SFC’s Supervision Weakness — Take Tianhe Chemical as an Example
Tags: Hong Kong, Tianhe Chemicals, Anonymous Analytics, Sfc, 小高投資

Tianyi Kao, 20/12/2020

How can investors get their money back from the prospectus scam?

Tianhe Chemical’s prospectus

There are two main types of labilities for misstatements in the prospectus, civil liabilities and criminal liabilities, which are both under Cap.32 and SFO (Cap.571). I have two questions. First, I want to discuss when misstatements happen, whether remedies available to shareholders of listed companies in Hong Kong under relevant statutes or common law or both are practicable. Second, I want to discuss whether Misrepresentation in prospectuses has been subject to effective deterrence. I will analyze these two questions under circumstances of civil and criminal liabilities, over statements and comments on the extent to which SFC can affect, under example of Tianhe Chemicals, former 1619.HK, delist.

Let’s first look at civil liability under Cap.32, s.40, two elements are that a prospectus contains untrue statements and that persons subscribed for shares based on the prospectus have suffered resultant loss. Let’s look at civil liability under SFO, s.108 now. Person A is liable to pay damages to person B for any loss if person B is subjected to, under common law, Fraudulent Misrepresentation, Reckless Misrepresentation, Negligent Misrepresentation, Innocent Misrepresentation, when person A induces person B to acquire, dispose of, subscribe for or underwrite securities or to acquire an interest in or participate in a collective investment scheme (CIS). Regarding civil liability offense under SFO, s.277, market misconducts include not only disclosure of false or misleading information inducing transactions, but also persons involved in circulation, dissemination or authorization, offenders should pay compensation.

As for criminal liability under Cap.32, s.40A, where a prospectus includes any untrue statements, any person who authorized the issue of the prospectus shall be liable to imprisonment and a fine. Also, under SFO, s.298, a person shall not disclose, circulate or disseminate, or authorize or be concerned in the disclosure, circulation or dissemination of, information inducing another person to subscribe, purchase securities. Under SFO, s.107, a person commits an offence if he/she makes any fraudulent misrepresentation or reckless misrepresentation for the purpose of inducing another person to enter into an agreement of acquire, dispose of, subscribe for or underwrite securities.

Tianhe Chemicals, which was delisted at 9:00 am on 11 June 2020, was a US$8 billion company that went public on the HKSE as one of the biggest IPOs of 2014. At present, SFC, through the Market Misconduct Tribunal, has launched an inquiry procedure against Tianhe Chemical and its executive director Wei Xuan, and pointed out the company’s prospectus’ recorded sessions of sales revenue and the profit over the fiscal year from 2011 to 2013 has false or misleading information. About 53% of its total revenue of RMB 12.6 billion has been exaggerated, that is, approximately RMB 6.7 billion of revenue. SFC announced that it is seeking an order from the Court of First Instance in accordance with Section SFO s.213, remedy for aggrieved public investors against person unknown in securities fraud, with orders granted by court, including a restitution order under s.213(2)(b) of the SFO to distribute the amounts frozen in the bank accounts of the Companies to the victims on a pro rata basis, an order under s.213(2)(d) of the SFO for the appointment of an administrator to facilitate the distribution and consequential directions, and an injunction order under s.213(2) against the person(s) unknown for carrying on a business/advertising itself as being prepared to carry on regulated activities including on all internet websites within its control; injunctions against the Companies from disposing of any of the funds in their bank accounts, to request the restitution of transactions from the delisted Tianhe Chemical. Tianhe needs to refund to public shareholders including but not limited to the time when the inquiry process commences on June 2, 2020, in order to restore them to their condition before subscribing or purchasing the relevant shares, and to pay damages to the public shareholders. Note that Tianhe Chemicals was listed in June 2014 which is more than 6 years from now.

Will individual shareholders loss be compensated after SFC’s action? SFC successfully cited SFO s.213 to came to an agreement that Hontex International repurchase from 7,700 minority shareholders at the closing price before trading suspension in 2012. However, SFC’s progress is slow since Tianhe Chemicals’ IPO in 2014. A listing company signs agreements with sponsor firms. In the agreements, no responsibility is determined. There are few chances for the SFC to take further action. In addition, Ashley Ian Alder, Chief Executive of the SFC, also pointed out that the enforcement actions were aimed at sponsor’s fault. Note that fault does not mean violation. As for barriers of shareholder civil claims, time is the main concern. Cap. 347 Limitation Ordinance restricts the retrospective period for most of civil claims. Cap. 347, 4(1)(a) points out that the limitation period based on infringement is counted to 6 years started from the cause of litigation time. Sadly, another SFC-failed example is China Forestry, another delisted company. SFC filed civil restitution request to China Forestry, sponsors UBS and Standard Charted, auditor KPMG to revert the transaction to minority shareholders in 2017, but by October 2017, the civil retrospective period had expired. Furthermore, in order to enforced the power granted from s.213’s application to the Court of First Instance, SFC need to prove that the person has contravened any relevant provisions under SFO or Cap.32, and any notice, requirement or condition imposed pursuant to any relevant provisions, and terms or conditions of any license or registration under SFO. The last part is clearly hard to meet since there agreements between listing companies and their sponsors typically do not include many responsibilities.

Tianhe Chemicals, according to Anonymous Analytics, has created fake SAIC filings to match its prospectus, and in the process, presented two sets of books to the SAIC. Tianhe Chemicals’ stated profitability is derived from operating margins of over 60% while Tianhe’s competitors report operating margins well below 30%. Tianhe has five onshore subsidiaries of which only Jinzhou DPF-TH and Fuxin Hengtong had commenced business operations as of 31 December 2013. Tianhe conducts all its business through these two subsidiaries. SAIC income statements for these two subsidiaries showed that real revenue and net income are significantly less than prospectus’ numbers. SAIC filings show that in 2012, Tianhe’s actual revenue was 85% less than it claimed in its prospectus, and its net income was nearly 100% less. Evidence also showed that the amount of tax revenue collected by the relevant local governments is only a fraction of what would be needed to validate Tianhe’s reported financial statements. After SFC investigation, on September 2, 2014, Tianhe Chemical was suspended from trading. The joint sponsors were UBS, Merrill Lynch, and Morgan Stanley. The three investment banks were condemned by the Securities Regulatory Commission and fined a total of HKD 727 million. UBS’s sponsor license was suspended for one year. The final ending for Tianhe and its Chairman/Executive Director, Qi Wei, is that SFC instituted proceedings in the MMT against Tianhe and Wei for market misconduct under SFO s.277. The SFC also suspended the share trading of Tianhe on 25 May 2017 under Section 8 of the Securities and Futures Rules. The shares of Tianhe were delisted by the Stock Exchange of Hong Kong Limited with effect from 11 June 2020. However, none of the directors, executives, CEOs, Accountants, professional accountants, auditors, and lawyers of Tianhe Chemical involved was punished yet! Under SFO, s.281, there is a civil liability that a person who has committed market misconduct shall be liable to pay compensation persons who have suffered loss as a result of the market misconduct, but regarding the jurisdiction, it is unclear how the court can enforce the punishment, because trial standard is not clear. This case is still in the inquiry procedure.

How can SFC best protect investors? SFC has limited access to court action, but it can increase IPO threshold and supervision. Also, SFC can punish insiders. Insider trading is an act of civil fault. Since it is a civil fault, the standard of proof is only to exceed reasonable doubt, and prosecution becomes possible. SFC has punitive measures for insider trading and misstatement in prospectus. For insider trading, Market Misconduct Tribunal will rule on civil standards of proof and can impose a variety of civil sanctions, such as ordering offenders to surrender their profits, issuing stop and termination orders and cold treatment orders, and revoking directors of companies in violation, etc. On the other hand, if the evidence is sufficient, the offender will also be subject to criminal prosecution. Once convicted, insider trading can be sentenced to a maximum of 10 years imprisonment and a fine of HKD 10 million. Investors can also claim their compensation through Investor Compensation Fund.