Chapter 14

Due Diligence Guidelines –

Distributors, Franchisees and Consignees

1. Understanding a Listing Applicant and its Business, Performance, Financial Condition and Prospects

1.1 Standards

1.1.1 Based on reasonable due diligence, a sponsor should have a sound understanding of a listing applicant, including its history and background, business and performance, financial condition and prospects, operations and structure, procedures and systems. [Paragraph 17.3(a)(i) of the Code of Conduct]

1.1.2 Regarding the preparation of a listing document, a sponsor should … gain a sufficient understanding of the industry in which the listing applicant operates, including reviewing key characteristics of the industry and data about competitors. [Paragraph 17.6(d)(iii) of the Code of Conduct]

1.1.3 Regarding the preparation of a listing document, a sponsor should …assess the legality and compliance of the business operations and whether the listing applicant is subject to any material legal proceedings or disputes. [Paragraph 17.6(d)(vii) of the Code of Conduct]

1.2 Guidance

Understanding the business model

1.2.1 Distributorship, franchising and consignment may take many different forms. Given that sellers may have different arrangements and degrees of control over their distributors, franchisees or consignees, the consequential risks could be very different.1 The sponsor should, therefore, gain a detailed understanding of the business model of the listing applicant in order to identify the specific risks associated with its operations and to ensure that the true nature of the listing applicant’s business is accurately described in the listing document.2

1.2.2 The following is a description of how a distributorship, franchise and consignment may typically be structured. It is not intended to be exhaustive:

(a) Distributorship

Distributorship refers to the business model where a distributor purchases goods from a supplier or manufacturer and resells them as principal to customers. There is no contractual relationship between the supplier or manufacturer and the customers. There are different types of distributorships, including exclusive distributorship, sole distributorship, non-exclusive distributorship and selective distributorship.3 Suppliers or manufacturers may, in the distributorship agreement, impose varying degrees of control over the distributors in areas such as product pricing, restrictions on the territories in which the products may be distributed, and minimum purchase commitments or sales targets.

(b) Franchise

In a franchise, the franchisee operates its business under the franchisor’s trade name or trade mark under licence by the franchisor. The franchisor exercises continuing and substantial control over the franchisee (such as requiring franchisees to adopt standardised marketing strategy, after-sales services, pricing and sales model) and provides assistance to the franchisee (such as management and employee training). The franchise may also involve the licensing of exclusive technical knowhow or bespoke operating systems (such as inventory control systems) by the franchisor to the franchisee during the term of the franchise. There are different types of franchising, including direct franchising, master franchising, development arrangements and subordinated equity arrangements.4 Typically, the franchisee has to pay the franchisor a one-off fee at the time when the franchise is granted and royalty payments on a recurring basis, which are typically tied to the level of revenue generated by the franchisee. The franchisee is usually obliged to purchase all products from the franchisor and is often required to contribute to the costs of marketing or advertising campaigns being conducted by the franchisor.

(c) Consignment

Under a consignment, products are placed by the consignor with the consignee for sale at the consignee’s premises but ownership remains with the consignor until the products are sold to the customers. The consignee is typically not responsible for loss or damage of the products during transportation or delivery or while they are in the consignee’s custody. The consignor pays the consignee a fee, which is usually calculated as an agreed percentage of the price of the consigned products which have been sold. When manufacturers of consumer goods sell their products at third party retail outlets (such as a department store), it is often done on a consignment basis.

1.2.3 Distributors, franchisees and consignees will normally enter into a specific written agreement with the listing applicant setting out the terms of their business relationship with the listing applicant, but this may not invariably be the case. Where there is any suggestion that the listing applicant may be selling its products through third party intermediaries, it is essential that the sponsor should identify and understand the exact nature of the relationship between the listing applicant and those intermediaries, particularly where such relationship is not evidenced by a written agreement. It is important, for instance, to draw the following distinctions in considering whether this due diligence guideline is applicable and hence, the recommended steps described below should be followed:

(a) Distributors, franchisees and consignees all operate as intermediaries and are not the end customers of the products being sold by the listing applicant. In the case of a distributorship or franchise, the distributors or franchisees will typically be purchasing products from the listing applicant as principal for on-sale to end customers or further levels of sub-distributors or sub-franchisees and hence, from the listing applicant’s perspective, those distributors or franchisees will also be its customers. It is important, therefore, to distinguish between distributors and franchisees (who may also be customers) and “normal” customers, particularly where the listing applicant sells its products both directly to end customers and through distributors or franchisees. In the case of a consignment, the consignees do not typically purchase products from the listing applicant and sales of those products should only be recognised by the listing applicant when they are sold by the consignees on behalf of the listing applicant. It is important to be alert to situations where e.g., the listing applicant purports to treat parties who are in substance consignees as customers and on such basis, to recognise sales when the products are delivered to the consignees when those sales should only be recognised when the products are sold by the consignees on behalf of the listing applicant.

(b) Distributors, franchisees and consignees should also be distinguished from agents of the listing applicant. Distributors, franchisees and consignees typically have a principal to principal relationship with the listing applicant and not one of agency. Distributors, franchisees and consignees would not normally have the power to enter into contracts on behalf of or otherwise to create any binding obligation on the listing applicant and the listing applicant would not normally become vicariously liable for their acts, both of which are common features of an agency relationship. An agency relationship (such as in the context of a property agency business) gives rise to different risks and due diligence considerations, which are not within the scope of this due diligence guideline.

1.2.4 For a business involving distributorship, it may operate with a distribution network that comprises a combination of the different types of distributorship arrangement described in paragraph 1.2.2(a) above and/or which comprises a vertical chain of distributors where one distributor resells the goods to a sub-network of distributors. In the latter case, the sponsor should consider performing different levels of due diligence on the different tiers of distributors reflecting the nature and extent of the relationship between the listing applicant and the distributors, and the number of distributors at different tiers in the chain.

Understanding the risks involved

1.2.5 The Stock Exchange has issued Exchange Guidance Letter GL36-12 (the “Guidance Letter”),5 which deals specifically with risks and disclosure in listing documents for listing applicants whose business models involve multi-level distributors, franchisees or consignees (collectively, “distributors”). In the Guidance Letter, the Stock Exchange highlighted the following risks:

(a) Inventory risk

(i) Where there has been a sharp increase in sales during the track record period, there is a risk that these are artificially inflated sales unsustainable by an actual rise in demand from ultimate end-users. Goods may be shipped to distribution channels and not to end customers (channel stuffing). The excess inventory may be stocked in multiple warehouses and retail outlets throughout the distribution chain over which the listing applicant has no information and control, thereby making it difficult to determine and manage the amount of excess inventory.

(ii) A minimum purchase condition in the listing applicant’s distribution agreement with its distributors may be translated into a risk of inventory accumulation.

(iii) The presence of one or more of the following features may require delay in revenue recognition:

(A) the applicant retains significant ownership risks of ownership although legal title has been passed to the distributors;

(B) sales to distributors on a “right of return” basis and payment is delayed or otherwise different from typical sales agreements;

(C) the applicant is required to repurchase the product at a price with adjustment that covers the distributor’s cost of holding the product, including financing cost; and

(D) the applicant guarantees a minimum resale value.

(b) Cannibalisation

Where aggressive growth in sales is achieved by sales made to a rapidly increasing number of distributors, there is a risk that such growth in sales, or profits arising from royalty payments (if any) received from distributors for initial set up, may not be sustainable if there are too many distributors in the market.

(c) Recoverability of accounts receivables

Where a substantial increase in sales is coupled with a substantial increase in accounts receivable and debtors’ turnover days, issues arise about the recoverability of these receivables and the sustainability of the listing applicant’s business.

(d) Independence of distributors

Goods may be sold to (1) distributors or sales representatives who were previously employees of the listing applicant or (2) sales partners who trade under the listing applicant’s name but who are owned or controlled by related parties of the listing applicant. This gives rise to uncertainty as to the independence of the customers of the listing applicant and the authenticity of its sales.

1.2.6 In addition to the risks highlighted by the Stock Exchange in the Guidance Letter, other operational risks associated with distributorships, franchises and consignments may include:

(a) Inadequate monitoring or control

The ability of the listing applicant to monitor and control the performance of its distributors, particularly in the case of a franchise where the franchisees will be using the trade name and/or trade mark(s) of the listing applicant to carry on business, is critical. The type and degree of monitoring and control which may be imposed on distributors may vary among different industries but typically, would cover areas such as competition control (by for instance, imposing limits on territory of operation), pricing control, inventory control, disposal of obsolete or unsold stock, regular reporting of sales and market feedback, minimum purchase commitments and sales performance targets. In the case of a consignment, it is important for the listing applicant to have an effective inventory record system to track the products which are being placed on consignment from time to time (including items which have been sold, those which have not yet been sold but have remained in the consignee’s custody and those which have been returned) and an effective cash management system to monitor the sales proceeds collected by the consignees on sale of the products placed on consignment. The sponsor should review whether the listing applicant has put in place adequate mechanisms to enable it to monitor and control the performance of its distributors.

(b) Inadequate protection of intellectual property rights

Where any intellectual property right (such as the right to use any trade name, trade mark or patent) is being licensed by the listing applicant to any of its distributors, the terms of the licence should impose control that would prevent the misuse of the relevant trade name, trade mark or patent by the distributor (such as specifying the purpose for which and the territory in which it may be used). The sponsor should review whether the listing applicant has put in place adequate mechanisms to enable it to protect any intellectual property right that has been licensed to its distributors.

(c) Conflict of interests

The listing applicant may sell its products entirely through a network of distributors or franchisees or it may sell its products partly through distributors or franchisees and partly through self-owned sales channels. In the latter case, the sponsor should review whether the listing applicant has put in place adequate mechanisms to ensure that competition will not arise between any of its distributors or franchisees and its self-owned sales channels.

(d) Reliance

If, in the opinion of the sponsor, the listing applicant derived a significant portion of its revenue from a small number of distributors over the track record period, the sponsor should review the consequential risks, such as the risk of any of those distributors discontinuing its business relationship with the listing applicant and the ability of the listing applicant to find a suitable replacement in such event.

(e) Corruption

(i) The risk of corruption exists generally in any business but the sponsor may need to be particularly vigilant where for instance:

(A) the market for the listing applicant’s products is dominated by a limited number of distributors or is particularly competitive;

(B) the listing applicant operates in an industry or market that is subject to a high degree of government regulation or control (e.g., pharmaceuticals); or

(C) the listing applicant has achieved what may appear to the sponsor to be an unusually high rate of growth in its sales within a relatively short period of time during the track record period.

(ii) The risk of corruption may exist in both (1) dealings between the listing applicant and the sales representatives or employees of its distributors, particularly where the arrangement includes the payment of incentives or where the listing applicant is responsible for reimbursing any marketing or other costs or has agreed to provide any other form of financial support; and (2) dealings between the distributors and representatives or employees of their sub-distributors or end customers, such as where the listing applicant is a pharmaceutical manufacturer and its distributors offer illegitimate benefits to doctors or procurement staff at hospitals in the course of selling the listing applicant’s products. In the latter case, even if the listing applicant was not involved in such conduct, this could have an indirect impact on the listing applicant as it could result in the loss of its distributors as well as reputational damage in the market.

(iii) The sponsor should review the internal control measures adopted by the listing applicant with respect to the risk of corruption (see also paragraph 1.3.6 below).

(f) Legal or regulatory restrictions

In certain jurisdictions, there may be specific laws or regulations governing franchising or distributorships (such as the Regulations on the Administration of Commercial Franchise in the People’s Republic of China). Certain clauses in franchise or distribution agreements which have the effect of reducing entry opportunities for other suppliers or distributors may be in breach of competition laws in the jurisdiction where the listing applicant or its distributors operate. The sponsor, in conjunction with legal advisers, should ascertain whether the listing applicant may be subject to any such legal or regulatory requirements and review the risk of any non-compliance.

(g) Transportation, logistics and quality control

For certain types of goods such as pharmaceutical products, there is a potential risk of the goods becoming defective due to improper handling by the distributors when they are passing through the distribution chain or stored at the distributors’ premises before being sold to the end customers. The listing applicant may be subject to product liability to the end customers without fault on its part. The sponsor should review the transportation and logistics arrangements and quality control measures adopted by the listing applicant and the relevant terms in the distribution/franchise/consignment agreements (e.g., indemnification by distributors) to assess whether such risk is adequately addressed.

(h) Insurance

Where the listing applicant sells its products by way of consignment and, under the terms of the consignment, retains ownership of the products which have been placed with the consignee and remains responsible for any loss or damage of those products during transportation or delivery or while they are in the consignee’s custody, the sponsor should review whether the listing applicant has taken out appropriate insurance cover for loss of or damage to its products. The risk may be particularly pertinent if the products are of high value, such as jewellery.

1.2.7 If one or more of the risks described above is/are identified during the due diligence process, the sponsor should assess, on the basis of the nature of the risk and its materiality, whether the risk(s) may be addressed by way of disclosure in the listing document, or they are so fundamental as to affect the listing applicant’s suitability for listing.

1.3 Recommended Steps

Materiality

1.3.1 If the listing applicant has a small number of distributors and none are immaterial in importance (e.g., less than 10 distributors), the sponsor should carry out the recommended steps described in paragraphs 1.3.5 to 1.3.16 below on all those distributors.

1.3.2 If (i) the listing applicant has a large number of distributors and it is not practicable for due diligence to be carried out with respect to all of them; or (ii) distributorship is not the primary sales channel of the listing applicant, the sponsor may consider carrying out the recommended steps described in paragraphs 1.3.5 to 1.3.16 below on selected distributors (the “key distributors”) rather than on all of them. The selection of key distributors may be based on factors such as:

(a) revenue contribution over the track record period (It would be a reasonable approach to seek where feasible to interview distributors accounting for at least approximately 50% of the Group’s revenue, except where there are more than approximately 20 distributors, in which case consideration should be given to selecting distributors for interview on a statistical sampling basis, taking into account geographical sub-sets, where relevant. Whilst every listing applicant should be evaluated individually, there may be cases where it would be unreasonable on balance, even taking into account the need for thoroughness in due diligence, to interview more than approximately 20 distributors6);

(b) revenue contribution by region over the track record period (e.g., distributors within any region where the aggregate revenue contribution is higher than other regions);

(c) length of relationship with the listing applicant (e.g., distributors who have the longest relationship with the listing applicant and distributors who have only recently established a relationship with the listing applicant but whose revenue contribution has increased significantly over a short period of time);

(d) “high risk” distributors, such as those described in paragraph 1.3.5(a)(v) below;

(e) distributors whose transaction volume with the listing applicant is subject to unusual fluctuations over the track record period;

(f) distributors who are parties to transactions with unusual or special characteristics (e.g., transactions whose terms are unique or much more favourable to a particular distributor and transactions which are not adequately documented).

1.3.3 In accordance with paragraphs 1.3.1 and 1.3.2 above, the distributors with respect to whom due diligence is to be carried out are hereafter referred to as “relevant distributors”.

Sub-distributors

1.3.4 The sponsor should enquire as to whether one or more levels of sub-distributors have been appointed by any of the distributors to sell the products of the listing applicant. Where one or more levels of sub-distributors are involved, and any of those sub-distributors or those sub-distributors together account for what the sponsor considers to be a material portion of the products sold or being sold by the listing applicant, the sponsor should consider what additional due diligence has to be carried out with respect to those sub-distributors. The sponsor may consider (i) requesting the listing applicant to provide a list of the key sub-distributors, selected on the basis of their respective attributable contributions to the revenue of the listing applicant over the track record period; (ii) carrying out public searches, interviews and site visits with respect to those sub-distributors as described in paragraphs 1.3.7 to 1.3.16 below. It is acknowledged, however, that sub-distributors are under no compulsion to cooperate in the interview process or site visits and the refusal of a sub-distributor to participate in an interview or site visit does not mean that the sponsor has failed to perform adequate due diligence, although the sponsor should assess the materiality of not conducting the interview or site visit to the veracity of the due diligence process as a whole. If access to any key sub-distributor for interview is refused by the listing applicant or the distributor, the sponsor should seek to understand the reasons for the refusal and assess whether those reasons are legitimate. In such situation, the sponsor may need to consider what additional steps should be taken to verify the genuineness of such sub-distributor (e.g., making enquiries in the market to see if the sub-distributor is known as a distributor of the listing applicant’s products or the sub-distributor has only been operating for a short period of time).

Review of documents

1.3.5 The sponsor should request the listing applicant to provide the following documents and information for review:

(a) List of relevant distributors

(i) The sponsor should request the listing applicant to provide a list of its relevant distributors during the track record period and up to the latest practicable date for operational data in the listing document (or for such other periods as the sponsor may request where e.g., a large number of new distributors were engaged to replace existing distributors shortly before the beginning of the track record period, in which case the sponsor should request a list of distributors covering also those significant distributors whose relationship with the listing applicant was terminated before the track record period). The listing applicant should be asked to include the following information with respect to each distributor in the list:

(A) name of distributor;

(B) where the distributor is a corporate entity, name(s) of its shareholder(s);

(C) type of distributor (if there are different types);

(D) business address(es);

(E) contact person at distributor and contact details;

(F) revenue contribution during the track record period;

(G) length of business relationship with the listing applicant;

(H) any special relationship with the listing applicant (e.g., whether any director or substantial shareholder or current or ex-employee of the listing applicant or any of its subsidiaries has any ownership interest in or is able to exercise any control over the distributor);

(I) prior instances of business interruption and the cause(s);

(J) any prior breach of any of the terms of the distributorship, franchise or consignment agreement by distributor; and

(K) past and current disputes or litigation or arbitration or mediation proceedings with the listing applicant or with third parties relating to the listing applicant’s products or intellectual properties.

(ii) Given the responsibilities of a sponsor it would not be appropriate for the listing applicant to withhold the identity of a distributor from a sponsor. In particular, the identity should not be withheld on the basis of the purported commercial sensitivity or confidential nature of the information. For guidance relating to the sponsor’s access to all information, including confidential information, see paragraph 2.2.2 of Chapter 3 “Due Diligence Guidelines – Approach and Scope”.

(iii) The sponsor should take steps to verify the integrity of the information on the list of relevant distributors provided by the listing applicant as part of the interview with those distributors (see paragraph 1.3.10 below).

(iv) The sponsor should also consider whether it is appropriate to ask the reporting accountants to cross-check the revenue contribution of the relevant distributors provided by the listing applicant with the amounts in the listing applicant’s accounting records. This can serve both to check the reliability of the names of relevant distributors on the list provided to the sponsor and the reliability of information about the amount of business done with a particular distributor.

(v) Where any of the following parties appear as a distributor, the sponsor should be particularly alert to the need to assess critically and verify the independence of that party and the arm’s length nature of the listing applicant’s dealings with that party:

(A) any former employee7 of the listing applicant (or any of its subsidiaries), particularly where such former employee, who received only a small salary under his former employment with the listing applicant (or the relevant subsidiary), was required to make sizeable upfront payments to the listing applicant to become its distributor;8

(B) any controlling shareholder, director, senior management member or employee (former or current) of the listing applicant (or any of its subsidiaries) or their respective associates (as defined in the Listing Rules);9

(C) any previous subsidiary or associated company of the listing applicant;10

(D) any person which has granted to or has received from the listing applicant (or any of its subsidiaries) any loan or guarantee other than trade credit in the ordinary course of business; or

(E) any person who has been appointed as a distributor shortly after the last audited balance sheet date (but before the listing) and became the largest/major distributor(s) of the listing applicant.

(vi) Where the listing applicant had been relying on a few distributors during the track record period, the sponsor should discuss with the management of the listing applicant to understand the reasons for the reliance, if any, and evaluate any measures adopted or to be adopted by the listing applicant to reduce such reliance.

(vii) The sponsor should also obtain information from the listing applicant on the turnover rate of its relevant distributors and movements in the number of its relevant distributors during the track record period, as well as the reasons for their termination or replacement or any other major change, in order to assess whether the listing applicant’s revenue is the result of cannibalisation among distributors.11

(b) Distribution/franchise/consignment agreements

(i) The sponsor should obtain copies of the distribution/franchise/consignment agreements entered into by the listing applicant with its relevant distributors (including any sub-distribution/franchise agreements) and review their principal terms, including:

(A) the nature of the relationship (such as whether it is a principal-to-principal or a principal-to-agent relationship);

(B) the effective term and any right to renewal;

(C) geographic or other exclusivity;

(D) the rights and obligations of the parties;

(E) sales and pricing policies;

(F) obsolete or unsold stock arrangements;

(G) goods return arrangements;

(H) sales and expansion targets;

(I) sales and inventory reports and estimates;

(J) any minimum purchase amounts;

(K) sharing of advertising or marketing expenses;

(L) payment and credit terms;

(M) conditions for terminating and renewing the agreements (including any penalties or compensation payable);12 and

(N) where the appointment of any sub-distributor is permitted, whether any payment, goods return or other arrangements between the listing applicant and the distributor is tied to corresponding arrangements between the distributor and its sub-distributor (e.g., is the obligation on the distributor to pay the listing applicant dependent on the distributor having received payment from its sub-distributor?).

(ii) The sponsor should look out for any terms which may appear to be a deviation from the market norm (provided a market norm can reasonably be determined to exist by looking at industry comparables – see paragraph 1.3.19 below) and terms which may cast doubt on the arm’s length nature of the agreement, such as unusually long credit periods or favourable fee arrangements.

(iii) The sponsor should also review the extent to which the terms of the agreement enable the listing applicant to monitor the performance of and to exercise control over the distributor in aspects such as competition control, pricing control, inventory control, disposal of obsolete or unsold stock, regular reporting of sales and market feedback, minimum purchase commitments and sales performance targets.13

(iv) Where the listing applicant imposes minimum purchase requirements on any of its distributors in the agreement, the sponsor should assess whether the sales growth of the listing applicant over the track record period is supported by real demand.14 The sponsor should obtain information from the relevant distributors during their interviews on sales of the listing applicant’s products by the relevant distributors to the end customers (see paragraph 1.3.10 below).15

(v) The sponsor should request the listing applicant to confirm if there has been any prior breach of the terms of the distribution/franchise/consignment agreement by any of its relevant distributors over the track record period. Where there was any prior breach, the sponsor should request the listing applicant to confirm in writing how the instance was discovered, whether the listing applicant’s measures to monitor compliance were effective, how the dispute was settled, and whether any aspect of the listing applicant’s control mechanism on distributors was revised as a result.

(vi) If the distribution/franchise/consignment agreement with any of the relevant distributors is due to expire within a relatively short period of time (the sponsor should exercise its discretion to determine what should be considered “a relatively short period of time” as this may vary among different kinds of businesses), the sponsor should obtain information from the listing applicant on whether it intends to renew the agreement, whether the distributor has indicated its intention to renew the agreement (and if and how any major terms may be varied) and the impact on the listing applicant’s business or results of operations if such agreement is not renewed.

(vii) Where the distribution/franchise/consignment agreement has clauses which may have the effect of reducing entry opportunities for other suppliers or distributors, the sponsor should obtain opinions from legal advisers in the jurisdictions in which the listing applicant and its distributors operate to ensure compliance with applicable competition laws.

(viii) The sponsor should review the transportation and logistics arrangement provided for in the distribution/franchise/consignment agreements and any provisions on indemnity by the relevant distributors in favour of the listing applicant in the event of product liability arising out of the improper handling of goods by the distributors.

(ix) In the case of a consignment, the sponsor should, in particular, review the provisions on: (1) who retains ownership of the products being placed on consignment; (2) who is responsible for taking out insurance cover when the products are in transit and when they are in the custody of the consignee (the sponsor should consider requesting the listing applicant to provide copies of such insurance policy for review); and (3) control over cash receipts arising from sales through the consignee (e.g., how cash from sales is handled, frequency of reporting, system for cross-checking).

(x) The sponsor should, in conjunction with legal advisers, verify whether the listing applicant has complied with all consent requirements and other terms of the distribution/franchise/consignment agreements, such as change of control or confidentiality.

(c) Licence agreements relating to the licensing of intellectual property rights

(i) In the case of a franchise or distributorship, where the listing applicant has licensed the use of any intellectual property right (such as trade name, trade mark or patent) to any of the franchisees or distributors, the sponsor should review the principal terms of the licence as set out in the distribution or franchise agreement or if a separate licence agreement has been entered into, obtain a copy of that agreement (and if any sub-licence has been granted by the franchisee or distributor, a copy of such sub-licence agreement) and review its principal terms, including:

(A) the scope of the licence;

(B) the effective term and any right to renewal;

(C) geographic or other exclusivity;

(D) the rights and obligations of parties involved;

(E) payment terms; and

(F) conditions for terminating and renewing the agreements (including any penalties or compensation payable).16

(ii) The sponsor should look out for any terms which may appear to be a deviation from the market norm (provided a market norm can reasonably be determined to exist by looking at industry comparables – see paragraph 1.3.19 below) and terms which may cast doubt on the arm’s length nature of the agreement, such as unusually favourable fee arrangements.

(iii) The sponsor should also review the extent to which the terms of the agreement enable the listing applicant to prevent the misuse of the relevant trade name, trade mark or patent by the distributor (such as specifying the purpose for which and the territory in which it may be used).

(iv) The sponsor should request the listing applicant to confirm if there has been any prior breach of the terms of the licence by any of its distributors over the track record period. Where there was any prior breach, the sponsor should request the listing applicant to confirm in writing how the instance was discovered, whether the listing applicant’s measures to monitor compliance were effective, how the dispute was settled, and whether any aspect of the listing applicant’s control mechanism on distributors was revised as a result.

(v) If the licence with any of the relevant distributors is due to expire within a relatively short period of time (the sponsor should exercise its discretion to determine what should be considered “a relatively short period of time” as this may vary among different kinds of businesses), the sponsor should obtain information from the listing applicant on whether it intends to renew the agreement, whether the distributor has indicated its intention to renew the agreement (and if and how any major terms may be varied) and the impact on the listing applicant’s business or results of operations if such agreement is not renewed.

(vi) The sponsor should, in conjunction with legal advisers, verify as to whether the listing applicant has complied with all consent requirements with respect to provisions in the licence agreements on e.g., confidentiality.

(d) Regulatory approvals

The sponsor should, in conjunction with legal advisers, ascertain whether the distribution, franchise or consignment arrangement entered into by the listing applicant with any of its relevant distributors, franchisees or consignees is subject to any approval of any governmental or regulatory authorities and if so, request the listing applicant to provide copies of such approvals. The sponsor should request the listing applicant to confirm if there has been any prior breach of any of the terms or conditions of such approval.

(e) Financial information

(i) In reviewing the financial information of the listing applicant over the track record period, the sponsor should focus, in particular, on any unusual trend in the sales volume, revenue, stock/inventory or volume of goods returned during the track record period. The effects of any seasonality should be taken into account.

(ii) If any of the features described in paragraph 1.2.5(a)(iii) above exist in any of the distributorship/franchise/consignment agreement entered into by the listing applicant, the sponsor should discuss with the reporting accountants as to whether the method of revenue recognition adopted by the listing applicant is appropriate. When making the assessment, the sponsor should work with the reporting accountants to examine the listing applicant’s returned goods policy and the amount of goods returned from distributors during the track record period.17

(iii) Where there has been a persistent increase in accounts receivables and debtors’ turnover days during the track record period, the sponsor should discuss with the listing applicant and satisfy itself that the listing applicant’s credit management policy is appropriate and the provisions for trade receivables are adequate.18

(iv) Where the listing applicant distributes its products through (i) its own sales representatives who are employees and (ii) its sales partners (e.g., corporate entities) using the listing applicant’s name in their trading, the sponsor should analyse the listing applicant’s financial information with respect to sales through the sale representatives on the one hand and those through the sales partners on the other separately.19

(f) Standards and policies applicable to distributors

(i) The sponsor should review all standards and policies adopted by the listing applicant that are applicable to its distributors with respect to areas such as selection of distributors, sales, pricing, credit control, inventory control, disposal of obsolete or unsold stock, return of unsold stock, cash management, transportation and logistics arrangement, quality control, use of any trade name, trade marks, patents or other intellectual property rights licensed by the listing applicant, control of conflict of interests and competition between different levels of distributors (e.g. use of non-compete undertaking in agreements with distributors, policy on the minimum distance between stores), and anti-corruption.

(ii) The sponsor should review internal control measures adopted by the listing applicant to monitor the performance of its distributors, their compliance with the terms of the relevant distribution/franchise/consignment agreement and the standards and policies referred to in paragraph 1.3.5(f)(i) above.20

(iii) Where the listing applicant distributes its products through (i) its own sales representatives who are employees and (ii) its sales partners (e.g., corporate entities) using the listing applicant’s name in their trading, the sponsor should review measures adopted by the listing applicant to address the potential conflict of interests between the sales representatives and the sales partners.21

Review of internal control system

1.3.6 As part of the overall review of the internal control system of the listing applicant to be carried out in compliance with Practice Note 21 to the Listing Rules, the sponsor should request the internal control consultant to review the following aspects of the listing applicant’s internal control measures with respect to its distributors:

(a) inventory control;

(b) credit control;

(c) corruption control; and

(d) (in the case of a consignment) cash management with respect to sales proceeds collected by the consignees.

Conduct public searches

1.3.7 It may be possible to carry out various types of public searches on relevant distributors. In determining whether to commission lawyers to perform such searches, the sponsor should address its mind to the relative level of additional comfort that might be gained from such searches against the feasibility and costs of doing so. For example, the sponsor is more likely to commission such searches if some form of “red flag” has been raised. The sponsor should also take into account that while company searches can often be performed relatively cheaply in a centralised registry, in many jurisdictions no centralised records are kept of matters such as insolvency/bankruptcy or litigation thus often making such searches impractical and very expensive and accordingly only justified in special circumstances. Against this background, public searches may include the following:

(a) company search in the place of incorporation of the distributor: for the purpose of verifying the due incorporation and continued existence of the distributor and (if available) information on its directors and shareholders (e.g., to see if these are the same as any persons known to be connected with the listing applicant);22

(b) winding up or bankruptcy search in the place of incorporation of the distributor or the principal location(s) where it carries on its business: for the purpose of checking, if the distributor is a corporate entity, whether it is subject to winding up proceedings or if the distributor is an individual, whether he is subject to bankruptcy proceedings;

(c) litigation search in the principal location(s) where the distributor carries on its business: for the purpose of checking whether the distributor is subject to any litigation proceedings or outstanding judgements;23 and

(d) trade mark or patent registry search: where the listing applicant has licensed the use of any trade mark or patent to any of the distributors, for the purpose of verifying that the listing applicant is the registered holder of such trade mark or patent (and in jurisdictions where there is a requirement for a security interest created or licence granted over trade marks or patents to be registered, checking whether any such security interest has been created and whether such licence has been properly registered).

1.3.8 The sponsor should consider carrying out news checks on the relevant distributors with a view to identifying any negative news coverage on any of them. News checks refer to searches of proprietary databases (e.g., World-Check) or using public search engines such as Google and/or any relevant home-country equivalents such as Baidu and Sohu.

1.3.9 The sponsor should keep proper records of all searches conducted against the distributors.24

Interview relevant distributors

1.3.10 The sponsor should interview the relevant distributors with a view to independently verifying matters such as:

(a) ownership of the distributor;

(b) length of business relationship with the listing applicant;

(c) legal relationship with the listing applicant (seller/buyer or principal/agent, when title to goods pass);

(d) contractual terms governing their business relationship, particularly listing applicant’s control over the distributors, sales and inventory reporting system, goods returned arrangements, minimum purchase amounts, control over cash receipts, payment and credit terms, insurance;

(e) prior instances or allegations by the listing applicant of any breach of the distribution/franchise/consignment agreements or violation of the listing applicant’s standards or policies;

(f) performance of the distributors during the track record period in terms of, for example, (in the case of distributors) volume of purchases from the listing applicant, (in the case of franchisees) amount of payment made to the listing applicant on joining franchise and subsequent purchase or (in the case of consignees) gross sales amount of the listing applicant’s products, stock/inventory, sales volume to end customers, amount of returned goods, accounts receivable;

(g) prior instances of business interruption and the cause(s);

(h) quality control measures;

(i) past and current claims under any insurance policies relating to the listing applicant’s products or, where relevant, intellectual properties; and

(j) past and current disputes with the listing applicant, or with third parties relating to the listing applicant’s products or intellectual properties.

1.3.11 If there are any peculiar circumstances with respect to any distributor, such as where the distributor has little or no experience in carrying on a distribution business other than acting as the listing applicant’s distributor or the distributor has only been established for a short period of time (e.g., less than 12 months), the sponsor should consider undertaking further due diligence on that distributor to confirm the bona fides of the arrangement.

1.3.12 The sponsor should conduct interviews with the relevant distributors in accordance with Chapter 9 “Due Diligence Guidelines – Interviews of Major Business Stakeholders”.

Conduct site visits

1.3.13 The sponsor should visit the premises where the relevant distributors carry on their business if it has not had the chance to do so during the interviews. If there are a large number of e.g., retail outlets or showrooms, the sponsor should consider visiting those retail outlets or showrooms with more significant sales and verifying the existence of the others by, for example, anonymously calling the telephone numbers in order to see if they answer and by asking a question that someone doing business with them might normally ask and see if the answer is consistent with how a genuine distributor might be expected to answer (e.g., “Can I confirm your address as I would like to visit your showroom?” or “Can you confirm the opening times of your showroom?”).

1.3.14 In the case of franchises and distributorships where detailed operational standards may have been prescribed by the listing applicant for its franchisees or distributors, such as the manner in which the retail outlet has to be designed and the licensed trade name or trade mark has to be displayed, the sponsor should observe whether these standards have been complied with during the site visits.

1.3.15 Where distributors or franchisees keep stocks of the listing applicant’s products on their premises, except where impracticable to do so the sponsor should also observe the volume of the stocks being kept and their physical condition during the site visits. Where distributors or franchisees do not keep stocks of the listing applicant’s products on their premises (but e.g., in a storage facility located elsewhere instead) and there is any particular concern as to e.g. channel stuffing, the sponsor may consider requesting site visit(s) to the place(s) where the stocks are kept.

1.3.16 To the extent possible e.g., in the case of retail outlets or showrooms open to the public, the sponsor should arrange site visits independently of the listing applicant.

Review industry comparables

1.3.17 The sponsor should discuss with the management of the listing applicant to understand the benefits of the listing applicant using the particular distributorship/franchise/consignment model, and assess whether it is an industry norm.25

1.3.18 The sponsor should compare the listing applicant’s business model, the terms of its distribution, franchise or consignment agreements, and its financial performance with industry comparables. Further due diligence should be conducted where, for example, the listing applicant achieved growth in sales during the track record period that significantly exceeded the industry average, or the listing applicant’s level of gross profit margin was particularly high when compared to its peers.26

1.3.19 Industry comparables may include/be found from: (a) companies in the same industry which are already listed; (b) industry publications; (c) general discussion with competitors of the listing applicant; and (d) discussion with industry consultants (particularly where one is engaged to prepare an industry report for use in the listing document).

Endnotes

1. In May 2012, the Stock Exchange issued the Guidance Letter on Distributorship Business Model – Risks and Disclosure in Listing Documents (Exchange Guidance Letter GL36-12), in which it sets out its observations on the risks involving distributors, franchisees and consignees and guidance on the disclosure of such risks in listing documents.

2. Paragraph 13(g) of Practice Note 21 to the Listing Rules. Typical due diligence enquiries include “reaching an understanding of the manner in which the new applicant manages its business…including distribution channels, pricing policies, after-sales service, maintenance and warranties”.

3. Distributorships Low Risk Expansion into New Markets, by Michael Arnold, PLC March 1993.

Exclusive distributorship is an exclusive appointment that has the effect of precluding the supplier from actively seeking sales in the appointee’s territory, whether through his own efforts or by appointing other distributors.

Sole distributorship is a sole appointment such that the supplier cannot appoint any other distributor, but may continue actively selling into the territory.

Non-exclusive distributorship is a non-exclusive appointment that gives the appointee no degree of protection in his territory from the supplier’s or other distributors’ activities.

Selective distributorship is a selective distributorship arrangement which exists where, although the supplier does not give exclusivity to the distributor, he does limit the number of distributors which he appoints.

4. Acquiring Franchise Businesses: Knowing What to Look Out For, by Joachim Sander, John McLaughlin and Babette Märzheuser-Wood, PCL September 2007.

Direct franchising is the most straightforward structure commonly adopted in domestic franchising. In a direct franchise, the franchisor grants unit franchisees the right to operate individual units of the franchise in the relevant territory.

Master franchising extends most of the advantages of franchising into the international arena. The franchisor grants the master franchisee the right to grant unit franchises to independent third parties in a particular territory.

Development arrangements. In larger territories, franchisors often grant a developer the right to operate unit franchises itself and to introduce third parties to the franchisor as unit franchisees without being able to grant a sub-franchise itself. In other words, the developer promotes the franchise in a particular territory but any unit franchisees are direct sub-franchisees of the franchisor.

Subordinated equity arrangements. Also referred to as joint venture arrangements, in subordinated equity arrangements the franchisor and a local business become shareholders in a master franchisee vehicle. The master franchisee vehicle then grants sub-franchises to unit franchisees.

5. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

6. Paragraph 26(1)(b) of Appendix 1 Part A to Listing Rules requires disclosure of the five (5) largest customers in the listing document.

7. In Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents, the Stock Exchange cited a case where the listing applicant encouraged its employees to become its independent distributors during the track record period, and when the Stock Exchange raised concerns on the independence of those distributors, the sponsor confirmed, after performing its due diligence, that the sales to those distributors had been on normal commercial terms which were fair and reasonable to the listing applicant and consistent with the terms offered to other non-employee distributors, that no employees had acted as distributors while still being employees and that the listing applicant would cease such practice after listing. Full disclosure was made in the listing document.

8. In SFC Dual Filing Update of July 2010, the SFC cited a case where the initial draft prospectus provided limited information on the sales of the listing applicant made to certain distributors who were its former employees. Upon the SFC’s enquiries, it was revealed that the listing applicant’s significant turnover growth during the track record period was mainly attributable to sales conducted through these distributors. The sponsor failed to critically assess how these distributors, who received only a small salary under their former employment with the listing applicant, were able to finance their initial purchases from the applicant, who required sizeable upfront payments from its distributors. The reason was explained only after repeated requests by the regulators and upon additional due diligence work by the sponsor at a very late stage of the listing process. The SFC commented that the lack of professional scepticism by the sponsor in its due diligence in that case led to inefficiencies and unnecessary delay in the listing process.

9. (i) In Update on SFC Dual Filing of 28 December 2006, the SFC cited a case where the listing applicant’s customers were distributors which in turn sell the products to retail stores. It was only revealed upon the regulators’ enquiries that some of the distributors, including one of the listing applicant’s top five (5) customers, were previously the listing applicant’s subsidiaries or associated companies, or were companies held by the company’s senior management during the track record period. The sponsor offered inconsistent explanations when asked about such relationships, which further suggested a lack of due diligence and understanding regarding the relationship between the listing applicant and its customers. (ii) In SFC Dual Filing Update of July 2010, the SFC cited a case where the initial draft prospectus suggested that the listing applicant’s distributors and their ultimate owners had no relationship with the listing applicant. Upon the regulators’ enquiries, it was revealed that some of the listing applicant’s employees were the shareholders of a majority of these distributors. This raised concerns on the terms of sales made to these distributors and potential conflict of interest on the part of such employees. The disclosures on the listing applicant’s relationship with these distributors were clarified only upon the regulators’ further enquiries.

10. SFC’s Update on Dual Filing of 28 December 2006 (see endnote 9 above).

11. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

12. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

13. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

14. In SFC Update on Dual Filing of 17 June 2008, the SFC cited a case whether the listing applicant sold its products to a large number of franchisees. It was only revealed after the SFC’s enquiries that the listing applicant imposed minimum purchase requirements on each franchisee. A substantial proportion of the listing applicant’s revenue during the track record period came from the initial minimum purchases made by new franchisees upon their joining the network. Against the substantial growth in overall sales, a significant percentage of the franchisees failed to meet the prescribed minimum monthly purchases. It raised the question whether the listing applicant’s sales growth is supported by real demand.

15. Opinion on Further Improving Quality of Disclosure of Financial Information of Companies in Initial Public Offering issued by China Securities Regulatory Commission on 23 May 2012.

16. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

17. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

18. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents. The Stock Exchange also requires the listing document to include (i) a commentary on the recoverability of accounts receivable and the subsequent settlement of the balance as at the latest practicable date; and (ii) the impact of the increase in accounts receivable and debtors’ turnover days on the liquidity and cash flow of the listing applicant.

19. In Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents, the Stock Exchange cited a case where the listing applicant distributed its products either directly through its own sales representatives who were part-time employees or indirectly through its sales partners that were corporate entities using the listing applicant’s name in their trading. Some of the listing applicant’s sales representatives or their associates also held equity interests in the sales partners. The Stock Exchange suggested in that case that the listing applicant should clearly delineate its sales between the sale representatives and the sales partners.

20. In Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents, the Stock Exchange stated that in addition to the general disclosure for listing applicants with distributorship models, the listing applicant’s listing document should contain:

(a) the terms of the agreement with the sales partners, including conditions of use of the listing applicant’s name;

(b) measures to address the potential conflict of interests between the sales representatives and the sales partners;

(c) internal controls and corporate governance measures to monitor the listing applicant’s sales activities to detect potential abuses; and

(d) management of the sales partners using the listing applicant’s trading name and the associated risks that the applicant’s overall business could be adversely affected by improper use of the listing applicant’s name by the sales partners.

21. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents (see note 19 above).

22. The company search will not be able to reveal any trust arrangement and hence the real ultimate beneficial owner(s) of the distributors.

23. Not all jurisdictions maintain publicly available record of proceedings. The litigation search will not be able to reveal any pre-proceedings claims or arbitration.

24. In the SFC’s press release “SFC fines and revokes the licence of Mega Capital (Asia) Company Limited” dated 22 April 2012, SFC set out its findings on the due diligence work conducted by Mega Capital (Asia) Company Limited as the sponsor for the listing of Hontex International Holdings Company Limited, one of which was the lack of records showing what background or other due diligence searches Mega Capital had conducted on the franchisees of the group.

25. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

26. (i) In SFC Update on Dual Filing of 17 June 2008, the SFC cited a case where the listing applicant sold its products to a network of distributors which then resold the products to retail outlets for sales to the final customers. The listing applicant achieved growth in sales that significantly exceeded the industry average, but the initial draft prospectus failed to provide clear information about its distribution network, such as where the listing applicant’s products attracted high demand or whether the growth in sales was supported by actual sales to retail customers. It was only upon the SFC’s repeated requests that the listing applicant provided more information about the sales and inventory level of its distribution network. (ii) In Exchange Listing Decision LD48-2013 published in January 2013, the Stock Exchange cited a case where it returned the listing application of a distributor of certain products for failure to include in the draft prospectus an explanation on what value-added services the listing applicant provided to its distributor customers to sustain its level of gross profit margin which was particularly high when compared to its peers.