Kenneth Yeo and Daniel Martin look at how the regulator is taking a stronger stance in overseeing the mergers and acquisition activity of Hong Kong-listed companies
In 2016, the mergers and acquisitions (M&A) market involving Hong Kong-based companies was valued at over US$152.4 billion, according to statistics from Thomson Reuters. Hong Kong topped the global initial public offering (IPO) market by the number of offerings in 2016, with just over US$39.4 billion raised through IPOs, share placements, rights issues and other offerings. However, despite this positive financial result, Hong Kong regulators have become concerned about a growing number of irregular listed company transactions.
Notably, the Securities and Futures Commission (SFC) has focused its attention on deemed incidences of Hong Kong-listed companies that have entered into material transactions to acquire assets at unreasonably high prices, or sell assets that are substantially undervalued. The economic value of these transactions does not always appear to equate to the price paid. A key overriding concern raised by the SFC is that the parties to the transaction may not have taken reasonable steps to verify the deal valuation, given the duty directors have to determine whether the terms of the transaction are fair and reasonable, including the consideration paid. The following represents two extremes whereby the directors of a listed company:
- May not have appointed a professional valuer to value the target company or assets of a planned transaction; or
- May have appointed a professional valuer, but placed too much reliance on the valuation, without a sufficient level of review of the valuation methodologies or the reasonableness of the financial projections underlying the valuation, including any key assumptions or qualifications on which the valuation has been based.
The SFC has concluded that as a result, shareholders and listed companies may have suffered losses due to ill-advised transactions in which valuations may be deemed not to have been fair. To address the above concerns, the SFC in May issued the following public documents:
i. A guidance note on directors’ duties in the context of valuations in corporate transactions;
ii. A circular to financial advisors regarding valuations in corporate transactions; and
iii. A statement on the liability of valuers for disclosure of false or misleading information.
These announcements reassert the SFC’s expectations about the responsibility of company directors and the professional duties of financial advisors and valuation practitioners when handling corporate transactions of listed companies.
The guidance note to directors included the following key points:
- The need for a professional valuer, when the directors do not have sufficient knowledge or expertise in the industry of the investment or disposal.
- Should directors place unquestioning reliance on valuation reports in circumstances where there is no exercise of independent judgment, and it is unreasonable to do so, this will likely be a breach of the directors’ duty of care, skill and diligence owed to the company.
- Due diligence by the directors includes “being satisfied that financial forecasts and assumptions provided in relation to the asset/target company are reasonably justified.”
The SFC’s circular to financial advisors set out some clear reminders to financial advisors on their responsibilities under the Corporate Finance Adviser Code of Conduct (CFA Code), with specific guidance on the steps that they should take to discharge their obligations. Under these guidelines, a financial advisor should:
- Not rely solely on representations made by the directors, their delegates or other third parties;
- Conduct their own assessment and undertake reasonableness checks as appropriate on the forecasts, assumptions, qualifications and methodologies of the valuation and the directors’ decision on whether or not to appoint a professional valuer. In certain circumstances, it may be appropriate for several valuation methodologies to be utilized in arriving at the final valuation result;
- Bring to the attention of the directors any incidence where it deems a financial forecast to be unduly optimistic, for the directors’ consideration and appropriate action.
The SFC set out a liability statement that provides guidance to valuers on their potential liability for false or misleading information in relation to their valuation report. This is relevant given valuation reports are often included in listed company publications. The SFC will likely investigate the involvement of a valuer in the disclosure of false or misleading information by a listed company if it appears to the SFC that:
- The valuer knew or should have known that the valuation and/or any of the underlying assumptions was not reasonable and fair;
- The valuer has made an obvious mistake in the valuation;
- The valuer has not exercised the degree of skill and care that is ordinarily exercised by reasonably competent members of the profession; and
- The valuer has lost independence or impartiality in performing the valuation — for example, a valuer would not be impartial if they, who the listed company instructed to produce the valuation, advised the vendor of the target company to amend key terms of sales agreements, e.g. the unit price and transaction volume of the sales agreements, which formed the basis for the revenue projection used in the valuation of the target company.
The announcements are an example of the stronger stance taken by the SFC in regulating the M&A activity of listed companies. The SFC and the announcements aim to ensure that listed companies acquire or sell assets at prices that are in the best interests of the shareholders and the listed company. The transacted prices should be fully supported by a robust valuation report and with due diligence conducted on the target by the directors and financial advisors.
The SFC’s current initiatives raise the required standards and responsibilities of directors, financial advisors and valuers. We note, regulators have and will continue to take action on directors or professional firms for alleged breaches of duties or misconduct. Earlier this year, the Hong Kong Independent Commission Against Corruption charged the directors of two listed professional services firms for alleged unannounced issues.
Ongoing changes to listing rules and accounting standards globally have increased the demand for high quality valuation and financial information. The accounting profession, alongside other professional bodies in Hong Kong, should also take on the responsibility for ensuring the quality of valuations for financial reporting.
This would help lift standards and aid the SFC’s work to minimize the irregularities in company transactions and protect investor interests.
Kenneth Yeo is Director and Head of Specialist Advisory and Daniel Martin is Principal of Specialist Advisory at BDO Hong Kong