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Banks who fell for IPO fictions get record fines, but punishment offers little deterrent

Four international banks have been slapped with record fines by Hong Kong’s securities regulator for failing to verify the information supplied by companies they nominated for IPO listings. The actions of the Securities and Futures Commission made good headlines, but the punishment offers little deterrent for this sort of behaviour.

The four banks – UBS, Standard Chartered, Morgan Stanley and Merrill Lynch – have been in the city for decades. None of them could claim not to have heard of fraud with Chinese characteristics.

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In 2002, a Liaoning-based listed company was caught recording chrysanthemums as export-grade orchids, and claiming farms it never owned.

In 2005, an eyewear manufacturer that claimed to be the world’s third largest was found sending its staff to the US to pose as clients at an auditors’ meeting at a hotel, in order to confirm the purchase of designer glasses.

More instances of book cooking followed, mostly from mainland China. Professionals shared tales of phoney bankers, bank branches, post offices, mailboxes and couriers fooling them into believing fake bank and customer information.

As a result, face to face interviews and on-site visits have long been the norm. Yet, in their work with the now-delisted China Forestry company in 2009, UBS and Standard Chartered decided otherwise.

They accepted phone interviews with purported customers on the grounds of earthquake disruption. All the customers’ names and numbers were provided by the company. The pair recorded no independent company, address or background search.

China Forestry was listed and went on to raise HK$4.2 billion. The auditor questioned its forest rights and revenue in early 2011. Regulators later caught it inflating its revenue and asset size by 92 per cent and 87 per cent respectively.

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Photo: GovHK.

In early 2013, another fraud was exposed. Employing the ancient trick of fake customers, China Metal Recycling over-stated its revenue by more than half. Who was the sponsor? UBS again.

Regulators responded with a more detailed guideline that asked for on-site face-to-face customer interviews as well as personal identity checks, business cards and authorisation letters from interviewees.

You would think the sponsors’ behaviour would have changed, and that of UBS in particular, given its track record? Wrong.

When it came to Tianhe Chemical’s listing, UBS, Morgan Stanley and Merrill Lynch asked for on-site interviews with customers, but backed down when the company resisted. Instead, they agreed to the company arranging meetings with six of its ten clients either by telephone or in person at Tianhe’s offices.

Among the six was a man who claimed to represent Tianhe’s largest customer, a state firm that bought 30 per cent of its products. He confirmed all the purchases. Yet, when asked for his business card at the end of the meeting, the man stormed out, shouting that he had defied house rules to attend the meeting, just to help out Tianhe’s chief executive officer.

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UBS. File photo: Martin Abegglen, via Flickr.

A fair-minded person would have smelled a rat. Yet none of the three bankers present thought further inquiries were called for.

Had they rung the state firm’s general line and asked for the man concerned, the operator would have told them that there was no such person. That is what a potential cornerstone investor did, avoiding an expensive mistake.

Had they sent a Chinese attorney to study filings at the State Administration of Industry and Commerce, they would have found that most of the purported customers were too small to have made the purchases claimed. That’s what a short-seller fund did, exposing Tianhe’s fraud and making itself a fortune.

Had the bankers paid a visit, they would have found the so-called third largest customer located in an empty room in a residential alley.

They didn’t. In fact, the reluctant cornerstone investor told Merrill Lynch about the phoney state firm official, but the bank chose to say nothing.

Stupidity or negligence cannot explain this. But money can. From every successful listing, investment banks earn a lot more than the sponsor fee of a few million US dollars, thanks to their one-stop-shop business strategy.

First, there’s the pre-IPO business. In the case of China Metal Recycle, UBS earned an undisclosed sum in commission by selling US$80 million of senior notes for the company. The bank also invested US$25 million in the notes and gained a handsome HK$36 million in interest. Half of the firm’s listing proceeds were for repaying these bonds.

Second, there’s the underwriting fee, ranging from 2 per cent to 3.5 per cent. UBS got an extra 1 per cent incentive fee from the metal firm. The higher the price secured, the higher the fee.

Next came the post-listing fundraising. When China Forestry issued US$300 million worth of bonds, UBS and Standard Chartered were the book runners. The latter also sold HK$398 million worth of shares for the company’s owner.

And then there is the wealth management for the controlling shareholders, who became billionaires overnight. The listing of a mid-size company can easily generate fees in the region of HK$100 million. Without an IPO, none of the above would have happened.

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Photo: GovHK.

Asking a sponsor to look carefully into its client’s financial standing is to risk a failed listing — like telling a hungry kid not to touch the cookies. Only the threat of a severe punishment can deter.

For these banks earning astronomical profits, that will mean astronomical fines. Hence, a French court decided to fine UBS 4.5 billion euros – the bank’s entire 2018 profit – for illegal soliciting of clients and laundering of tax evasion proceeds.

In comparison, the Securities and Futures Commission’s fine of HK$375 million imposed on UBS is not even peanuts. The commission has also reduced the suspension period of its sponsor business from 18 months for one of the three failures to 12 months for all. The other three banks were ordered to pay fines ranging from HK$59.7 million to HK$220 million.

Commission officials explaining the compromise said the banks had agreed to engage an independent reviewer of sponsor business, and responsible officers of UBS and Standard Chartered would be suspended for two years.

They called these “more meaningful quality up-grading” measures. The problem is the four have long been squeezed out of the top league table by mainland Chinese rivals. What matters is the message to the latter. Unfortunately, what they have heard is a lenient sentence for some outrageous wrongdoing. Why should we expect them to be more prudent?

Banks who fell for IPO fictions get record fines, but punishment offers little deterrent