Chapter 31

Due Diligence Guidelines –

Dealing with “Material Deficiencies” of the Listing Applicant

1. Advice on Material Deficiencies

1.1 Standards

Where material deficiencies are identified in relation to the operations and structure, procedures and systems, or directors and key senior managers of a listing applicant, a sponsor should provide adequate advice and recommendations to assist the listing applicant to remedy these material deficiencies. [Paragraph 17.3(b)(ii) of the Code of Conduct]

1.2 Guidance

1.2.1 The SFC has indicated its view that, where a material deficiency is identified, it is critical that the sponsor discusses the position with the listing applicant and provides advice and recommendations to assist the listing applicant whenever possible to address the deficiency before the application is made.1

1.2.2 The term “material deficiencies” refers to deficiencies in relation to a listing applicant which would reasonably be expected to affect the consideration of the applicant’s suitability by the regulators or which, if disclosed, would reasonably be expected to materially and adversely affect an investor’s decision.2

1.3 Recommended Steps

1.3.1 The sponsor should review its due diligence findings, together with the findings of any experts or third parties engaged by the sponsor or listing applicant to assist with the due diligence, such as internal controls consultants, lawyers, industry consultants and others. Sponsors should refer to Chapter 18 “Due Diligence Guidelines – Interaction with Third Parties including Expert Advisers” for general guidance in relation to reviewing the work results of third parties and Chapter 13 “ Due Diligence Guidelines – Internal Controls”, Chapter 20 “Due Diligence Guidelines – Accountants”, Chapter 21 “Due Diligence Guidelines – Inspection of Assets and Property Valuers’ Reports” and Chapter 23 “Due Diligence Guidelines – Mineral Companies” for specific guidance in relation to the reports prepared by internal controls consultants, reporting accountants, property valuers and Competent Persons, respectively.

1.3.2 The sponsor should discuss with the listing applicant and the relevant third party advisers and consultants the findings of the due diligence review and any reports produced. Where relevant and practical, the sponsor should seek advice or an opinion from lawyers in relevant jurisdictions with regard to any actual or potential material non-compliance and as to the potential legal consequences of the non-compliance. The sponsor may additionally need to obtain legal advice or a legal opinion for the purposes of disclosure of material non-compliance incidents in the listing document (see paragraphs 2.3.5(b) and 2.3.6 below). Sponsors should refer to Chapter 17 “ Due Diligence Guidelines – Legal and Regulatory Compliance and Legal Proceedings and Disputes”.

1.3.3 The sponsor should consider with the listing applicant and relevant third parties the categorisation of any deficiencies identified to assess whether the deficiency is, either alone or in conjunction with other deficiencies identified, material (as defined in paragraph 1.2.2 above). The sponsor should have regard to the potential risks posed by the deficiencies identified and whether such deficiencies amount to a breach of any regulatory requirements applicable to listed companies. The Stock Exchange addresses three categories of non-compliance incidents and provides guidance on their treatment and the disclosure and rectification requirements:

(a) “Material Non-compliances”: non-compliance incidents which, individually or are reasonably likely to have had or may have in the future, a material financial or operational impact on the listing applicant. For example, non-compliances giving rise to significant financial penalties or which may result in the closure of material operating facilities.

(b) “Systemic Non-compliances”: non-compliance incidents which are not Material Non-compliances, but their recurring nature may reflect negatively on the listing applicant’s or its directors’/ senior management’s ability or tendency to operate in a compliant manner.

(c) “Immaterial Non-compliances”: Non-compliance incidents which are neither material non-compliances nor systemic non-compliances.3

1.3.4 Where deficiencies relate to non-compliance incidents which involve fraud, deceit or dishonesty (“Integrity Non-compliances”) or are Material Non-compliances by a listing applicant or its directors or controlling shareholder(s) which raise concerns regarding a director’s competency of suitability or certain other non-compliances, this may translate into an issue of suitability of the directors or suitability of the listing applicant for listing. This may result in the listing application being rejected by the Stock Exchange or the Stock Exchange may require the listing applicant to demonstrate that it could still meet the eligibility requirements under the Listing Rules after adjusting the trading record results for the impact of the relevant non-compliances. 4

1.3.5 The Stock Exchange normally expects Material Non-compliances to be fully rectified before listing unless this is not applicable or possible. The Stock Exchange also expects the listing applicant to have implemented enhanced internal control measures to prevent the recurrence of Material Non-compliances.5 Material Non-compliances that involve bill financing from banks and interest rate/loan arbitrage that are not criminal in nature may be addressed by disclosure. The listing applicant will be required to cease all non-compliant bill financing and for a period of at least 12 months demonstrate that its business is sustainable when it is in compliance. 6

1.3.6 Sponsors should refer to Chapter 4 “Due Diligence Guidelines – Submission Readiness” for further guidance on matters which may impact suitability for listing. In addition, sponsors should refer to the following chapters for specific guidance on suitability issues: Chapter 7 “Due Diligence Guidelines – Knowing the Listing Applicant and its Management”; Chapter 8 “Due Diligence Guidelines – Business Model”; Chapter 10 “Due Diligence Guidelines – Controlling Shareholders’ Relationship with the Listing Applicant”; Chapter 13 “Due Diligence Guidelines – Internal Controls”; Chapter 15 “Due Diligence Guidelines – Anti-Corruption, Anti-Money Laundering and Sanctions”; Chapter 17 “Due Diligence Guidelines – Legal and Regulatory Compliance and Legal Proceedings and Disputes”; and Chapter 23 “Due Diligence Guidelines – Mineral Companies”.

1.3.7 The sponsor should also be aware of its obligations under Paragraph 17.9(c) of the Code of Conduct which requires the sponsor to report to the Stock Exchange in a timely manner any material information which it becomes aware of relating to a listing applicant which concerns non-compliance with the Listing Rules or other legal or regulatory requirements relevant to the listing. Where the sponsor ceases to act for a listing applicant before completion of the listing, the sponsor is required to inform the Stock Exchange in a timely manner of the reasons for ceasing to act.7

1.3.8 The sponsor should discuss with and advise the listing applicant (together with the relevant third parties where appropriate) as to the recommended steps to be taken and the timeline for rectification of any deficiencies identified through the due diligence, and in particular any deficiencies determined to be material.

1.3.9 The sponsor should conduct a follow up review, either itself or via the relevant third party, to assess whether the listing applicant has adopted the recommended measures to rectify the deficiencies and should assess whether all the deficiencies have been satisfactorily rectified or whether any still require rectification.

1.3.10 Where material deficiencies identified cannot be remedied prior to the submission of the listing application to the Stock Exchange, the sponsor should have regard to section 2 of this chapter below. In addition, sponsors should refer to Chapter 4 “Due Diligence Guidelines – Submission Readiness”. As mentioned above, it should be noted that the Stock Exchange normally expects all rectification actions in respect of Material Non-compliance incidents to be completed before listing.8 The decision to rectify any Systemic or Immaterial Non-compliance rests with the listing applicant’s directors and the sponsor.9

1.3.11 The sponsor should also consider the Stock Exchange’s expectations on disclosure of Material Non-compliance incidents in listing documents, irrespective of whether they have been rectified before listing. See paragraphs 2.3.5 to 2.3.8 below.

Endnotes

1. Paragraph 98 of the Consultation Conclusions on the Regulation of Sponsors.

2. Paragraph 97 of the Consultation Conclusions on the Regulation of Sponsors.

3. Paragraph 3.1 of Exchange Guidance Letter GL63-13.

4. See Exchange Guidance Letter GL63-13 on Guidance on suitability for listing in respect of non-compliances. Paragraphs 3.3 to 3.6 of Exchange Guidance Letter GL68-13 provide guidance on Integrity Non-compliances and paragraphs 3.7 to 3.8 provide guidance on Material Non-compliances.

Exchange Listing Decisions LD92-2015, LD107-2017 and LD121-2019 contain examples where the Stock Exchange has rejected listing applications due to non-compliances. In Exchange Listing Decision LD107-2017, the Stock Exchange rejected company A and company E on the grounds that they did not meet the minimum profit requirement after excluding income from non-compliant sources.

5. See paragraph 3.4 of Exchange Guidance Letter GL63-13.

6. See paragraph 3.7 of Exchange Guidance Letter GL63-13.

7. Paragraph 17.9(d) of the Code of Conduct.

8. Paragraph 3.4(d) of Exchange Guidance Letter GL63-13.

9. Paragraph 3.10A of Exchange Guidance Letter GL63-13.