Chapter 21

Due Diligence Guidelines –

Inspection of Assets and Property Valuers’ Reports

1. Inspection of Assets

1.1 Standards

A sponsor should conduct the following independent due diligence steps: … inspection of key physical assets including, where appropriate, production facilities. [Paragraph 17.6(e)(ii) of the Code of Conduct]

1.2 Guidance

Scope and materiality

1.2.1 Apart from production facilities, key physical assets to be inspected typically include property (i.e., land and buildings, e.g., industrial, utilities and residential buildings, offices and shops), plant and equipment, inventory (e.g., products to be sold) and biological assets (e.g., livestock and crops) – whether they are owned or leased by the listing applicant.1 Note that the standards for inspection and due diligence on certain moveable assets (see paragraph 1.2.11) warrant a separate focused discussion, which is beyond the scope of this Chapter.

1.2.2 The Code of Conduct provides for an “inspection of key physical assets” while the Listing Rules provide for a “physical inspection of material assets”.2 There is no definition of materiality under the Code of Conduct or the Listing Rules. However, the Stock Exchange’s FAQ3 on the requirement to disclose information in a listing document on material properties offers some useful reference on what may be regarded as material properties in the context of inspection of assets.

Under the FAQ, the Stock Exchange states that it expects listing applicants and sponsors to consider materiality taking into account all the relevant facts and circumstances. Furthermore, listing applicants and sponsors may consider the following factors in determining whether a property is material: (a) whether it contributes to a significant portion of the revenue of the listing applicant; (b) any encumbrances that may impact the listing applicant’s operations; (c) any defects that may have a major impact on the listing applicant’s business or operations (e.g., breach of environmental regulations or title defects); and (d) its re-development potential. The Stock Exchange has also indicated that the above listed factors are not exhaustive. The sponsor should therefore consider the particular circumstances of each listing applicant in determining materiality.

1.2.3 See Chapter 2 “Due Diligence Guidelines – General Principles” and Chapter 3 “Due Diligence Guidelines – Approach and Scope”.

Methodology

1.2.4 As a starting point:

(a) assets that are material (i.e., those above the materiality thresholds as determined based on the above criteria) should be inspected through site visits by the sponsor, subject as provided in paragraph 1.2.5 on the appropriate sample size; whereas

(b) for assets that are not material, other forms of due diligence enquiries (short of a site visit by the sponsor itself) should be conducted, mainly to: (i) confirm the existence of the assets; and (ii) check that the listing applicant has been in compliance with the relevant laws, regulations and internal control procedures in respect of the ownership, operation and maintenance of such assets.

1.2.5 For each listing assignment, the sponsor should devise a scope of site visits and inspections by reference to the materiality thresholds as determined above. In certain cases, the material assets may be numerous in number but similar in terms of materiality, having regard to all the relevant facts and circumstances, e.g., where there are a large number of small retail shops. In such cases, the sponsor may have to determine an appropriate sample size of the material assets to be inspected by way of a site visit, by balancing the practicality (and costs) of the inspection and the reliability (and benefit) of the results. The appropriate sample size varies on a case by case basis. For example, it will differ depending on whether the listing applicant is the owner or landlord (e.g., a property company or a REIT) or it is the tenant (e.g., in retail business) of the property – in the former case, the property may be a key income-generating asset; and in the latter case, the property may just represent an expense item. If an issue is identified during the due diligence process, the sponsor may need to enlarge the sample size to better assess the magnitude of the problem.

1.2.6 The sponsor should conduct site visits of the assets falling within the scope above, together with the professional advisers of the listing applicant and the sponsor (if appropriate), and make appropriate enquiries of the personnel at the sites.

1.2.7 The Listing Rules provide that the sponsor should visit the site of the asset in order to view the asset and to assess its extent, quality and quantity and the purpose for which it is used.4 Furthermore, where, in the reasonable opinion of the sponsor, assessment of an asset genuinely cannot be achieved without the use of an expert (e.g., if the assessment requires technical expertise or if the sponsor becomes suspicious that the asset does not exist as to the extent represented or exists but is not used for the purpose claimed), the sponsor should ensure that the listing applicant instructs an appropriately qualified independent expert to conduct all or part of the inspection. In such cases the sponsor should ensure the expert is required to provide a written report in respect of the inspection.5 The sponsor may also cross check by using available technology, e.g., GPS (Global Positioning System) or Google Maps.

1.2.8 In the case of inspection of assets comprising inventory that is numerous in number or located at numerous locations, it is expected that the sponsor would rely to a large extent on the stocktaking exercise undertaken by the auditors.

Specific standards

1.2.9 See Chapter 23 “Due Diligence Guidelines – Mineral Companies” and Chapter 24 “Due Diligence Guidelines – Biological Assets” for specific standards and guidance on due diligence of mining and natural resources companies and of biological assets, respectively.

1.2.10 See Chapter 22 “Due Diligence Guidelines – Environmental”.

1.2.11 Special standards and guidance may apply to the due diligence on certain moveable assets, depending on the nature of the asset. Here are a few common examples for illustration purposes:

(a) It may not be expedient for the sponsor to conduct a physical inspection of moving assets such as aircrafts and ships. Experts in the relevant area should be engaged to carry out the inspection.

(b) Try to inspect fungible moveable assets which are at different locations within one day, to avoid being manipulated into inspecting the same assets over and over again by someone who is trying to artificially inflate the quantity of the assets in question.

1.3 Recommended Steps

1.3.1 The sponsor should take photos (or videos) and either make discreet enquiries or conduct interviews (as appropriate) at the sites and be alert to anything that it sees, hears or learns that is inconsistent with its knowledge and understanding (or the listing applicant’s representations) about the listing applicant, its business and business plans and, in due course, with the contents of the listing document.6 See Chapter 9 “Due Diligence Guidelines – Interviews of Major Business Stakeholders” and Chapter 25 “Due Diligence Guidelines – Record Keeping”.

1.3.2 The sponsor should follow up on any issues with the other working parties, including representatives from the listing applicant, the lawyers, auditors and valuers, as appropriate, and determine the appropriate action to be taken.

1.3.3 Information obtained from the site visits and asset inspections will often be particularly useful in the drafting and verification of the descriptions in the listing document of, e.g., intricate manufacturing processes, the condition and state of repair of the facilities, the surrounding environment and competitive landscape of retail businesses, etc.

1.3.4 See Chapter 18 “Due Diligence Guidelines – Interaction with Third Parties including Expert Advisers” for the generic standards and guidance as to the due diligence the sponsor should conduct in respect of non-expert third parties under Paragraph 17.6(g) of the Code of Conduct.

Endnotes

1. Paragraph 13(e) of Practice Note 21 provides that “typical due diligence inquiries in respect of each new applicant and the preparation of its listing document and supporting information include … undertaking a physical inspection of material assets, whether owned or leased, including property, plant, equipment, inventory and biological assets (for example, livestock or crops) used or to be used in connection with the new applicant’s business”.

2. Ibid.

3. FAQ No. 10 of FAQ Series 15 Rule Amendments Relating to Property Valuation Requirements (“FAQ Series 15”).

4. Note 1 to paragraph 13(e) of Practice Note 21.

5. Note 2 to paragraph 13(e) of Practice Note 21.

6. For example, information from the site visits and inspections may raise concerns or cast doubt as to whether the listing applicant has breached the permitted use of its relevant properties, or on the legality of its business or actual or potential non-compliance issues. In a case referred to in the SFC Dual Filing Update of August 2011 involving a property developer, the listing applicant only developed one property during the track record period, which was a complex with residential apartments and office premises. However, the land parcel on which the complex was constructed was permitted to be used for warehouse and storage only. The listing applicant had already sold and leased out part of the complex, and could be subject to potential claims by purchasers and tenants. Despite repeated enquiries by the regulators, the draft listing document failed to demonstrate that the actual use of the property was consistent with the permitted use for the land parcel and to explain the possible consequences of the apparent breach of the terms of the relevant land use rights.

In another case referred to in the SFC Dual Filing Update of January 2010, the listing applicant delayed construction of a project, leaving the relevant land idle, and was in breach of land grant contracts signed with the PRC local regulatory bodies. However, the listing document failed to disclose basic information relating to the idle land, the amounts invested, any regulatory notices received or any measures taken to address the breach, and it did not provide analysis of the potential adverse financial and operational impact on the business.