Chapter 13

Due Diligence Guidelines –

Internal Controls

4. Advice and Guidance to Listing Applicant to Remedy Material Deficiencies

4.1 Standard

4.1.1 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]

4.1.2 To the extent that the sponsor finds that the new applicant’s procedures or its directors and/or key senior managers are inadequate in any material respect on issues referred to at paragraph 15 above, the sponsor should typically discuss the inadequacies with the new applicant’s board of directors and make recommendations to the board regarding appropriate remedial steps. It should also typically ensure that these steps be taken before listing. These steps might include training tailored to the needs of individual directors and senior managers. [Paragraph 16 of Practice Note 21 to the Listing Rules]

4.2 Guidance

4.2.1 The SFC has indicated 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 listing application is made.14

4.2.2 “Material deficiencies” for these purposes refers to deficiencies in relation to a listing applicant which would reasonably be expected to affect the consideration of the listing applicant’s suitability by the Regulators or which, if disclosed, would reasonably be expected to materially and adversely affect an investor’s decision.15 The same definition is adopted by the Hong Kong Institute of Certified Public Accountants in the Technical Bulletin.

4.3 Recommended Steps

4.3.1 The sponsor should typically require that the Internal Controls Consultant prepare a preliminary report (“Preliminary Report”) identifying any internal controls deficiencies identified and, in the case of a long form report, the recommended steps to be taken to address any deficiencies identified.

4.3.2 The sponsor should review the Preliminary Report prepared by the Internal Controls Consultant. Sponsors should refer to Chapter 18 “Due Diligence Guidelines – Interaction with Third Parties including Expert Advisers” for further details of the procedures to be adopted in reviewing the Preliminary Report prepared by the Internal Controls Consultant.

4.3.3 The sponsor should discuss with the listing applicant and the Internal Controls Consultant the findings of the Internal Controls Consultant’s review of the listing applicant’s systems and controls set out in the Preliminary Report. As mentioned above, long form reports and agreed-upon procedures engagements provide a report on the factual findings resulting from the procedures adopted and in neither case is assurance expressed by the Internal Controls Consultant on the design, implementation or operating effectiveness of the listing applicant’s internal controls systems and procedures.

4.3.4 The sponsor should discuss with and advise the listing applicant (in conjunction with the Internal Controls Consultant where a long form report approach is adopted which includes recommendations) on the recommended steps to be taken and the timeline for the rectification of any deficiencies identified by the Internal Controls Consultant in its Preliminary Report. 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.16 In addition, the sponsor should consider the Stock Exchange’s expectations on specific disclosure in the listing document where there have been material non-compliance incidents as discussed in paragraph 1.2.11 above. 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.

4.3.5 The sponsor should also consider the categorisation of the deficiency in the Preliminary Report where a long form report is adopted, which will set out the Internal Controls Consultant’s opinion as to whether the deficiency is material, is an “other control deficiency” or is an “observation for improvement”. Material deficiency is defined in the Technical Bulletin in the same way as the SFC’s definition in its consultation conclusions set out in paragraph 4.2.2 above. Another control deficiency is “a deficiency, or a combination of deficiencies, that is less severe than a material deficiency yet important enough to merit attention by those responsible for operations, structure, procedures and systems, directors and key senior managers, and oversight of the company’s financial reporting.” Observations for improvement are those matters that would not result in a control weakness, but if remedied, may improve the efficiency of the process.17

4.3.6 The sponsor should require that the Internal Controls Consultant conduct a follow up review to assess whether the listing applicant has taken measures to rectify any deficiencies identified in the Preliminary Report prepared by the Internal Controls Consultant. This will typically involve the Internal Controls Consultant conducting a further review and walk-through processes and the preparation of a follow-up report (“Follow-up Report”), normally with a view to completing the follow up review process in advance of the submission of the listing application.

4.3.7 The sponsor should review the Follow-up Report prepared by the Internal Controls Consultant and discuss the findings set out in the report with the Internal Controls Consultant and the listing applicant to assess whether all of the deficiencies identified in the Preliminary Report have been rectified and whether any material deficiencies identified still require rectification.

Endnotes

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

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

16. Recent areas of focus on internal controls failings in Listing Committee disciplinary cases relating to listed companies have included failures to have in place effective procedures to: (i) ensure detection and disclosure of notifiable and connected transactions; (ii) prevent breaches of the requirement to disclose inside information under Rule 13.09; (iii) cover specific areas of compliance, namely the requirement to disclose share charges under Rules 13.17 to 13.21 of the Listing Rules; and (iv) ensure compliance with financial reporting obligations.

In Exchange Guidance Letter GL68-13 the Stock Exchange states that it will take into account all relevant facts and circumstances in determining whether Integrity Non-compliances would render a listing applicant unsuitable for listing, including:

(i) the underlying reasons for the Integrity Non-compliances and the relevant mitigating factors;

(ii) their operational and financial impact;

(iii) the culpable person’s influence on the listing applicant’s operations, internal controls and trading results; and

(iv) whether any effective internal control measures have been implemented (and for how long) to avoid re-occurrence of any similar Integrity Non-compliances.

17. Paragraph 57 of the Technical Bulletin.