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The Securities and Futures Commission (SFC) has reprimanded and fined Citigroup Global Markets Asia Limited (Citi) $57 million after resolving concerns with Citi over its discharge of duties as a sponsor in relation to the listing application of Real Gold Mining Limited (Real Gold) (Notes 1 & 2).
An SFC investigation revealed that Citi had failed to (i) conduct adequate and reasonable due diligence on Real Gold’s customers and (ii) properly supervise its staff when carrying out the sponsor work on Real Gold’s listing application.
Failure to conduct adequate and reasonable due diligence inquiries
Real Gold, established in Mainland China, owned three gold mines in Chifeng Municipality, Inner Mongolia, and specialised in the mining of gold and the processing of ore into concentrates containing gold and other minerals for subsequent sale, according to the company’s 2009 prospectus (Prospectus).
The Prospectus disclosed that Real Gold’s sales increased by more than twenty-fold between the year ended 31 December 2007 and the 10 months ended 31 October 2008 (being respectively the last full year and the last 10 months of the track record period).
The SFC found that information provided to Citi during its due diligence inquiries showed that apart from one customer, the customers of Real Gold for the two periods were completely different.
The Prospectus also disclosed that Real Gold had entered into a memorandum of long-term cooperation (MLC) with each of three customers who contributed to an aggregate of 35.2% of Real Gold’s sales in the 10 months ended 31 October 2008. Pursuant to the MLCs, the customers were obliged to purchase whatever amount of gold or zinc concentrates Real Gold decided, in its absolute discretion, to sell them.
Citi considered that production was the key risk for early stage mining companies producing a commodity with a ready market such as gold, as in the case of Real Gold. As a result, Citi’s due diligence placed emphasis on production-related diligence, such as retaining an independent technical mining expert and performing on-site validation. Citi also considered that verifying Real Gold’s production was comparable to verifying its sales.
While Citi did conduct some customer-related due diligence on Real Gold, the SFC considers it inadequate and substandard (Note 3).
- Citi conducted all customer interviews by telephone on telephone numbers provided by Real Gold, without independently verifying the identities and contact details of the representatives of the customers;
- Citi did not seek direct confirmation from the customers in regard to their transaction amounts with Real Gold; and
- Citi did not interview one of the three customers with whom Real Gold had allegedly entered into MLCs with, and when Citi did interview another one of them, no question about the MLC was asked. Citi also did not verify the authenticity of the MLCs.
Under these circumstances, the SFC considers that Citi’s approach towards customer due diligence was not justified by the relevant regulatory requirements and the SFC’s view is supported by the opinion of an independent market expert (Note 4).
Failure to supervise the transaction team
The SFC’s investigation found that the sponsor principals did not supervise the transaction team in the manner expected of them under the Additional Fit and Proper Guidelines for Corporations and Authorized Financial Institutions applying or continuing to act as Sponsors and Compliance Advisers (Sponsor Guidelines) (Note 5). For instance:
- A sponsor principal was only appointed to supervise the transaction team more than four months after Citi was mandated by Real Gold to act as the listing sponsor, by which time preparation for Real Gold’s listing application, including making arrangements for due diligence calls with major customers, suppliers and banks and drafting of the Prospectus, as well as due diligence on connected transactions, were well underway.
- One of the sponsor principals was a director of another investment banking team at Citi, and listing applications were not her responsibility. She thought that she was the “signing responsible officer” of Real Gold’s listing application while another team member was the sponsor principal. She was not involved in conducting due diligence nor corresponding with the Stock Exchange of Hong Kong Limited (SEHK). Her involvement was limited to assisting the deal team when she was called upon to do so, for example, when the deal team needed a responsible officer to sign certain documents.
- It appeared that the transaction team was mainly supervised by a managing director who was not a sponsor principal but was nonetheless involved in the due diligence on the assets and operations of Real Gold.
The SFC’s investigation also found that the due diligence work conducted on Real Gold’s customers was handled by junior and inexperienced staff members of Citi with little supervision. For instance:
- The telephone interviews with Real Gold’s customers were organised and attended by an analyst and a senior analyst, who were the most junior members of the transaction team, with apparently little supervision, notwithstanding the participation in these calls by external legal counsel.
- The deal team captain had assigned the workstream involving due diligence on Real Gold’s customers to the senior analyst, the second most junior member of the transaction team, and expected him to raise any significant issue for discussion.
In view of the deficiencies in Citi’s due diligence work identified above, notwithstanding Citi’s view that its approach to due diligence was the result of a reasoned weighting of production-related concerns over customer-related concerns, it appeared that Citi was in breach of its undertaking and declaration to SEHK (Note 6).
In reaching this resolution, the SFC took into account all circumstances, including:
- this is the first and only listing application in which the SFC has had concerns over Citi’s work as a listing sponsor;
- the breaches and deficiencies identified above related to a limited portion of the due diligence conducted by Citi in the course of Real Gold’s listing application;
- the SFC found no evidence that the breaches and deficiencies identified above were deliberate, intentional or reckless;
- Citi’s approach to due diligence reflected a reasoned weighting of production-related concerns over customer-related concerns, albeit one that the SFC does not consider to be compliant with the relevant regulatory requirements;
- Citi’s early engagement of its senior management and an external counsel to address the SFC’s regulatory concerns;
- Citi has taken action to strengthen its internal controls and systems in respect of its sponsor work since Real Gold’s listing; and
- Citi’s full cooperation with the SFC to resolve the SFC’s regulatory concerns.
- Citi is licensed to carry on Type 1 (dealing in securities), Type 2 (dealing in futures contracts), Type 4 (advising on securities), Type 5 (advising on futures contracts), Type 6 (advising on corporate finance) and Type 7 (providing automated trading services) regulated activities under the Securities and Futures Ordinance.
- Real Gold was listed on the Main Board of the Stock Exchange of Hong Kong Limited (SEHK) on 23 February 2009 with Citi as its sole sponsor. At the request of the company, trading in the shares of Real Gold was suspended on 27 May 2011. On 28 June 2016, the SFC directed the suspension of the company’s shares under Rule 8(1) of the Securities and Futures (Stock Market Listing) Rules.
- The customer-related due diligence carried out by Citi included collecting materials (such as shipment records and sales contracts) from Real Gold during its on-site diligence; conducting customer interviews; relying on Real Gold’s reporting accountant and auditor to verify customer revenues; as well as obtaining a legal opinion as to the validity and enforceability of the memorandums.
- Details of the relevant regulatory requirements are set out in the Statement of Disciplinary Action.
- Paragraph 1.3.3 of the Sponsor Guidelines provides that, “As a general guidance, a Principal is expected to be in charge of the supervision of the Transaction Team(s). The Principal should be involved in the making of the key decisions relating to the work carried out by the Transaction Team and must be aware of the key risks in such work and responsible for the measures to address them.”
- As is relevant here, a sponsor is required to submit an undertaking and a declaration to the SEHK that it would/has made reasonable due diligence inquiries.
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