Chapter 8

Due Diligence Guidelines –

Business Model

5. Reliance

5.1 Guidance

5.1.1 The sponsor should conduct due diligence on the listing applicant’s ability to operate as a going concern independent of its controlling shareholder(s) and/or connected persons. The degree of reliance should be viewed in light of:

(a) transactions with connected persons, including financial (e.g., loans and guarantees) and other forms of support (e.g., personnel, technology, administrative assistance, centralised and procurement purchasing/sales marketing network); and

(b) the revenue or profits attributable to transactions with connected persons.27

5.1.2 Transactions with connected persons do not necessarily mean the listing applicant’s business is overly reliant on the connected persons. To evaluate the degree and implications of reliance, the sponsor should focus on the reasons and justification for such transactions, such as:

(a) whether such transactions are of a nature that is typical or common in the relevant industry (e.g., they are necessitated by industry regulation); and

(b) whether the transactions are conducted on commercial terms that are comparable to those obtainable from independent third parties.

5.1.3 The sponsor should also ascertain the listing applicant’s degree of reliance on any third party stakeholders, such as major suppliers and customers.

5.1.4 The sponsor should bear in mind that in some cases, over-reliance on a parent28 or third party stakeholder29 may give rise to concerns about suitability for listing.

5.2 Recommended Steps

5.2.1 Reliance on connected persons for financial, administrative or operational support:

If the sponsor determines that the listing applicant is reliant on its controlling shareholder or other connected parties in respect of paragraph 5.1.1(a) above, follow-up due diligence should be conducted. Key considerations include:

(a) whether, in substance, the listing applicant is seeking to list a part as opposed to the whole of an integrated operation;30 and

(b) where the reliance arises from a centralised function being performed by the connected person:

(i) whether the centralised function can be easily replicated by the listing applicant;31

(ii) whether the reliance was due to a separation of functions between the listing applicant and its connected persons and whether such separation is commercially advantageous to the listing applicant;32

(iii) to what extent the function performed by the connected persons is crucial for the listing applicant’s operations33 and whether the functions can be performed by independent third parties;

(iv) whether the connected person is a stable provider of the relevant function;34

(v) whether the function is performed to a high quality and is provided on fair and reasonable terms with respect to prevailing market rates;35

(vi) whether there are any protections (e.g., indemnities) for the listing applicant against losses flowing from unexpected disruptions in the performance of the function;36 and

(vii) in appropriate cases, whether there are any transfer pricing issues arising from the function, and whether there are any enquiries from, or actions taken by, tax authorities on any historical transfer pricing practices.

5.2.2 The following steps are recommended to ascertain the listing applicant’s reliance on any third party stakeholders:

(a) Relevant parties – a decision should be made, with participation of the listing applicant’s management, to draw up a list of persons relevant for this exercise, which may include major suppliers and customers, and joint venture partners. For guidance on conducting interviews of the listing applicant’s major business stakeholders, see Chapter 9 “Due Diligence Guidelines – Interviews of Major Business Stakeholders”;

(b) Materiality – the Hong Kong regulators have not specified any standards for determining materiality in the context of due diligence issues; the sponsor should determine materiality of the major stakeholders based on a number of factors including:

(i) whether the stakeholders are parties to:

(A) high value transactions, individually or cumulatively, with the listing applicant, its subsidiaries or associates;

(B) transactions, individually or cumulatively, that are material to the listing applicant’s business;

(C) long term contracts that are material to the listing applicant’s business; or

(D) transactions with unusual or special characteristics (e.g., one-off transactions, transactions whose terms are unique to a particular stakeholder or not consistent with established market practice, transactions with parties in OFAC countries and transactions which are not adequately documented); or

(ii) whether the stakeholders are:

(A) entities with special or unusual characteristics (e.g., by virtue of geographical coverage / concentration);

(B) major customers / suppliers which have not maintained consistent transaction volumes or business relationships throughout the track record period; or

(C) entities that are not independent of the listing applicant, its major shareholders and management; and

(iii) whether the transactions or relations with the stakeholders may materially and adversely impact the business and results of operations of the listing applicant; and

(c) Look-back period – the Hong Kong regulators have not specified any standards for determining how far back in time the sponsor should look for the purpose of third party stakeholder due diligence; in practice the sponsor would typically cover the trading record period and continue the relevant due diligence exercise up to the time of listing; where exceptional circumstances exist (e.g., to establish a strong case for a long-term relationship with the party involved), the sponsor may designate a longer look-back period for this purpose.

5.2.3 Reliance on connected persons or third parties for profit and revenue:

If the sponsor determines that the listing applicant is reliant on its controlling shareholder or other connected parties in respect of paragraph 5.1.1(b), or that the listing applicant is reliant on a small circle of third party stakeholders under paragraph 5.1.3, follow-up due diligence should be conducted to facilitate disclosure of the relevant facts and to ascertain the applicant’s ability to lessen the adverse impact of such reliance. The key considerations may include:

(a) whether the listing applicant has made efforts to reduce reliance;37

(b) whether the business model can be easily changed to reduce the level of reliance (e.g., whether the industry landscape is dominated by a few players and whether the listing applicant can find substitute suppliers or customers, whether it has the necessary skill, technology and network to break off the reliance);38

(c) whether the reliance is likely to increase or decrease in future;39

(d) whether the reliance is mutual and complementary;40

(e) whether the listing applicant is capable of maintaining its revenue in light of the reliance (including the overall prospects of the industry and whether it is showing a downward trend);41 and

(f) whether the reliance is caused by the regulatory environment and meets with regulatory or government support or approval.42

5.2.4 Please see also Chapter 10 “Due Diligence Guidelines – Controlling Shareholders’ Relationship with the Listing Applicant” and Chapter 11 “Due Diligence Guidelines – Connected Persons and Connected Transactions”.

Endnotes

27. See SFC Dual Filing Update of January 2010 in which the SFC questioned whether an applicant could carry on its business independently, where a large part of its business was substantially derived from its connected persons and employees, and its ability to obtain third party funding also depended on its ability to generate a sufficient level of revenue which in turn was substantially derived from such transactions. Please see also Exchange Listing Decision LD92-1 where a listing applicant was found unsuitable for listing where a significant portion of its turnover and net profit were derived from transactions with directors and employees; it had no track record of carrying on its business independently; it was doubtful if the applicant could obtain financing otherwise than on the basis of revenues generated from connected transactions; and the reliance was expected to continue after listing.

28. See Exchange Listing Decision LD30-2012 where the Stock Exchange was concerned about a company’s suitability for listing given that, among other things, the company had significant reliance on its parent, which the company must take concrete steps to address before the Stock Exchange would consider any further review of the listing application.

29. See SFC Dual Filing Update of August 2011 where the SFC cited a case where the listing applicant was one of many value-added service providers of a major telecommunications operator. The applicant’s business relied solely on the mobile platform operated by the telecommunications operator under a cooperation agreement that was due to expire soon after the expected listing date. The listing applicant was unable to demonstrate that the cooperation agreement would be renewed on similar or reasonable terms, or that the listing applicant would still be able to continue its business after the termination of such agreement. The listing application was allowed to lapse. Contrast this with Exchange Listing Decision LD107-1 where a company with heavy reliance on a major customer initially raised listing suitability concerns which were later determined to be capable of being dealt with by disclosure.

30. See Exchange Listing Decision LD46-1 where the Stock Exchange ruled that reliance on the parent group could not be sufficiently addressed by disclosure alone.

31. In Exchange Listing Decision LD46-1, the Stock Exchange found that certain centralised procurement and sales functions could not be easily replicated if the connected person discontinues the provision of such functions because (i) the service volume was large in size and the listing applicant’s experience in these functions were not based on contractual arrangements but on the goodwill between the listing applicant and its parent; and (ii) the injection of the functions into, or the independent development of such functions by, the listing applicant might require new licences and government approvals.

32. Exchange Listing Decision LD51-1.

33. Exchange Listing Decision LD51-1.

34. Exchange Listing Decision LD51-1.

35. Exchange Listing Decision LD51-1.

36. Exchange Listing Decision LD51-1.

37. Exchange Listing Decision LD107-1.

38. Exchange Listing Decision LD107-1.

39. Exchange Listing Decision LD107-1.

40. Exchange Listing Decision LD107-1.

41. Exchange Listing Decision LD107-1.

42. See Exchange Listing Decision LD46-2 where the listing applicant was engaged in advertising business and was reliant on the parent for editorial content for the relevant publications. The applicant’s principal business was sale of advertising space and printing production of several publication materials owned by the parent on an exclusive basis pursuant to an advertising agreement between the applicant and the parent. The Stock Exchange found the extent of reliance acceptable based on the following facts: (i) the media industry in the PRC was highly regulated; (ii) the applicant’s reorganisation from the parent was on a “separation of business model” which was the only viable model under the regulatory environment; and (iii) the business model was supported and approved by the government.