Chapter 7

Due Diligence Guidelines –

Knowing the Listing Applicant and its Management

2. Due Diligence on Major Business Stakeholders

2.1 Standards

Based on reasonable due diligence, a sponsor should have a sound understanding of … a listing applicant, including its history and background, business and performance, financial condition and prospects, operations and structure, procedures and systems. [Paragraph 17.3(a)(i) of the Code of Conduct]

2.2 Guidance

2.2.1 The Stock Exchange identifies the following scope of disclosure in the listing document with respect to a listing applicant’s history and background in Exchange Guidance Letter GL86-16, Appendix 1, Section D, Paragraph 3.3, which should also serve as guidance for the sponsor’s due diligence effort and to which reference should be made by the sponsor in relation to the listing document:

(a) establishment and development of the listing applicant and its major subsidiaries,

(i) information on founders (i.e. background and relevant industry experience if the information is not disclosed in the “Directors and Senior Management” section of the listing document);

(ii) the listing group’s material developments milestones/ in a tabular form; and

(iii) incorporation and commencement of business of each member of the listing group that made material contribution to the listing group’s track record results;

(b) corporate structure,

(i) an applicant’s corporate structure charts, in legible size, before and after major reorganizations, and upon completion of the share offer;

(ii) the identities and the principal business activities of an applicant and its major subsidiaries/jointly controlled entities;

(iii) by way of notes to the corporate structure chart, the identities of the minority shareholders of each non-wholly owned subsidiary and whether they are independent third parties;

(iv) where there are many subsidiaries, an explanation for the need for a complex group structure;

(v) the material steps of any reorganization (i.e. incorporation, share swap, disposal and acquisition);

(vi) whether relevant regulatory approvals for reorganizations have been obtained and/or the reorganization complies with the relevant laws and regulations, with the support of a legal opinion, if applicable;

(vii) the date of completion of the registration under Circular No. 37 of PRC State Administration of Foreign Exchange, if applicable; and

(viii) reasons for excluding certain companies/businesses from the listing group if they are in the same or an ancillary business;

(c) acquisitions, disposals and mergers,

(i) major acquisitions, disposals and mergers (including the basis and amount of consideration involved, settlement date of the consideration, etc.), the reasons for the disposals and their significance to the applicant;

(ii) whether each of the acquisitions, disposals and mergers has been properly and legally completed and settled, including all applicable regulatory approvals having been obtained; and

(iii) the transferor/transferee’s relationship with the applicant, its shareholders or connected persons or that they are independent third parties;

(d) shareholders,

(i) shareholders’ identities;

(ii) relationship amongst shareholders (e.g. family members, relatives, and parties acting in concert);

(iii) for significant shareholding changes during the track record period, the background of the then shareholders, their relationships with the applicant and its connected persons, reasons for the shareholding transfer, amount, settlement date and basis of consideration involved. The use of tables, charts, diagrams and arrows to ensure clear and concise disclosure is recommended; and

(iv) details of outstanding options, warrants and convertibles;

(e) listing on other exchanges,

(i) reasons for the listing applicant to seek listing on the Stock Exchange;

(ii) listing status (e.g., privatized or if delisted, why and when it was delisted);

(iii) compliance record during an applicant’s listing on other exchanges and whether there is any matter that should be brought to investors’ attention; and

(iv) where the applicant has been privatized, details of the privatization, including the consideration offered to then shareholders, how the privatization was financed, and, if the privatization offer price and the IPO offer price are materially different, reasons for the difference.

2.2.2 The sponsor should thoroughly understand the business model of a listing applicant and its viability, particularly identifying all material business risks which may potentially result in the suspension, discontinuation or termination of its business, before submitting the listing application.30 For guidance on the sponsor’s due diligence on the business model of the listing applicant, please refer to Chapter 8 “Due Diligence Guidelines – Business Model”.

2.2.3 The Stock Exchange identifies the following key focus areas of disclosure in the listing document with respect to a listing applicant’s suppliers, customers and subcontractors in Exchange Guidance Letter GL86-16, Appendix 1, Section E, Paragraph 4.1, which should also serve as guidance for the sponsor’s due diligence effort and to which reference should be made by the sponsor in relation to the listing document:

(a) for suppliers, raw materials and inventory,

(i) background of any material suppliers (e.g. business activities, years of business relationship, whether they are connected persons, credit terms and payment method);

(ii) costs related to an applicant’s five largest suppliers during the track record period;

(iii) detailed terms and conditions of any long-term agreements (e.g. duration, minimum purchase commitment and any penalty for non-compliance with such commitment, price adjustment provision, renewal and termination clauses) and whether they are legally binding. Details of any breaches of these agreements during the track record period;

(iv) major countries where an applicant purchases its raw materials;

(v) concentration risk and counterparty risk, if any;

(vi) sensitivity and breakeven analysis in relation to changes in costs;

(vii) any shortage or delay in the supply of raw materials and measures to manage such shortage (e.g. alternative suppliers with comparable quality and prices and substitutes);

(viii) measures to manage fluctuations of raw materials prices and whether an applicant can pass on the increase in purchase costs to its customers;

(ix) inventory control measures (e.g. purchase on a back-to-back basis upon receipt of orders, level of inventory to be maintained) and provisioning policy; and

(x) legality of the source of supply (e.g. parallel import, fur, wood, diamond);

(b) for customers,

(i) background of any major customers (e.g. business activities, years of business relationship, whether they are connected persons, credit terms and payment method);

(ii) revenue from an applicant’s five largest customers during the track record period;

(iii) detailed terms and conditions of any long-term agreements (e.g. duration, minimum purchase commitment and any penalty for non-compliance with such commitment, price adjustment provision, renewal and termination clauses) and whether they are legally binding. Details of any breaches of these agreements during the track record period;

(iv) whether major customers are also an applicant’s suppliers or vice versa, and if so, the reasons for this arrangement, the percentage of revenue and costs related to them and a breakdown of their gross profit during the track record period;

(v) major countries where an applicant sells its products; and

(vi) concentration risk and counterparty risk, if any;

(c) for subcontractors (only if applicable to the applicant’s business),

(i) reasons for subcontracting and basis of selecting subcontractors. Details of subcontractors, including years of business relationship with an applicant and whether they are independent third parties;

(ii) salient terms of the subcontracting arrangements/agreements (e.g. duration, responsibilities of the subcontracting parties, raw materials procurement policy, compliance with relevant quality requirements, basis of determining the subcontracting fee, terms for renewal and termination clauses).

2.2.4 At the time of submission of the application for listing, a listing applicant must submit to the Stock Exchange the lists of its top five customers and suppliers during the track record period, including details of the amounts of sales/purchases (expressed in dollars and percentages) for each track record period, the products sold/purchased, the length of each customer/supplier’s relationship with the listing group, terms offered (and where different, provide an explanation), settlement information, and profile and background of each customer/supplier including their business, size of operation and location.31

2.2.5 The reliance of a listing applicant on a single major supplier or customer may impact on its suitability for listing.32 If a listing applicant relies heavily on its major customers and suppliers, the listing document should disclose information as required under Exchange Listing Decision LD107-1, e.g. details of the customers and the suppliers, and plans and measures to mitigate the reliance.33 For detailed guidance on conducting due diligence on the degree of reliance of the listing applicant’s business, please refer to section 5 of Chapter 8 “Due Diligence Guidelines – Business Model”.

2.2.6 If a listing applicant’s business involves distributorship, franchising or consignment, please refer to Exchange Guidance Letter GL36-12 for guidance on general disclosure in listing documents.34 For guidance on the sponsor’s due diligence on a business involving distributorship, franchising or consignment, please refer to Chapter 14 “Due Diligence Guidelines – Distributors, Franchisees and Consignees”.

2.2.7 For a listing applicant who conducts business in countries which are subject to trade or economic sanctions, the sponsor should consider the relevant exposure to sanctions risk.35 For guidance on the sponsor’s due diligence on a business in countries which are subject to trade or economic sanctions, please refer to Chapter 15 “Due Diligence Guidelines – Anti-Corruption, Anti-Money Laundering and Sanctions”.

2.2.8 The information relating to a listing applicant’s major customers and suppliers required to be included in a listing document under paragraph 28(1)(b) in Part A of Appendix 1 to the Listing Rules is reproduced in Appendix I.

2.3 Recommended Steps

2.3.1 Other than the customary categories of major business stakeholders of a listing applicant, such as major customers, suppliers and creditors, the Listing Rules do not specifically list the major business stakeholders in respect of which due diligence should be conducted. As such, it is important that the sponsor has a good understanding of the business of a listing applicant, including but not limited to its strengths, strategies and risks, in order to ascertain the major business stakeholders for each listing applicant. The major business stakeholders may vary between listing applicants. In addition to customary considerations, the sponsor should also take into account the following factors when identifying major business stakeholders:

(a) whether the stakeholders are parties to:

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

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

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

(iv) 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);

(b) whether the stakeholders are:

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

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

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

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

The paragraphs below focus on recommended due diligence steps for a non-exhaustive group of major business stakeholders for listing applicants generally. Conducting interviews is a key due diligence step applicable to all major business stakeholders. For guidance on conducting interviews with major business stakeholders, please refer to Chapter 9 “Due Diligence Guidelines – Interviews of Major Business Stakeholders”. For guidance on a sponsor’s due diligence enquiries with respect to distributors, franchisees and consignees, please refer to Chapter 14 “Due Diligence Guidelines – Distributors, Franchisees and Consignees”.

Major customers

2.3.2 In addition to the matters set forth under paragraph 2.2.3 above, when conducting due diligence on the major customers of a listing applicant, the sponsor should:

(a) review the financial statements and related information of a listing applicant, and especially analyse the proportion of the revenue attributable to each major customer of a listing applicant during the track record period;36

(b) assess if the listing applicant’s entering into contracts with any major customers breached relevant regulatory provisions such that any such contract could be rendered illegal or invalid or result in the loss of the listing applicant’s key business licences. In any such case, the sponsor should question whether the listing applicant is suitable for listing at all;37 and

(c) assess the business viability of a listing applicant which generates a substantial portion of its revenue from its connected persons and/or employees during the track record period (especially if such business model is expected to continue after listing).38

Major suppliers

2.3.3 In respect of due diligence in respect of a listing applicant’s major suppliers, the sponsor should review the background of each major supplier of the listing applicant (e.g., business activities, years of business relationship, credit terms and payment method), and identify whether any major supplier is connected with the controlling shareholders and/or directors of the listing applicant, or a business competitor.39

Major creditors, landlords and licensors

2.3.4 The sponsor should conduct due diligence in respect of each of the major creditors, landlords and licensors (to the extent that the listing applicant’s business relies materially on licence arrangements with a licensor regarding trademark, technology, concession and/or know-how) of a listing applicant.

2.3.5 To the extent applicable, the sponsor should:

(a) review the relevant documentation, such as the credit agreement, lease agreement or licence agreement;

(b) assess the legality of the relevant agreement with the assistance of lawyers in the relevant jurisdiction;

(c) identify any claim, dispute, litigation or proceedings between the listing applicant and the relevant major business stakeholder;

(d) conduct interviews with the relevant major business stakeholder; and

(e) identify whether any major business stakeholder is connected with the controlling shareholders and/or directors of the listing applicant.

Key JV partners

2.3.6 The sponsor should identify whether a listing applicant has any key joint venture (“JV”) partners and assess the following aspects in respect of each such JV partner:

(a) the importance of the arrangements with each JV partner: whether it forms an integral part of the listing applicant’s business, or is critical to the business development of the listing applicant;

(b) the background of each JV partner: whether it is connected with the controlling shareholders and/or directors of the listing applicant, or a business competitor;

(c) the consequences for the listing applicant of breach of material terms of the JV contract: whether it would subject the listing applicant to a significant penalty or lead to termination of the JV contract or other related contacts;40 and

(d) whether there was any major dispute or breakdown of the relationship between the listing applicant and the JV partner during the track record period.

2.3.7 In addition, the sponsor should discuss with the management of the listing applicant the relationship with each key JV partner, review the relevant JV contract, material contracts entered into by the JV entity and all other related documents, and assess the transactions performed in connection with the JV contract. The sponsor may consider interviewing the JV partner.

2.3.8 If a listing applicant has entered into a cooperation agreement or agreement of similar nature which is material to the business operations and/or business development of the listing applicant, the sponsor should conduct due diligence similar to that conducted on key JV partners and/or other major business stakeholders described above.41

Sanctions against major business stakeholders

2.3.9 With respect to certain business dealings with major business stakeholders which are subject to a sanction, ban, restriction and/or blockage imposed by the authority of any relevant jurisdiction (e.g., the U.S. Treasury Department’s Office of Foreign Assets Control) or under applicable laws and regulations, there may be legitimate concerns about the legality of such dealings under the laws of the relevant jurisdiction. The sponsor should, to the extent relevant, conduct due diligence on the relevant business dealings and consult with lawyers in the relevant jurisdiction if necessary.

Endnotes

30. For a listing applicant engaged in the restaurant business, Exchange Guidance Letter GL28-12 requires the sponsor to check with the relevant consumer protection organisations regarding any customer complaints or claims against the listing applicant. For a listing applicant engaged in PRC pawn loan business, Exchange Listing Decision LD33-2012 requires disclosures specific to the PRC pawn loan business to be made in the prospectus so that investors would have sufficient information to arrive at an informed investment judgement. For a listing applicant using a number of contract-based structures (or the so-called “variable interest entity” structure) in the conduct of its business in the PRC, Exchange Listing Decision LD43-3 lays out the main areas for the sponsor’s due diligence on these contract-based structures. For a listing applicant whose business model relies significantly on forfeited income from prepaid services and products, Exchange Guidance Letter GL26-12 introduces the key risks involved on which the sponsor’s due diligence should focus. If a listing applicant’s business involves distributorship, franchising or consignment, Exchange Guidance Letter GL36-12 provides guidance to understand the potential risks. For a listing applicant which is a mineral company, Exchange Guidance Letter GL52-13 requires disclosure of all material risks mentioned in the competent person’s report in the risk factors section of the listing document. For listing applicants engaged in gambling activities, Exchange Guidance Letter GL71-14 and Exchange Rejection Letter RL25-09 set out the conditions to be satisfied in order for such applicants to be considered suitable for listing and additional listing document disclosure requirements.

31. See paragraph A (1) of Main Board: IPO – Additional information to be submitted together with the Form A1 (Form M104)

32. Exchange Listing Decision LD107-1.

33. In Exchange Listing Decision LD84-2014, the Stock Exchange found certain prospectuses lacked sufficient disclosure on the risks of reliance on customers and information as required under Exchange Listing Decision LD107-1. In Exchange Listing Decision LD75-2013, a listing applicant’s largest supplier accounted for a majority of purchases, but the Stock Exchange found that there was insufficient disclosure on the relationship with and reliance on such supplier.

34. The Stock Exchange returned certain listing applications because the prospectuses lacked sufficient disclosure on the distributorship business models as required under Exchange Guidance Letter GL36-12. In Exchange Listing Decision LD84-2014, some listing applicants failed to make the required disclosure on their distributorship business models. In Exchange Listing Decision LD91-2015, a listing applicant sold its products through distributors who then resold them to sub-distributors and/or ultimate retailers. However, the application proof did not disclose material information on the distributorship model.

35. See paragraph 21 of the Exchange Listing Decision LD76-2013. In Exchange Listing Decision LD84-2014, a listing applicant sold products to a sanctioned country and there was no disclosure on whether the company or any parties involved in the listing would be subject to sanctions risk. The Stock Exchange returned the listing application.

36. The SFC cited a case in SFC Dual Filing Update of January 2011 that “the listing applicant’s revenue more than doubled in the latest financial period. A significant portion of the revenue growth was attributable to one customer that was not among the top five customers in previous years. Initially, this customer was said to have been the applicant’s customer for six years. However, further enquiries by the regulators revealed that this customer was incorporated only five years ago and it placed its first order with the applicant only about one year ago. The customer, which was initially described as a specialist “solution provider” for the industry, was found to be merely a one-man trading company”.

37. In SFC Dual Filing Update of January 2010, the SFC cited a case where, the listing applicant breached certain regulatory provisions when entering into contracts with its customers which, in the worst case, might render the contracts illegal. The potential result could be the loss of its business licence, the very basis on which the listing was sought.

38. In SFC Dual Filing Update of January 2010, in one case, the SFC raised serious concerns as to whether the listing applicant could carry on its business independently. In that case, a large part of the applicant’s business was substantially derived from its connected persons and employees, although the proportion decreased from over 90% to 40% of its profit during the track record period. The reliance on these connected clients was expected to continue after listing. The applicant’s ability to obtain third party funding for its business also depended on its ability to generate a sufficient level of revenue, which in turn was substantially derived from the transactions with the connected clients.

39. In SFC Dual Filing Update of August 2011, the SFC noted a case where “the key raw material of the listing applicant was originally supplied at cost by a single supplier that was originally owned by a related party. Shortly before submission of the listing application, the supplier was disposed of to an independent third party, which led to a change in the pricing mechanism of the raw material sold to the applicant. The initial draft listing document only disclosed in general terms that the price of the raw material would be changed to third-party price subject to discounts to be provided after negotiations. The draft listing document failed to properly explain the impact of the change in pricing mechanism on the applicant’s cost structure going forward until additional disclosure was made at the request of the regulators”.

40. In SFC Dual Filing Update of July 2010, the SFC was critical of a case where the initial draft prospectus omitted material information on the listing applicant’s financial obligations under a project with a joint venture partner, which amounted to more than two times the applicant’s net assets.

41. In SFC Dual Filing Update of August 2011, the SFC referred to a case where the listing applicant was one of the 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 co-operation agreement that was due to expire soon after the expected listing date. Shortly before the end of the track record period, the telecommunications operator initiated a substantial reduction in the percentage of fees shared by the applicant because the telecommunications operator was said to have decided to take a more active role in the provision of that service. Despite repeated enquiries by the regulators, the sponsors failed to provide sufficient facts to demonstrate that the co-operation agreement would likely be renewed on similar or reasonable terms or, if the agreement were not renewed, the applicant would still be able to continue its business without an operating platform.