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(Reuters) - Hong Kong's financial market watchdog is launching a public consultation process in the next couple of weeks that seeks to toughen rules for banks sponsoring initial public offerings, including holding them liable for faulty deal documents.
Such a move would spark fierce opposition from foreign investment banks, who have long stood by the assertion that sophisticated fraud is nearly impossible to detect.
According to sources with direct knowledge of the matter, the Securities and Futures Commission (SFC) is set to issue a two-part consultation paper, with one section proposing to toughen the code of conduct for IPO sponsors and the second making them liable for the contents of listing prospectuses.
"The focus is likely to be on due-diligence practices and liability, in case sponsors do not execute their work up to a required standard," said Bonnie Chan, a partner at law firm Davis Polk & Wardwell and former head of Hong Kong Exchange's IPO transactions department, who has not seen the consultation paper.
The initiative follows a string of scandals at Chinese companies that went public, only to then face accusations -- and in some cases proof -- of fraud shortly after listing.
Investment banks that often serve as sponsors of the IPOs hoped the issue would fade or, at worst, involve a few tweaks to existing disclosure rules. Sponsors, usually banks or smaller corporate finance houses, prepare a company's listing documents and perform due-diligence to ensure they comply with Hong Kong's listing rules.
Liability could leave investment banks, and possibly some of their employees, open to massive legal cases and fines, force them to abandon sponsorship of IPOs and leave that to less-experienced local banks and firms.
That means banks and other sponsors are likely to lobby hard against prospectus liability, arguing there's only so much they can do to prevent a fraudulent company executive from misleading investors.
In some other countries, banks are subject to greater accountability in IPO deals. In the United States, for instance, banks underwriting an IPO can be held liable for misleading statements in a listing prospectus if it's proved they were negligent in their due-diligence.
The SFC proposed regulation similar to the planned one in 2005 but didn't proceed with the move following widespread opposition from the finance industry.
But since the last consultation, the Hong Kong market, which was the world's biggest for IPOs in 2009 and 2010 when $89 billion was raised there, according to consultancy PricewaterhouseCoopers, has been hit by a number of scandals at companies soon after they listed.
Chinese textiles maker Hontex 0946.HK had its shares suspended in early 2010, just three months after it listed, when the SFC alleged its IPO prospectus "materially overstated" its financial position.
The SFC said last year that an inspection of IPO sponsors found a series of deficiencies in their work, including inadequate due-diligence and questionable disclosures to the Hong Kong Stock Exchange.
In the light of this, many in the legal industry doubt that investment banks will be able to stave off tougher rules a second time round.
"I would be surprised if there's much scope to roll back what's in this paper. I expect even the soft consultation has been mainly just a courtesy to the industry," said one Hong Kong lawyer, who declined to be named given the sensitivity of his relationship with the SFC.
An SFC spokesman said the regulator had no comment to make on the consultation paper.
The new proposals mean sponsors, especially the big name U.S. and European investment banks, are likely to be more selective about the work they take on, despite Hong Kong's IPO market currently going through a slow period.
"The Hong Kong market is likely to further segment as the Chinese banks assert their presence more in that space," said Hayden Flinn, a partner at law firm King & Wood Mallesons in Hong Kong.
This consultation will be one of the first big initiatives undertaken by the SFC since chief executive Ashley Alder took the helm in October. When he took on the role, Alder said he supported bringing in new regulation for IPO sponsors.
Tighter regulations are likely to get investor backing, coming at a time when there is a strong focus on the quality of some Hong Kong-listed companies after a number of problems cropped up at the end of this year's company reporting season.
"By sponsoring a listing, a firm should be taking all reasonable steps to verify the contents of a company's prospectus, particularly the parts for which other advisers are not liable," said David Webb, an activist investor who runs his own governance website.
"If a sponsor is negligent in carrying out due-diligence then it should be held liable to investors for that," he said.
Last month, Deloitte resigned as auditor of Daqing Dairy Holdings Ltd 1007.HK and childrenswear manufacturer Boshiwa International Holdings 1698.HK, with both companies now having special investigations into possible financial irregularities.
Several other companies, including Ausnutria Dairy 1717.HK and Ports Design Limited 0589.HK, have had their shares suspended after they missed the deadline for filing their annual reports due to their auditors saying they needed more time to complete their work.
Those incidents, coupled with any new regulation, are likely to make big-name banks doubly careful about who to take on as clients.
"Everyone will be taking a step back and revisiting whether it makes economic sense to even pursue those deals," said Davis Polk's Chan.
Reporting by Rachel Armstrong in SINGAPORE; Editing by Michael Flaherty and Muralikumar Anantharaman