Chapter 3

Due Diligence Guidelines –

Approach and Scope

1. Reasonable Judgement

1.1 Standards

A sponsor should conduct due diligence in order to have a thorough knowledge and understanding of a listing applicant and to satisfy itself in relation to the disclosure in the listing document. A sponsor should exercise reasonable judgement on the nature and extent of due diligence work needed in relation to a listing applicant having regard to all relevant facts and circumstances. A sponsor should recognise that the nature and extent of due diligence varies from case to case depending on the facts and circumstances and there is no exhaustive list of due diligence steps that would apply in all circumstances. [Paragraph 17.6(a) of the Code of Conduct]

1.2 Guidance

1.2.1 Under the Companies (Winding Up and Miscellaneous Provisions) Ordinance, there is a statutory liability for misstatements in a prospectus which falls on the issuer and other specified parties including the sponsor.1 For the civil liability under section 40 of the Companies (Winding Up and Miscellaneous Provisions) Ordinance, the principal defences are having reasonable grounds to believe that the statement was true (i.e. a due diligence defence) and, in the case of expert opinions, that the expert was competent to give the opinion and had given its consent.

1.2.2 For the criminal liability under section 40A of the Companies (Winding Up and Miscellaneous Provisions) Ordinance, the SFC proposes that section 40A be amended such that the standard of liability will be that the defendant knew that the prospectus contained an untrue statement or was reckless as to whether this was the case and that the untrue statement was materially adverse to investors. In this regard, the SFC has stated that a due diligence failure is not of itself intended to involve criminal liability. If a sponsor has complied with the new Code of Conduct provisions, the SFC believes it is highly unlikely that the prosecution would be able to establish knowledge or recklessness.2

1.2.3 The SFC does not expect sponsors to be able to detect all attempts by the listing applicant or other parties to conceal information in order to mislead others.3 The SFC acknowledges that the requirement to carry out reasonable due diligence cannot be expected to amount to a guarantee of an absence of fraud, forgery or deliberate non-disclosure.4

1.2.4 In assessing the nature and extent of due diligence work needed, the sponsor should bear in mind that it is required to provide a confirmation to the Stock Exchange that the disclosures in a prospectus contain sufficient particulars and information to enable a reasonable person to form a valid and justifiable opinion of the shares and the financial condition and profitability of the listing applicant.5

1.2.5 The following examples of due diligence work were considered by the SFC to be inadequate and sub-standard. In the Hontex case,6 material information about suppliers and customers (such as their transaction figures with the listing applicant) was missing from due diligence questionnaires and yet the sponsor failed to follow up on the missing information. The sponsor also rushed a number of interviews with customers and suppliers on the day when the listing application was filed. In addition, the sponsor failed properly to verify information concerning the listing applicant’s franchisees which was provided by the listing applicant.

1.2.6 There will be many circumstances when a sponsor has to exercise judgement in determining the level of materiality to be applied in conducting due diligence on assets such as properties, machinery, produce or stock or when determining the number of distributors, suppliers or customers to interview. As the Code of Conduct states, the sponsor must exercise reasonable judgement and the sponsor should exercise its discretion in this regard on the basis of a sound understanding of the listing applicant’s business, the markets within which it operates and those anticipated further developments in the applicant’s business plan. Chapters 7 to 24 provide detailed guidance on various categories of due diligence, including business due diligence, financial due diligence and legal due diligence. Within that guidance there are suggestions as to how the sponsor can seek to assess what is the appropriate level of materiality for determining particular types of due diligence thresholds. There is, of course, no fixed formula for determining the appropriate level of materiality. While a sponsor must be prepared and able to justify how it reached its conclusions on determining the level of materiality in its diligence, it is also reasonable to have regard to the practicality and cost implications of a particular diligence exercise when compared to its overall contribution to the sponsor’s understanding and knowledge of the applicant’s business as required to enable it to provide the necessary level of assurance to itself, the regulators and the investors.

Endnotes

1. The SFC has stated that it considers sponsors to be covered by the category of “persons who authorize the issue of a prospectus” who are potentially liable under sections 40 and 40A of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (paragraph 10 of the SFC’s Supplemental Consultation Conclusions on the Regulation of IPO Sponsors – Prospectus Liability of 22 August 2014).

2. Paragraphs 281 and 292 of the Consultation Conclusions on the Regulation of Sponsors.

3. Paragraph 283 of the Consultation Conclusions on the Regulation of Sponsors

4. Paragraph 125 of the Consultation Paper on the Regulation of Sponsors.

5. Appendix 19 (Sponsor’s Declaration) to the Listing Rules. There is a similar requirement under paragraph 3 of Schedule 3 to the Companies (Winding Up and Miscellaneous Provisions) Ordinance.

6. SFC Press Release – “SFC fines and revokes the licence of Mega Capital (Asia) Company Limited” dated 22 April 2012. Mega Capital acted as the sole sponsor of the listing application of Hontex International Holdings Company Limited in 2009. It was later discovered that the prospectus of Hontex materially overstated the turnover and profit before tax of the group for the track record period as well as the value of cash and cash equivalent balances and the number of franchise stores.