As financial markets globalize, particular markets have increasing opportunities to shape themselves by adopting processes, concepts and regulatory frameworks borrowed from other markets. Given their highly-developed nature, United States capital markets feature many aspects that have been mimicked widely in developing markets and economies. However, in most cases developing markets usually strive to preserve particular facets of their past, for conceptual or, just as often, purely historical reasons, rather than adopting things wholesale from other parts of the world.
Hong Kong provides an excellent example of this evolutionary clash between developing global best practices and historical legacy. In the Hong Kong initial public offering market, certain aspects – such as standards of prospectus disclosure – have quite clearly been shaped, for more than a decade, by global thinking led, in many respects, by the standards prevailing in the US. On the other hand, other key characteristics of Hong Kong IPOs (for example, the continuing emphasis on the public offer process, the “retail” portion of HK IPOs) can very easily be linked to Hong Kong’s past and the British colonial experience. One facet of the IPO process which has been considered recently in quite a bit of detail by Hong Kong regulators and market professionals is the use of pre-deal research reports, produced by research analysts at financial institutions participating in the underwriting syndicate for an IPO, in conjunction with the marketing process for the IPO. Arguably, and somewhat unfortunately, the latest evolutionary step in this area may reflect the worst of both worlds.
In the United States, research reports written by analysts affiliated with an underwriter of a particular IPO are generally prohibited from being used in connection with the marketing of that IPO, out of concern that the report could be deemed by a court or regulator an offer to sell securities, potentially running afoul of federal securities laws or regulations relating to timing issues, antifraud standards or other technical aspects of the regulatory regime. This prohibition is by no means a global standard, and research reports are quite often used in conjunction with IPOs in many non-US markets, including Hong Kong (relevant standards in Hong Kong require such reports to be somewhat more balanced and comprehensive than in a non-IPO context, without recommendations or pricing targets regarding the shares, or even any references to a prospective offering, but including such things as significant risk factors; still, the purpose of publishing such reports shortly before an IPO is easy to glean).
The Securities and Futures Commission of Hong Kong, the principal securities regulator, showed a strong interest in the issue of use of research reports in Hong Kong IPOs in releasing a Consultation Paper on the Regulatory Framework for Pre-deal Research in September 2010 and, following significant input from financial institutions and other market participants, promulgating Consultation Conclusions on the Regulatory Framework for Pre-deal Research in June 2011. In connection with a substantial overhaul of the Code of Conduct for Persons Licensed by or Registered with the SFC, effective as of October 2013, a group of industry participants created the Hong Kong Sponsor Due Diligence Guidelines in September 2013, which embody in Chapter 30 the Consultation Conclusions and a wide variety of model documents for use in connection with research reports in HK IPOs.
The Consultation Conclusions set forth a core standard which is spelled out in the very first paragraph of Chapter 30 of the Guidelines and restated, in similar language and varying contexts, repeatedly throughout the Chapter:
“A sponsor should take reasonable steps to ensure that all material information … concerning a listing applicant or listing application disclosed or provided to analysts is contained in the relevant listing document." 1
This is neither a mistaken concept nor an unreasonable one. The problem, rather, is that it is unnecessary – there can be no material information given to analysts that is not in the prospectus because, under relevant disclosure standards, there can be no material information that is not in the prospectus. The requirements regarding inclusion of material information in a Hong Kong IPO prospectus (as well as those governing use of such a document as an international offering memorandum) are quite clear.2 There is no need to prohibit giving material information to analysts if that information is not in the prospectus, because regardless of whether the analyst gets it, it needs to be in the prospectus.
Given the substantial amount of effort the SFC clearly put into the Consultation Paper and the Consultation Conclusions, it seems reasonable to assume that the core concept regarding provision of material information to research analysts is not to be read as simply redundant or even nonsensical. Rather, it seems likely that the concept of “materiality” was not intended to be read too narrowly, and that the quality of the information not to be given to analysts if it is not intended to be in the prospectus actually falls somewhere between “material” and “substantive". 3 Obviously, there is a great deal of substantive information about issuers and their businesses that is not typically included in IPO prospectuses. With this more generous reading of “materiality”, the SFC’s position appears more aptly tailored to address its publicly-expressed concerns about fairness of disclosure and equal access to information.
Even if more sensible, there are at least three concerns about using a more expansive reading of “materiality” in this context, one conceptual, and two practical. First, there is no principled basis for denying analysts factual information which, by definition, is not material. Simply put, if it isn’t material, it should not matter (from a legal disclosure obligation standpoint) who has the information, and who doesn’t. Second, if all substantive information given to analysts is also included in the prospectus, research reports will almost certainly devolve to executive summaries of the prospectuses, lacking much in the way of substance not included in the latter documents. Financial institutions may see some benefits to this, as investors may prefer to have access to a streamlined document instead of only a bulky prospectus, but this cuts significantly into the overall value of research reports, which leads directly to the final point. If analysts are denied substantive (but not material) information about issuers, they will be unlikely to be able to compile certain of the factual data necessary to support their creative ideas; in other words, they will be prevented, in the IPO context, from doing the very type of analysis that allows them to differentiate themselves from their peers and, more importantly, provide real value to their clients.4
It is difficult or impossible to determine exactly where issuers and underwriters are drawing the line between information that is “material” and that which is not in deciding what may be provided to research analysts before a Hong Kong IPO, in part because there may not be complete consistency from transaction to transaction and in part because what is given to analysts and what ends up in research reports may be different things. Anecdotally, it appears that those parties who review drafts of pre-deal research (such as legal professionals) have seen (and provided) comments along the lines of “This information is not in the prospectus – please delete from the research report” with far greater frequency than before the Consultation Conclusions were promulgated. It is therefore possible that, in many cases, analysts receive information needed to support their views, but are prevented from including that information in their reports (or else do so against the advice of professional parties). Nevertheless, while some limited availability to analysts of non-material information not included in prospectuses may lessen the extent of the problem, it does not eliminate it: it is still the case that research analysts are often being prevented from seeking information they should be entitled to, and/or from using that information in their writings to voice their opinions.
If the effect of the Consultation Conclusions and the Guidelines is to devalue the research reports produced in connection with HK IPOs, then what are the available alternatives? Here are four possibilities:
Restore the status quo ante. Revert to the prior regime, where analysts were permitted to seek information relatively freely from issuers, on the theory that all such information not included in the prospectus was by definition not material, since all material information was required to be so included. While this may have a certain conceptual propriety, given the regulators’ apparent general distaste for the provision of information to analysts where such information is not in an IPO prospectus, it seems the least likely option to be accepted by the SFC.
Focus on the provision of information, not prospectus disclosure. Require issuers to keep records of all written information provided to research analysts, and to ensure that copies of that information are also given to representatives of the parties involved in preparing the prospectus. This will ensure that the working group parties consider such information and take a view on its materiality and the need to disclose it in the prospectus, just as is the case with all other information provided by the issuer to the working group in the due diligence process. In this manner, factual information included in a research report but not the prospectus may be presumed to have been found not to be material, though it will of course be subject to the same standards of liability for material omissions from the prospectus as is the case with any other factual information. This option is somewhat similar to a reversion to the prior regime, but inserts an additional level of control (tracking disclosure to analysts) to provide certainty that information provided to research analysts is also subject to business and legal due diligence in the context of prospectus preparation.
Make all pre-deal research publicly available in Hong Kong. Concerns about policing the research analysts and the information provided to them would be reduced, if not eliminated, if their work product was made available to all prospective investors, not just a select few, perhaps in the same variety of ways (hard copy distribution, availability on various websites, etc.) as prospectuses are made available. If this option were chosen, financial institutions would have to decide on their own whether to continue producing IPO research in Hong Kong, evaluating the commercial benefit of preparing reports for public consumption, as opposed to just for their clients.
Ban pre-deal research in Hong Kong. This option would appear somewhat revolutionary to Hong Kong financial institutions and market professionals (and may be objectionable to those believing that even the new style of stripped-down IPO research is favored by customers) though, as noted above, it is unlikely to faze US-trained personnel, as it would bring HK in line with US practices, while at the same time mooting the need to expend resources to ensure that the production of pre-IPO research reports meets with SFC standards and the Guidelines, even as those efforts leave such reports with reduced value. However, just as restoring the status quo is perhaps unlikely to satisfy the SFC, prohibiting pre-deal research in Hong Kong would probably not appeal, at least at present, to underwriters and institutional investors in HK IPOs.
While it is not at all certain that the SFC will choose to pursue any of these alternatives (or any other), or that financial institutions or other market professionals are widely dissatisfied with the current research report regime, it seems that something should be done to modify the present situation. Both the role of research reports in connection with securities offerings, and the broader core concepts of transparency and fairness in disclosure, are too important to be left subject to a regulatory mechanism which is, on its face, flawed.
1 Section 1.1, Standards, of Chapter 30 of the Guidelines. This concept is also noted elsewhere in the Chapter in the negative: “To avoid the risk of liability, the directors and senior management of the Company must ensure that no material information about the Company or its securities is provided to any investment research analyst, unless the information is reasonably expected to be included in the prospectus or is publicly available.” Addendum 2 to Chapter 30.
2 See, for example, the statement included in the prospectus for every HK offering of equity securities pursuant to Appendix 1-A, Section 2 of the Rules Governing the Listing of Securities on the Stock Exchange of Hong Kong Limited:“The directors, having made all reasonable enquiries, confirm that to the best of their knowledge and belief the information contained in this document is accurate and complete in all material respects and not misleading or deceptive … [emphasis added].” See also Rule 10b-5 under the US Securities Exchange Act of 1934, which makes it unlawful for any person, in connection with an offering of securities, “[t]o make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading … [emphasis added].”
3 Regarding the meaning of material in this context, the Consultation Conclusions say: "In judging whether any information … is material, consideration has to be given as to whether, if included in a prospectus, it is likely to significantly influence a reasonable person’s opinion of the listing applicant and its financial condition and profitability.” Paragraph 40 of the Consultation Conclusions. Compare this to the traditional definition of materiality under US law, where information is material if there is:“a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”
4 It should be noted that, in addition to certain types of financial analysis that may be done in reliance on financial information in prospectuses, there is one other area typically addressed in research reports, but not necessarily in prospectuses, that will still be open to research analysts. Analysts will be able to draw comparisons between IPO issuers and other public companies in similar businesses, based on information included in the IPO prospectus and publicly available information about the comparable companies.