Due Diligence Guidelines –
Regarding the preparation of a listing document, a sponsor should … assess the legality and compliance of the business operations and whether the listing applicant is subject to any material legal proceedings or disputes. [Paragraph 17.6(d)(vii) of the Code of Conduct]
6.2.1 The sponsor should perform due diligence on the legality, tax and regulatory compliance of the listing applicant’s business with regard to its impact on the viability of the business model. The sponsor should also familiarise itself with the main rules and regulations applicable to the listing applicant’s operations, particularly where the listing applicant operates in a highly regulated industry.
6.2.2 Common themes in legal and regulatory compliance due diligence include:
(a) scope of the business licence and whether the listing applicant’s activities are and will continue to be conducted within the prescribed parameters;
(b) breach of contract and/or infringement of third party intellectual property;43
(c) breach of land use restrictions and other laws and regulations relating to land;44
(d) engaging in activities that are potentially illegal or contrary to public policy, or exceeding regulatory limits in a regulated business;45
(e) breach of foreign investment restrictions;46
(f) breach of environmental laws and regulations.
6.2.3 The sponsor should perform reasonable due diligence on instances or suspected instances of material non-compliance with rules and regulations, bearing in mind specific regulatory requirements on the disclosure of such non-compliance in the listing document. The sponsor should also focus its mind on whether the listing applicant will be able to demonstrate a period of compliance from the cessation of such incidents, to show that any rectification and enhanced internal controls measures (if appropriate) are effective and to evaluate the financial impact on the listing applicant.47
6.3 Recommended Steps
6.3.1 The sponsor should obtain appropriate advice48 from lawyers in jurisdictions in which the listing applicant has major operations as to the compliance status of the listing applicant, with a view to:
(a) discovering and measuring any deficiencies in relation to:
(i) the soundness of the listing applicant’s business model and its suitability for listing;49 and/or
(ii) the character, experience, integrity and competence of the directors and management of the listing applicant,50
as may be revealed by any legal or regulatory irregularities;
(b) measuring the likelihood of the listing applicant being compelled to change or modify its business model to address such issues;
(c) measuring any continuing exposure of the listing applicant to legal or regulatory action, such as:
(i) revocation or suspension of business licences;
(ii) inability to use any properties or rights that have in the past contributed to the listing applicant’s results;
(iii) any liability to criminal, regulatory or administrative penalties and fines, or civil liability to pay compensation, or the taking of other remedial actions; and
(iv) any litigation, dispute, investigations and other proceedings,
and the possible impact of the above on the financial prospects and results of the listing applicant;
(d) determining whether and how such continuing exposure may be managed or reduced (e.g., appropriate indemnities, internal control measures, independent professional advice, internal reviews and reporting51); and
(e) determining the appropriate disclosure in the listing document.
Please see also Chapter 17 “Due Diligence Guidelines – Legal and Regulatory Compliance and Legal Proceedings and Disputes”, Chapter 19 “Due Diligence Guidelines – Foreign Lawyers” and Chapter 31 “Due Diligence Guidelines – Dealing with ‘Material Deficiencies’ of the Listing Applicant”.
6.3.2 Where appropriate and practicable, the sponsor should seek opportunities to interview relevant government officials or otherwise to obtain regulatory assurance on any points of law or regulation that may raise issues of actual or potential non-compliance.52
6.3.3 Where practicable, the sponsor should conduct, or procure the conducting of, independent litigation, court and/or bankruptcy searches on the listing applicant, its subsidiaries and their directors, in the jurisdictions in which the listing applicant’s group has its key operations. Please see also paragraph 3.2.4 of Chapter 17 “Due Diligence Guidelines – Legal and Regulatory Compliance and Legal Proceedings and Disputes” and paragraph 2.3.1(f) of Chapter 19 “Due Diligence Guidelines – Foreign Lawyers”.
43. See SFC Dual Filing Update of August 2011 where a listing applicant’s business model of operating an online trading platform for virtual items of third party-operated websites was held to be unacceptable, as the applicant had to download and use the relevant third-party developed software to transfer the virtual items on behalf of the customers, which was potentially in breach of the relevant user agreements with the website operators.
44. See SFC Dual Filing Update of August 2011 where a listing applicant engaged in property development had developed and sold only one property project, namely a commodity trade centre complex with residential apartments and office premises, while the land was permitted to be used for warehouse and storage only. Please see also SFC Dual Filing Update of January 2010 where a listing applicant did not obtain the construction permit before commencing construction of a property project, which exposed it to penalty or forfeiture of the land.
45. See SFC Dual Filing Update of July 2010 where a listing applicant engaged in a highly regulated business charged fees to customers that exceeded and were in breach of the limits imposed by regulatory requirements. The excess fee income represented a significant portion of the applicant’s profits. Please see also SFC Dual Filing of January 2010 where a listing applicant breached certain regulatory provisions when entering into contracts with its customers which, in the worst case, might render the contracts illegal and cause the applicant to lose its business licence. The sponsor was criticised for failing to assess the applicant’s business viability, which might not be adequately addressed by disclosure alone. For business involving gambling activities, see Exchange Guidance Letter GL71-14.
46. See SFC Dual Filing Update of June 2009 where a listing applicant operates its principal business in a jurisdiction which prohibits foreign controlling ownership in the business. The applicant claimed to have control because of an arrangement with a local employee from that jurisdiction, despite a relevant law which explicitly prohibits “nominee” arrangements. The severe legal problems could result in the applicant losing control over the principal business, the very basis on which the listing was sought.
47. Exchange Guidance Letter GL63-13.
48. See the SFC Report on Sponsor Theme Inspection Findings of March 2011 where the SFC criticised a sponsor firm for unduly relying on a piece of legal advice which was prepared based upon certain facts which did not reflect the full and actual business operation of the listing applicant.
49. See paragraph 12 of Exchange Listing Decision LD19-2011 where the Stock Exchange stated it would, in determining the impact of the non-compliance on the listing, consider:
(a) the nature, extent and seriousness of the breaches, e.g. whether the breaches involved dishonesty, or newly established laws and regulations which may be subject to different interpretations by legal professionals;
(b) the reasons for the breaches: whether the breaches were intentional or due to recklessness or negligence;
(c) the impact of the breaches on the issuer’s operations;
(d) the rectification measures adopted;
(e) the precautionary measures put in place to avoid future breaches; and
(f) whether the issuer’s business and financial performance could be sustained without reliance on the non-compliant activities.
The Stock Exchange stated in paragraph 13 that in precedent cases, it had requested the listing applicant to demonstrate for a reasonable period (not longer than 12 months) that it would be financially sound and could operate without reliance on the non-compliant activities.
50. Paragraphs 8-9 of Exchange Listing Decision LD19-2011.
51. Paragraph 14 of Exchange Listing Decision LD19-2011.
52. See paragraph 13(d) of Exchange Listing Decision LD43-3, where the Stock Exchange stated that subject to availability and practicability, appropriate regulatory assurance should be obtained from the relevant regulatory authorities in relation to the status of businesses operated on contract-based structures (i.e. variable interest entities).
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.