guarantee than the proceeds it derived from the disposal. Aside from concerns surrounding how the listed issuer had conducted its business and affairs, and how the directors had performed their duties, the disposal also gave rise to concerns about an undisclosed relationship or arrangement between the purported independent third party buyer and the connected vendor.
In another instance, the target company acquired by a listed issuer recorded startling sales growth driven only by a handful of customers in a short period of time, thereby inflating the valuation of the target. Subsequent investigations revealed that the fees and income received by the target were derived from parties associated with the directors of the listed issuer.
While they may not fall within the definitions of connected persons or connected transactions under the Listing Rules, parties who have undisclosed relationships, arrangements or understandings that cause them to act (or refrain from acting) in a coordinated manner to the detriment of the listed issuer and its shareholders, or resulting in a distortion of the market for its shares, can expect enforcement action to be taken against them under the SFO and other applicable laws.
Proper investigation and due diligence
The SFC reminds directors that they owe a duty to ensure that any forecast or estimate used in relation to a planned corporate acquisition or disposal (eg, to appraise a target business or to determine the amount of a vendor’s profit guarantee) was compiled with due care; and that the underlying assumptions are fair, reasonable and represent company management’s best judgment or estimates at the time, taking into account all relevant information. In adopting or approving any forecast or estimate, directors should understand the implications of the underlying assumptions and ensure that the main uncertainties are appropriately reflected. Moreover, assumptions should be specifically (rather than generally) described, and be definite rather than vague.
Whilst it is not mandatory by law or under the Listing Rules to engage a financial adviser to advise the board in relation to the valuation of a target company, the board should carefully consider whether the directors, collectively, have the time, resources and expertise to perform the work necessary without the assistance of such an adviser. A failure by the directors to appoint an adviser when it is appropriate to do so risks a subsequent finding of misconduct.
As a professional adviser to the board, a financial adviser2 should conduct its own independent assessment of and undertake appropriate reasonableness checks on: (i) the forecasts, assumptions, qualifications and methodologies of the valuation; and (ii) where applicable, on the directors’ decision not to appoint a professional valuer. Where a valuer has been appointed, financial advisers should satisfy themselves that the directors have given due consideration to, amongst other things, the valuer’s professional qualifications and relevant experience, the scope of the mandate and the reasonableness of the forecasts, assumptions, qualifications and methodologies used in the valuation.
For the avoidance of doubt, obtaining an independent professional valuation in relation to a planned acquisition or disposal would not reduce or modify the statutory duties of care, skill and diligence, or the fiduciary duties, owed by directors of listed issuers. Directors are also reminded that they have a duty to exercise due and reasonable care, skill and diligence in the discharge of their duties. They may refer to the SFC’s guidance note on directors’ duties in the context of valuations in corporate transactions dated 15 May 2017.
The functions of the SFC include, so far as reasonably practicable: (i) to take such steps as it considers appropriate to maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness of the securities and futures industry, including the securities and futures markets; (ii) to secure an appropriate degree of protection for members of the public investing in financial products; and (iii) to suppress illegal, dishonourable and improper practices in the securities and futures industry including the securities and futures markets.
Where the SFC has serious concerns that an announced acquisition or disposal may be structured or conducted in a manner that constitutes a breach under the SFO or other applicable laws, it will have no hesitation in using its powers under the SFO and the SMLR to protect market integrity and the investing public.