Jul 19 Legal Update
SFC Statement on director duties in acquisitions/disposals
Broadly, this statement is a follow-up on SFC’s Guidance Note on directors’ duties in the context of valuations in corporate transactions (for details: our May 17 legal update). The statement gave useful examples on recurring types of misconduct, typically involving unfair valuations.
SFC reminds directors of their duty to ensure that forecast/estimate used in a transaction was compiled with due care; underlying assumptions are fair, reasonable, and represent management’s best judgment/estimate, considering all relevant information.
Directors should carefully consider the need to engage an independent valuer, even if not required under the Listing Rules ─ in light of the board’s time, resources, and expertise to perform the necessary work without the assistance of a valuer. Failure to do so risks a finding of misconduct.
However, directors are also reminded that obtaining an independent valuation would not reduce directors’ duties of care, skill, and diligence.
What you should know:
Useful examples of recurring “misconduct”:
- Lack of independent valuation
— E.g. issuers simply announced without further explanation, that there were arm’s length negotiations, taking into account vaguely described factors
- Lack of independent judgment and accountability
— Independent valuation obtained
— Directors simply relied on valuation without performing due diligence or other work
— E.g. valuers simply carried out “mathematical computations” on vendors’ forecasts; failed to exercise independent judgment
— E.g. “cherry-picked” comparables to justify a pre-determined estimate
- Quality of earnings
— Due diligence on forecasts, assumptions, business plans not performed
— E.g. risk factors (historic losses; sudden increases in sales; unjustifiably high margins when compared with peers; suspect non-recurring items; unsustainable sources of revenue)
— E.g. failed to explain paying a hefty premium to enter a new industry with low barriers; instead of starting the business itself at a lower cost
- Fair presentation of comparables
— E.g. “cheery picked” companies with higher trading multiples and disregarded those with poor performance
— E.g. chosen comparables had longer and more profitable track records; without making adjustment
- Impact on financial position of issuer
— E.g. substantial additional funds for acquisition cost, and capital investment to meet the forecasts or sustain the business
— Upfront payment of price, with vendor guarantee (if profit forecasts not met)
— E.g. no verification of ability of vendor to pay; funds not held in escrow
— E.g. vendor guaranteed amount substantially lower than acquisition price
- Suspicious connected parties
— Noteworthy: degree of association not necessarily confined to “Connected Persons” under Listing Rules
— Undisclosed “relationships, arrangements, understandings that cause them to act (or refrain from acting) in a co-ordinated manner to the detriment of the issuer and its shareholders… or distortion of the market for its shares”
— E.g. sales growth driven by a handful of customers; subsequently found to be related with issuer’s directors
What you should watch out for/do:
- Board process in approving transactions — should seriously consider engaging a valuer
- Directors’ duties of care, skills, and diligence in approving transactions — more rigour expected
- Internal controls — embed principles of the SFC Guide and SFC Statement in your company’s policies and procedures.
- The need to engage a valuer; interpretations of “connected parties” not confined to Listing Rules
- Our further observations: valuation is an important, but not the sole consideration of the board in approving transactions. Other factors like risks, strategic fit, alternative investment options are also relevant for directors’ duties