Chapter 31

Due Diligence Guidelines –

Dealing with “Material Deficiencies” of the Listing Applicant

Code of Conduct Paragraph

17.3(b)(ii)

17.3(b)(iii)

17.9(c)

17.9(d)

Key Stock Exchange Guidance Letters

Exchange Guidance Letter GL63-13

Key Stock Exchange Listing Decisions

Exchange Listing Decision LD19-2011

Exchange Listing Decision LD75-2013

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 categorises non-compliance incidents in three ways which determines their treatment and the disclosure and rectification requirements:

(a) “Material Impact Non-compliances” – non-compliance incidents which, individually or in the aggregate, 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 impact non-compliances, but which reflect negatively on the listing applicant’s or its directors’/ senior management’s ability or tendency to operate in a compliant manner. For example, repeated and/ or continuous breaches of laws.

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

1.3.4 Where deficiencies relate to non-compliance incidents which are of a serious nature, for example involving fraud or deceit by directors or senior management or a systemic failure of internal controls, or where the matter had a significant financial impact on the listing applicant, this may translate into an issue of suitability of the directors or suitability of the listing applicant for listing.4 This may result in the listing application being rejected by the Stock Exchange or the Stock Exchange may require a demonstration period of compliance from the cessation of the non-compliance incidents to demonstrate that the rectification measures and enhanced internal control measures adopted are effective, and that there is no financial impact on the listing applicant. The demonstration period would generally be required to be an audited period.5 Non-compliance incidents may also affect the listing applicant’s ability to meet the listing criteria.6

1.3.5 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”. In addition, the Stock Exchange has issued a number of Listing Decisions relating to non-compliance incidents. Sponsors should refer to Exchange Listing Decision LD96-1 (directors with past SFC disciplinary records), Exchange Listing Decision LD97-1 (regulatory non-compliance record), Exchange Listing Decision LD19-2011 (non-compliant bill financing), Exchange Listing Decision LD33-2012 (compliance with laws applicable to pawn loan industry in the PRC) and Exchange Listing Decision LD73-2013 (non-compliance with building laws).

1.3.6 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

1.3.7 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.

1.3.8 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.

1.3.9 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”. It should be noted that the Stock Exchange normally expects all rectification actions in respect of Material Impact Non-compliance incidents to be completed before listing.8 The decision to rectify Systemic Non-Compliances and Immaterial Non-compliances rests with the listing applicant’s directors and the sponsor.9

1.3.10 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. Paragraph 3.2 of Exchange Guidance Letter GL63-13. Exchange Listing Decisions LD91-2015 and LD92-2015 contain examples where the Stock Exchange has rejected listing applications due to non-compliances.

5. Paragraph 3.2 of Exchange Guidance Letter GL63-13.

For example, in Exchange Listing Decision LD19-2011, the Stock Exchange required the listing applicant to delay its listing for a period of 12 months from the date it ceased carrying on non-compliant bill financing arrangements. The listing applicant was required to include in its prospectus audited financial statements for that 12 month period to enable investors to fully appraise the company’s performance without reliance on the non-compliant activities. The Stock Exchange additionally required the appointment of an independent consultant with relevant experience to assess the internal controls systems and for such consultant not to have major negative findings about the internal controls at the end of the 12 month period.

6. In Exchange Listing Decision LD86-2015, the Stock Exchange determined that cash flow generated during a period of non-compliance could not be counted towards the calculation of minimum cash flow under GEM Listing Rule 11.12A(1).

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

8. Paragraph 3.6 of Exchange Guidance Letter GL63-13.

9. Paragraph 3.9 of Exchange Guidance Letter GL63-13.

Disclaimer

HKCFEF Limited and the contributing law firms, accountants and sponsors are not offering these due diligence guidelines as legal, financial or professional advice or services and they should not be relied upon as such. These due diligence guidelines should not be used as a sole basis for any decision, action or inaction and are not meant to serve as a substitute for the advice of qualified professionals. See here for the full terms and conditions.

Due Diligence Guidelines

Listing Applicant

Material Deficiencies

Hong Kong Sponsors Due Diligence Guidelines

Advice on Material Deficiencies

Dealing with Material Deficiencies of the Listing Applicant

Hong Kong Securities and Futures Commission SFC

Paragraph 17.3(b)(ii) of the Code of Conduct

Due Diligence Checklist

Due Diligence Process

Due Diligence Compliance
Materially and Adversely Affect an Investors Decision
Paragraph 17.9(c) of the Code of Conduct

Table of contents