Hong Kong’s Securities And Futures Commission Reprimands And Fines Morgan Stanley Asia Limited $224 Million For Sponsor Failures

The Securities and Futures Commission (SFC) has reprimanded and fined Morgan Stanley Asia Limited (Morgan Stanley) for failing to discharge its obligations as one of the joint sponsors in relation to the listing application of Tianhe Chemicals Group Limited (Tianhe) in 2014 (Notes 1 and 2).

The SFC’s investigations revealed that Morgan Stanley had failed to follow the specific guidelines on due diligence interviews under paragraph 17.6 of the Code of Conduct (Notes 3 and 4).

Involvement of Tianhe in due diligence interviews

Morgan Stanley had interviewed ten customers of Tianhe: six of which were interviewed either by telephone or at face-to-face interviews at Tianhe’s offices in Jinzhou of Mainland China, and the rest of them were interviewed at the customers’ own premises.

Morgan Stanley did not have direct contact with Tianhe’s customers for the purpose of setting up due diligence interviews or confirming the mode and place of the interviews.  On the contrary, Tianhe informed Morgan Stanley that two customers were unable to attend face-to-face interviews and that one customer would not conduct interviews at its business premises.  There is no evidence that Morgan Stanley had taken any steps to check with these three customers as to why they were not amenable to be interviewed at their offices.

Failure to address red flags in an interview

Morgan Stanley had initially requested to interview the largest customer of Tianhe, Customer X, at its office, but eventually accepted Tianhe’s explanation that since an anti-corruption campaign in Mainland China was underway, Customer X, a large state-owned enterprise, would normally turn down any third party request to visit its premises.

Morgan Stanley then agreed to interview Customer X at Tianhe’s office.  At the end of the interview, the representative of Customer X refused to produce his identity and business cards and stormed out of the meeting room.  He told Morgan Stanley and other parties that he would not have agreed to be interviewed under Customer X’s internal procedure, and he only attended the interview to help the family of Tianhe’s chief executive officer (CEO).

Nonetheless, Morgan Stanley did not conduct any follow up inquiries to ascertain that the person it interviewed was the representative of Customer X and that he had the appropriate authority and knowledge for the interview.

Unclear interview questions

Tianhe conducted business with its customers through its subsidiary, Jinzhou DPF-TH Chemicals Co. Limited (Jinzhou DPF-TH), based upon the sales documents provided to Morgan Stanley.

During the customer interviews, Morgan Stanley asked the interviewees questions in relation to the business between their companies and the “Tianhe Group”, instead of Jinzhou DPF-TH. 

Although the interviewees were also asked a question “which entity of the Tianhe Group and which business department do you mainly contact with”, only three out of ten customers interviewed confirmed that they had contact with Jinzhou DPF-TH.  However, Morgan Stanley did not follow up with the remaining customers as to which entity of the “Tianhe Group” they had business with.

One of the purported top ten customers of Tianhe interviewed by Morgan Stanley informed the SFC that when its representative answered questions about the dealings between the customer and the “Tianhe Group” during the interview, its representative was referring to the dealings with Liaoning Tianhe Fine Chemicals, a private company wholly owned by the family of the CEO of Tianhe but no longer a part of Tianhe’s group to be listed at the material times.

As both the listed and unlisted chemical businesses of the family of the CEO of Tianhe were named “Tianhe”, the SFC considers that it was insufficient for Morgan Stanley to merely refer to the “Tianhe Group” during customer interviews and/or not to request the interviewees to identify the exact Tianhe entity with which their organisations had dealings.

In deciding on the sanctions, the SFC took into account that:

• as a sponsor, Morgan Stanley has a clean disciplinary record;
• Morgan Stanley allowed Tianhe to control the due diligence process and failed to take appropriate steps to address the red flags raised in the customer interviews;
• the breaches and deficiencies identified above related to the due diligence conducted on Tianhe’s top customers, including its largest customer, during the track record period;
• Morgan Stanley cooperated with the SFC to resolve the SFC’s regulatory concerns; and
• Morgan Stanley agreed to engage an independent reviewer to review its policies, procedures and practices in relation to the conduct of its sponsor business in Hong Kong.

Notes:

1. Morgan Stanley is licensed under the Securities and Futures Ordinance to carry on Type 1 (dealing in securities), Type 4 (advising on securities), Type 5 (advising on futures contracts), Type 6 (advising on corporate finance) and Type 9 (asset management) regulated activities.
2. Tianhe was listed on the Main Board of Stock Exchange of Hong Kong Limited (SEHK) on 20 June 2014, and was engaged in the manufacture and sale of chemical products.  At Tianhe’s request, trading in the shares of the company was suspended on 26 March 2015.  On 24 May 2017, the SFC issued a notice under section 8(1) of the Securities and Futures (Stock Market Listing) Rules directing the SEHK to suspend all dealings in the shares of Tianhe effective from 9 am on 25 May 2017.  Trading in Tianhe’s shares remains suspended as of today.
3. Code of Conduct for Persons Licensed by or Registered with the SFC.
4. Paragraph 17.6(f) of the Code of Conduct provides that, in conducting interviews, the sponsor should, among other things:

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  • carry out the interview directly with the person or entity selected for interview with minimal involvement of the listing applicant;
  • confirm the bona fides of the interviewee (including establishing the identity of the interviewee and other relevant information) to satisfy itself that the interviewee has the appropriate authority and knowledge for the interview; and
  • identify any irregularities noted during the interview (e.g. interview not taking place at the registered or business address of the person or entity selected for interview, reluctance on the part of the interviewee to cooperate) and ensure any irregularities are adequately explained and resolved.