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SFC reprimands and fines Morgan Stanley and Standard Chartered Securities

Friday, March 15, 2019
Opalesque Industry Update - 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.

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.

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.

SFC reprimands and fines Standard Chartered Securities

The Securities and Futures Commission (SFC) has also reprimanded and fined Standard Chartered Securities (Hong Kong) Limited (Standard Chartered Securities) $59.7 million for failing to discharge its obligations as one of the joint sponsors in relation to the listing application of China Forestry Holdings Company Limited (China Forestry) in 2009 . The SFC's investigations revealed that Standard Chartered Securities had failed to make reasonable due diligence enquiries in relation to several core aspects of China Forestry's business.

Failure to verify the existence of China Forestry's forestry assets

According to China Forestry's 2009 prospectus, the company and its subsidiaries (Group), a plantation forest operator whose main businesses were the management and sustainable development of forests and the harvesting and sale of logs, owned approximately 171,780 hectares of forests in Yunnan and Sichuan Provinces of Mainland China.

In December 2007, Standard Chartered Securities conducted site inspections of the Group's forests in Sichuan and Yunnan in its then capacity as the sole sponsor for China Forestry's listing application. It made the same endeavour in February and May 2008. The SFC's investigations, however, revealed that on such site visits Standard Chartered Securities did not verify the location visited with the location of the Group's forests as stated in the prospectus.

Standard Chartered Securities claimed that other professional parties, including lawyers and forestry experts, were involved in some of the site inspections. However, none of them had been instructed to verify the existence of the Group's forests as disclosed in the prospectus.

Further, despite the fact that the Group acquired 150,000 hectares of forests in Yunnan in 2008 which accounted for over 90% of its forestry assets, there is no evidence to suggest that Standard Chartered Securities visited the Group's forests in Yunnan after the acquisition or commissioned an assessment of the impact of the earthquake of magnitude 6.0 on the Richter scale that hit Yunnan on 9 July 2009 on the Group's forestry assets.

Failure to verify China Forestry's compliance with relevant laws and regulations

Standard Chartered Securities relied on written confirmations purportedly issued by the relevant forestry bureaus that China Forestry had provided for them to confirm that the business and logging activities of China Forestry were in compliance with the relevant Mainland Chinese forestry and environmental laws. There is, however, no evidence that Standard Chartered Securities had verified whether the written confirmations were issued by the relevant forestry bureaus and that the information recorded therein was accurate.

Inadequate due diligence on insurance coverage for the Group's forestry assets

Having sufficient insurance coverage for the Group's forestry assets, which were pivotal to its business operation, was of fundamental importance. Standard Chartered Securities relied on insurance documents provided by China Forestry as evidence of such insurance coverage without independently verifying the authenticity of the insurance documents.

Although Standard Chartered Securities claimed that its deal team members and Mainland Chinese lawyers had reviewed the insurance documents, it did not identify a number of issues (for example, an inconsistency between the location of a forest as stated in the insurance document and as stated in the forestry right certificate) that should have called for further inquiries.

Inadequate due diligence on China Forestry's customers

Over 70% of China Forestry's customers by revenue for the last 18 months during the track record period were located in Yunnan (Note 5). Standard Chartered Securities had planned to conduct face-to-face interviews with some of China Forestry's customers in Yunnan, but subsequently decided to postpone the face-to-face interviews because of the earthquake in Yunnan. Standard Chartered Securities only conducted telephone interviews with these customers in the end.

The SFC found that Standard Chartered Securities called the customers on telephone numbers provided by China Forestry without conducting any background searches on the customers to verify their telephone numbers and/or the identities of the individuals interviewed.

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