Hong Kong SFC Statement On The Conduct And Duties Of Directors When Considering Corporate Acquisitions Or Disposals.

 

6 August, 2019

 

 

The Hong Kong SFC published a statement on the conduct and duties of directors when considering corporate acquisitions or disposals in July 2019, which highlights recurring types of misconduct relating to corporate acquisitions and disposals.

 

The Hong Kong Securities and Futures Commission (SFC) has been using its powers under the Securities and Futures (Stock Market Listing) Rules and the Securities and Futures Ordinance to step in at an early stage in situations of serious corporate misconduct. A large number of these cases involved proposed corporate acquisitions or disposals.

 

In this connection, the SFC published a statement on the conduct and duties of directors when considering corporate acquisitions or disposals (the Statement) in July 2019.  

 

The Statement highlights recurring types of misconduct relating to corporate acquisitions and disposals.  Set out below is a summary of the Statement.

 

Independent professional valuation not obtained

 

The SFC is of the view that obtaining an independent professional valuation in relation to a proposed acquisition or disposal is often the prudent approach, even though listed issuers are not expressly required to do so under law or the Listing Rules.

 

Obtaining a valuation is a step that may be taken to protect the interests of the listed issuer and its shareholders.  If directors do not obtain a valuation, they may have failed to exercise the degree of care, skill and diligence that may be reasonably expected of them.

The SFC notes that in cases where an independent professional valuation was not obtained, issuers often simply announced that the consideration was arrived after arm's length negotiations, without giving thorough reasons.  This meant that the listed issuer's shareholders were not provided with information that they might reasonably expect. 

 

Lack of independent judgment 

Even when directors have obtained a valuation, they should not simply rely on the valuation report without reviewing it critically.  The SFC has come across valuers that merely carried out mathematical computations on forecasts provided by the seller(s) without exercising independent judgment.

 

In many of these cases, the valuation report included the results of certain companies that were presented as comparable companies, but in fact, these companies appear to have been cherry-picked to artificially justify a pre-determined result.  

 

It would be imprudent for directors to simply rely on such valuation reports to approve a transaction. In addition, any collusion between the directors and the valuer to use the valuation report to artificially justify a predetermined price estimate may amount to potential fraud. 

 

Lack of due diligence on earnings

 

The SFC has noted cases where directors conducted little or no independent due diligence on the forecasts, assumptions, or business plans provided by the seller(s) or the target, particularly in relation to the target's earnings.

 

Common issues include the lack of analysis on the quality of the target's earnings, and ignoring risk factors such as historical losses, unexplained sudden increases in sales, unjustifiably high margins, suspicious non-recurring items and questionable sources of revenue.  In some cases, the listed issuer paid a high premium for a business with low entry barriers without explaining why it did not simply start the same business at a lower cost.  

 

Comparables not presented fairly

 

The bases for compiling information on comparable companies must be justifiable and clearly stated in the valuation report (if applicable).  Directors should exercise independent judgment to select companies that are suitably similar to the target company, and ensure that the comparables in the valuation report (if applicable) reflect a fair and representative sample. 

 

The SFC has noted cases in which directors appear to have cherry-picked companies that had higher trading multiples or longer and more profitable track records, and ignoring those with poorer performance, without making for adjustments in the valuation report (if applicable).  

 

Not assessing impact on financial position

 

The SFC has noted cases in which the directors did not appear to have assessed any negative impact on the listed issuer's resources and financial position resulting from the proposed transaction, in particular, when the listed issuer appears to require substantial amounts to fund the acquisition or when investment is required by the target to meet any forecasts given by the vendors. 

 

Cases involving compensation from vendors to listed issuers

 

The SFC has noted that cases involving seller(s) paying compensation to listed issuers if projected profits were not met.  There were often no verification of the seller's ability to pay or other safeguards (such as escrow arrangements) to protect the listed issuer's interests.

 

Suspicious related parties or arrangements 

 

The SFC has noted some suspicious transactions that suggest an undisclosed relationship or arrangement among purported independent third parties, even though these relationships or arrangements may not fall within the definitions of "connected persons" or "connected transactions" under the Listing Rules.

The SFC may take enforcement against these parties if they act (or refrain from acting) in a manner to the detriment of the listed issuer and its shareholders, or which results in a distortion of the market of its shares.

 

Reminders for directors

 

• Directors have the duty to ensure any forecast or estimate in relation to a proposed corporate acquisition or disposal was compiled with due care and that the underlying assumptions are fair and reasonable – they should critically review it and conduct proper investigations and due diligence before approving it.
• Directors should carefully consider whether they need to engage a financial adviser to advise the board in relation to the valuation of a target company, taking into account whether the board has the time, resources and skills to perform the necessary work without an adviser. A failure to appoint an adviser when they should do so may amount to misconduct.
• Obtaining an independent professional valuation does not reduce the statutory duties of care, skill and diligence or the fiduciary duties owed by the directors.
• Directors should also refer to the SFC's guidance note dated 15 May 2017 on directors' duties in the context of valuations in corporate transactions. 
   

For a copy of the Statement, please click here.