Hong Kong's financial market watchdog will launch a public consultation in the next couple of weeks that seeks to toughen rules for banks sponsoring initial public offerings, including holding them liable for faulty deal documents.
The move is likely to draw strong opposition from foreign investment banks worried about increased risk in a market that has been the world's biggest for listings in two of the past three years, but has also seen a number of scandals.
According to sources with direct knowledge of the matter, the Securities and Futures Commission (SFC) is set to issue a two-part consultation paper, with one section proposing to toughen the code of conduct for IPO sponsors and the second making them liable for the contents of listing prospectuses.
"Everyone will be taking a step back and revisiting whether it makes economic sense to even pursue those deals," said Bonnie Chan, a partner at law firm Davis Polk & Wardwell and former head of Hong Kong Exchange's IPO transactions department. She had not seen the consultation paper.
The initiative follows a string of scandals at Chinese companies that went public, only to then face accusations -- and in some cases proof -- of fraud shortly after listing.
Sponsors, usually banks or smaller corporate finance houses, prepare a company's listing documents and perform due-diligence to ensure they comply with Hong Kong's listing rules.
If accepted, the rules are likely be some of the toughest for IPO sponsors or deal managers in Asia. In Singapore for instance, lawyers say that while prospectus liability can extend to underwriters, the onus usually rests with the listing company and its directors.
"This could make it more expensive to list in Hong Kong," said a capital markets lawyer in Singapore.
Liability could leave investment banks, and possibly some of their employees, open to massive legal cases and fines if a deal went wrong.
"We're an easy target," said one investment banker who asked not to be named as he is not authorized to speak to media.
"In some ways, sponsors act as whipping boys," he added.
The SFC estimates that the total income derived from IPO sponsorship in Hong Kong was HK$4.8 billion ($618.50 million) and HK$2.2 billion for the years ended September 30, 2008 and 2009, respectively, the most recent years available.
The SFC proposed similar regulation in 2005 but dropped it following widespread opposition from the finance industry.
But since then the Hong Kong market, the world's biggest for IPOs in 2009 and 2010 when $89 billion was raised there, according to consultancy PricewaterhouseCoopers, has been hit by a number of scandals at companies soon after they listed.
Chinese textiles maker Hontex 0946.HK had its shares suspended in early 2010, just three months after it listed, when the SFC alleged its IPO prospectus "materially overstated" its financial position.
The SFC said last year that an inspection of IPO sponsors found a series of deficiencies in their work, including inadequate due diligence and questionable disclosures to the Hong Kong Stock Exchange.
In the light of this, many in the legal industry doubt that investment banks will be able to stave off tougher rules a second time round.
"I would be surprised if there's much scope to roll back what's in this paper. I expect even the soft consultation has been mainly just a courtesy to the industry," said one Hong Kong lawyer, who declined to be named given the sensitivity of his relationship with the SFC.
An SFC spokesman said the regulator had no comment to make on the consultation paper.
NEW SFC CEO'S PUSH
The new proposals may also result in smaller local banks picking up listing work that big name U.S. and European investment banks may no longer be willing to do.
"The Hong Kong market is likely to further segment as the Chinese banks assert their presence more in that space," said Hayden Flinn, a partner at law firm King & Wood Mallesons in Hong Kong.
This consultation will be one of the first big initiatives undertaken by the SFC since chief executive Ashley Alder took the helm in October. When he took on the role, Alder said he supported bringing in new regulation for IPO sponsors.
Tighter regulations are likely to get investor backing, coming at a time when there is a strong focus on the quality of some Hong Kong-listed companies after a number of problems cropped up at the end of this year's company reporting season.
"By sponsoring a listing, a firm should be taking all reasonable steps to verify the contents of a company's prospectus, particularly the parts for which other advisers are not liable," said David Webb, an activist investor who runs his own governance website.
"If a sponsor is negligent in carrying out due diligence then it should be held liable to investors for that," he said.
Last month, Deloitte resigned as auditor of Daqing Dairy Holdings Ltd (1007.HK) and childrenswear manufacturer Boshiwa International Holdings (1698.HK), with both companies now being investigated for possible financial irregularities.
Several other companies, including Ausnutria Dairy (1717.HK) and Ports Design Limited (0589.HK), have had their shares suspended after they missed the deadline for filing their annual reports due to their auditors saying they needed more time to complete the work.
($1 = 7.7607 Hong Kong dollars)
(Editing by Michael Flaherty and Muralikumar Anantharaman)