Chapter 12

Due Diligence Guidelines –

Financial

12. “Red Flags” and Similar Irregularities

12.1 Standards

12.1.1 As a reporting accountant performs audit procedures on information received from a listing applicant under applicable professional standards, a sponsor is not expected to carry out any further due diligence on this information. [Note 1 to Paragraph 17.7(b) of the Code of Conduct]

12.1.2 Nevertheless if a sponsor is aware of any matters which raise concerns relating to the information underlying the accountants’ report, the sponsor should conduct further enquiries necessary to satisfy itself that these concerns are addressed; these enquiries may involve obtaining relevant supporting information and documents. [Note 1 to Paragraph 17.7(b) of the Code of Conduct]

12.1.3 Where the sponsor becomes aware of circumstances that may cast doubt on information provided to it or otherwise indicate a potential problem or risk, the sponsor should undertake additional due diligence to ascertain the truth and completeness of the matter and information concerned. Over-reliance on management’s representations or confirmations for the purposes of verifying information received from a listing applicant cannot be regarded as reasonable due diligence. [Paragraph 17.6(c) of the Code of Conduct]

12.2 Guidance

12.2.1 These limitations in the Code of Conduct on a sponsor’s reliance on expertised input to a listing document are reflective of case law which has developed in jurisdictions outside Hong Kong, most famously in In re WorldCom, Inc. Securities Litigation, (S.D.N.Y. 2004) (02 Civ. 3288 (DLC)) (“Worldcom”) but also including (among others) In re Software Toolworks Inc., Securities Litigation 60F 3d 615 (9th Cir. 1994) (“Toolworks”).

12.2.2 The cases are commonly considered to demonstrate at least two general propositions concerning sufficiency of due diligence where a “red flag” has appeared:

(a) Blind reliance on experts is not acceptable, and mere reliance is not sufficient where a “red flag” has emerged; and

(b) That concept can apply to (and trigger a duty to further investigate) even audited financial statements.

12.3 What Is a Red Flag?

12.3.1 The Code of Conduct refers to “matters which raise concerns” and “circumstances which cast doubt on information provided” and “over-reliance on management’s representations or confirmations”.

12.3.2 Cases (outside Hong Kong but considering similar issues) have considered underwriters having “no reasonable grounds to believe (the information to be) untrue” or (conversely) having “reasonable grounds to believe (the information to be] true”.

12.3.3 It is clear that all of these concepts envisage and require something which is specific, as a result of which underwriters can no longer rely at face value (or “blindly”) on the financial information presented by the listing applicant without further enquiry. This concept has commonly been referred to as a “red flag” or (occasionally) “storm warning”.

12.3.4 There is no statutory or “brightline” test for a “red flag” or other circumstances which compromise reliance on audited financial statements (or on comfort letters on unaudited information). It will always depend on the facts and context of a particular case.

12.3.5 Nevertheless, the term “red flag” has been considered to encompass two concepts:

(a) First, facts that would place a reasonable party “on notice that the audited company was engaged in wrongdoing to the detriment of its investors”; and

(b) Second, facts or circumstances that “would suggest to an investor of ordinary intelligence the probability that she has been defrauded”.

12.3.6 In the Worldcom case, a number of “red flags” were alleged primarily comprising (i) a key financial ratio which was significantly lower than the equivalent for its two closest competitors and (ii) extrinsic grounds to be suspicious of accounting treatment in a substantial business segment where there was significant deterioration. (On the particular facts the court was less receptive to further allegations of a “red flag” comprising stressed personal financial circumstances of the company’s founder).

12.3.7 In the Toolworks case, the alleged “red flags” primarily comprised discovery of a memorandum that revealed the backdating of a sales contract. (As to the further investigation which ensued, see further below).

12.3.8 In the earlier case of Frontier Ins., 318 F.3d the court found that a company’s taking three substantial reserve charges over four years should have “alert[ed] any reasonable investor that something is seriously wrong”.

12.4 Recommended Steps

12.4.1 There is no definable method to determine where or whether a “red flag” exists in context of audited or unaudited financial statements.

12.4.2 The sponsor’s execution team members should therefore consult internally and (where applicable) with external lawyers if they detect something significantly anomalous.

12.4.3 The additional steps required in light of a “red flag” will always be fact and case-dependent.

12.4.4 Because “red flags” are cause for enhanced diligence to determine the circumstances underlying the “red flag” scenario, sponsors will commonly have internal procedures or practices which are aimed to ensure a considered decision on appropriate additional steps.

12.4.5 Sponsor transaction team members should consult in-house lawyers in case of any doubt.

12.4.6 It is to be noted that cases have shown the particular importance of recording supplementary investigations made to address concerns raised by “red flags”. (See section 17 below (“Records”)).

12.4.7 Investigation of circumstances underlying a “red flag” will also involve consideration of additional disclosure in the listing document depending on how underlying issues are resolved in the particular case.

12.4.8 The regulator expects the sponsor to make such enquiries as may be necessary until the sponsor can reasonably satisfy itself of compliance with regulatory requirements in relation to the disclosure in the listing document. A sponsor is expected to perform additional due diligence work with a questioning mind in response to sceptical circumstances. [HKMA Report on Thematic Examinations of Sponsor Activities, November 2011 paragraph 27]