Due Diligence Guidelines –
2. The EDD Process
2.1.1 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]
2.1.2 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]
2.1.3 Before submitting an application on behalf of a listing applicant to the Stock Exchange, a sponsor should come to a reasonable opinion that: … the listing applicant has established procedures, systems and controls … which enable the listing applicant and its directors to comply with the Listing Rules and other relevant legal and regulatory requirements on an ongoing basis; [Paragraph 17.4(c)(ii) of the Code of Conduct]
2.1.4 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; and [Paragraph 17.6(d)(vii) of the Code of Conduct]
2.1.5 A sponsor should: … (ii) conduct inspection of key physical assets including where appropriate production facilities … [and] (iv) in relation to material matters, review relevant underlying records and supporting documents of the listing applicant. [Paragraph 17.6(e)(ii) and (iv) of the Code of Conduct]
2.2.1 Environmental factors can impact a listing applicant in a variety of ways. Environmental law and regulation can condition and constrain the listing applicant’s current and future activities. They can have major cost implications for the listing applicant, such as:
(a) capital and operating costs connected with complying with laws and industry standards, including the cost of bringing facilities, processes and practices up to requisite standards;
(b) penalties and third party claims arising from non-compliance;
(c) adverse economic consequences flowing from suspension or termination of operations because of the intervention of regulators or due to accidents; and
(d) the cost of site and plant remediation.
2.2.2 Even where there is no breach of law or legal constraint on a listing applicant’s activities, environmental factors may have less readily ascertainable, but significant effects on it and its business. For example, adverse market and social sentiment may negatively affect its business and reputation where the listing applicant’s products or production processes are perceived to be environmentally damaging or become the subject of negative publicity. Environmental factors may create an uneven playing field. For example, one company that needs to acquire carbon credits may have higher operating costs than a competitor engaged in the same line of business that does not need to purchase them. Some banks’ internal lending guidelines prohibit lending to companies involved in activities that are regarded as environmentally unfriendly, which may restrict a listing applicant’s ability to fund its business through borrowing.
2.2.3 Environmental issues may flow directly from the nature of the listing applicant’s business or the way in which it conducts its business. However, a listing applicant may have unforeseen exposures that are unrelated to its current activities, such as because of its ownership or occupation of contaminated land or that arise from discontinued activities.
Therefore, EDD should be tailored to address the specific circumstances of the listing applicant.
2.3 Recommended Steps
2.3.1 The EDD process should generally comprise the following key stages:
(a) understanding the listing applicant’s current and proposed activities;
(b) checking legal and regulatory compliance;
(c) identifying environmental risks;
(d) carrying out due diligence; and
(e) reviewing the results and considering rectification and disclosure.
2.3.2 Understanding the listing applicant’s current and proposed activities
The sponsor should form an understanding of the listing applicant’s current and proposed activities to enable it to assess whether environmental issues are significant for it. Appendix I provides guidance and source materials relating to this initial screening process.
If the listing applicant carries out a number of activities, each should be assessed and an overall assessment of environmental risk can be made by considering the scale of each activity relative to the size of the overall business.
While a listing applicant with some involvement in activities included on the EBRD’s Exclusion List and Referral List, or the IFC’s Exclusion List, may, nonetheless, be considered suitable for listing, the sponsor is likely to take special care to ensure that it has fully identified, understood and assessed the impact of the environmental risks associated with the listing applicant.
2.3.3 Checking legal and regulatory compliance
(a) Understanding the legal and regulatory framework
To help identify those aspects of the listing applicant’s activities that may be subject to environmental regulation, the applicable legal and regulatory framework to which the listing applicant is subject should be established in collaboration with the listing applicant’s management, its lawyers and any other environmental advisers. The framework will include national, regional and local laws and regulations, international standards and best practice guidelines, both current and anticipated changes that may affect the listing applicant’s business in the future.
The review of the legal framework should seek to identify:
(i) those environmental permits that the listing applicant requires for its current and proposed activities, such as permits for water use, wastewater discharge, air emissions and storage and disposal of hazardous substances;
(ii) the listing applicant’s ongoing compliance obligations, such as regarding materials storage, emergency procedures and plans and monitoring and reporting;
(iii) any legal restrictions to which the listing applicant is or may be subject that may condition or constrain its activities or development, or necessitate significant expenditure. For example, whether the listing applicant will need additional permits or authorisations, or has sufficient headroom under existing permits (or generally under applicable law) to continue or develop its activities in the way it contemplates; and
(iv) the identity of the appropriate regulatory bodies that supervise the listing applicant to ensure that the listing applicant has been interacting with the correct regulators.
While a listing applicant’s processes and products may satisfy local environmental laws, they may not meet required standards in the listing applicant’s international markets, and therefore the sponsor may want the legal and regulatory analysis to extend beyond domestic compliance if there are grounds to think this may be a material concern.
(b) Checking legal compliance
The sponsor, in discussion with the listing applicant, local lawyers and other relevant parties, should seek to identify those authorisations and permits that are material to the listing applicant and its business. The sponsor should then take reasonable steps to confirm that they are in place with the conditions to their grant having been duly satisfied and, to the extent practical, that the listing applicant is in compliance with them, and assess the implications for the listing applicant and its business if that is not the case. It may be appropriate to look at the listing applicant’s historical compliance record if having previously operated without the necessary authorisations and permits, or having operated in breach of them, could still have material adverse consequences for the listing applicant or its business (such as significant fines or the forced closure of a plant).
The existence of an apparently valid permit does not mean that a business is operating legally – for example if emissions to air and water exceed the permitted limits. However, while a sponsor should be mindful of this, in most cases it will be unrealistic to obtain independent verification of compliance. Therefore, a sponsor may not be able to go beyond checking whether relevant regulatory authorities have notified the listing applicant of a breach. However, if there are grounds to believe there has been non-compliance that has given or could give rise to material adverse consequences, expert assistance may be required.
Certain activities, or major developments or the expansion or modification of existing facilities, may require the listing applicant to have carried out an environmental impact assessment and to have obtained relevant approvals before commencement. In such cases, the legal review should seek to establish that the environmental impact assessment has been carried out in compliance with the law, that the approvals have been granted and that the listing applicant has complied with all conditions to which the approvals are subject.
Sponsors are discouraged from relying purely on confirmations from management, and it may be possible to check compliance by contacting regulatory authorities to establish whether they believe the listing applicant’s activities are in compliance.
For further guidance on legal and regulatory compliance due diligence, see Chapter 17 “Due Diligence Guidelines – Legal and Regulatory Compliance and Legal Proceedings and Disputes”.
2.3.4 Identifying environmental risks
With an understanding of the listing applicant’s activities and the applicable legal and regulatory regime, the sponsor can develop an understanding of where environmental issues may arise from the listing applicant’s activities, the associated risks, their actual and potential consequences on the listing applicant, and how the listing applicant manages those risks. In scoping the due diligence, the areas of environmental risk for examination and discussion may include:
(a) the current use of the site and facilities, and any previous uses that may have caused contamination;
(b) any identifiable or known contamination of the site from current or previous uses, or from the activities carried out on the site;
(c) the underlying geology and hydrology of the site, the location of nearby water courses and recipients of run off from the site;
(d) the adequacy and condition of plant, storage facilities and conduits, including pipes, especially underground facilities and conduits;
(e) the sources of water, the adequacy of supply and water use;
(f) methods of collection, storage and treatment of waste waters on site and arrangements for the disposal of effluent and waste water;
(g) the main solid, liquid and gaseous raw and intermediate materials stored on site, particularly those of a hazardous nature and the arrangements for handling and storage of them;
(h) the nature and quantities of waste, waste storage facilities and arrangements for waste disposal;
(i) sources, volumes, and composition of emissions to air, whether from chimneys, vents and exhausts, and occasional sources, such as dust from vehicles;
(j) workplace environment, including noise, dust, fumes and odours;
(k) sources and effect of noise and vibration;
(l) ecology and nature conservation (habitats and species);
(m) contamination or destruction of land and plant; and
(n) changes to existing landscapes or negative changes to cultural heritage.
2.3.5 Engagement with the listing applicant’s management
The sponsor should engage with the listing applicant’s management, including its technical staff charged with management of environmental issues, to develop an understanding of the listing applicant’s ability to identify and manage environmental risks and comply with applicable laws and regulations, in particular:
(a) whether the management are fully familiar with, and understand the legal and regulatory framework within which the listing applicant has operated, currently operates, and is expecting to operate;
(b) whether the management have a clear appreciation of the environmental risks that flow from the listing applicant’s activities, where those risks arise (whether directly from the listing applicant’s activities or indirectly, for example from those of its suppliers or contractors) and how they affect, or could affect, the listing applicant’s activities;
(c) whether the management believe the listing applicant’s activities have complied, comply and are expected to continue to comply with all legal and regulatory requirements;
(d) whether the listing applicant has all statutory records, permits and authorisations; and
(e) the extent of the listing applicant’s non-compliance with legal and regulatory requirements, and consequences flowing from such non-compliance.
Discussion of the following areas will also help in developing that understanding:
(a) the listing applicant’s environmental policy;
(b) the listing applicant’s environmental management systems and practices;
(c) the level of awareness of and expertise in environmental matters, both technical and regulatory, among staff and management, particularly the team charged with managing environmental matters, and the level and quality of staff training;
(d) the listing applicant’s internal arrangements for identifying and managing environmental risks, including its monitoring and reporting procedures;
(e) the types of environmental data collected and reported (whether for internal or regulatory purposes);
(f) the existence and quality of the listing applicant’s environmental and accident prevention practices, procedures, plans and manuals;
(g) the listing applicant’s history of environmental problems, including regulatory breaches and complaints from or to neighbours, how they have been dealt with and the consequences flowing from such problems (such as remedial actions, fines and associated costs);
(h) the quality of the listing applicant’s written records of environmental problems;
(i) the identity of the listing applicant’s environmental regulators, the extent of interaction with those regulators and the state of the relationship with them; and
(j) the annual cost of compliance with applicable rules and regulations and the expected cost of compliance going forward.
The outcome of the discussion should be tied back to the outcome of the legal due diligence to ensure consistency, with any discrepancies being further examined.
2.3.6 Review of documentation
To assist with developing its understanding of the listing applicant’s environmental track record and its ability to manage environmental risk, the sponsor should undertake, or arrange to have undertaken, a review of relevant documentation. Documentation might include:
(a) permits and authorisations;
(b) environmental reports;
(c) environmental impact assessments;
(d) correspondence with regulatory authorities regarding compliance, non-compliance, required improvements, fines;
(e) environmental and management action plans; and
(f) environmental monitoring and audit programmes, and accident prevention practices, procedures, plans and manuals.
2.3.7 Site visit
The sponsor should ascertain what activities are undertaken at each of the listing applicant’s sites with a view to identifying where environmental hazards may exist and how they are managed. The sponsor’s site visit plan should include sites where material environmental risks exist or may exist. Ideally, the site visit would be undertaken with the listing applicant’s environmental management team (if there is one) or management personnel who are familiar with its environmental background and processes.
For further guidance on inspecting production facilities and key physical assets, see Chapter 21 “Due Diligence Guidelines – Inspection of Assets and Property Valuers’ Reports”.
Much of what the sponsor will be looking for is likely to be a matter of common sense – are there obvious signs of contamination or discolouration of drainage channels, are storage facilities in good condition and do they look well maintained, are there signs of escaping dust or gases, strong odours or excessive noise, are fire extinguishers and other emergency equipment located at appropriate places, do employees use protective equipment? However, where the listing applicant’s activities have an inherently higher environmental risk, a more thorough examination and discussion of a site may be appropriate.
The impact of the listing applicant’s operations on its neighbours and neighbouring environments may be relevant, although normally a sponsor would only be expected to consider this if the listing applicant’s business had an inherently higher environmental risk. Therefore in a site visit it may be appropriate to consider adjacent properties and land use, particularly residential developments, schools, hospitals, parks, conservation and protected areas and water courses.
Many listing applicants may not have material exposure to environmental risks through their activities. They may, however, have residual exposure where they own or occupy land that is already contaminated, or they have sold contaminated land subject to warranties or indemnities relating to its condition.
Resources available to help plan a site visit are available on the EBRD website and include a site visit guidance note, a detailed site visit checklist and sub-sectoral environmental and social guidances.
2.3.8 Discussions with regulators
In cases where there is a relatively high level of environmental risk, or where there are concerns about material non-compliance by the listing applicant, the competence of its management or the quality of management’s disclosure, the sponsor may consider discussing the listing applicant’s past and current environmental compliance track record with the listing applicant’s principal environmental regulators and inspectors.
In jurisdictions where there is a concern that the local regulators may be subject to local factors that may impair their impartiality, it may be appropriate to check compliance with regulators at a level higher.
The sponsor should also consider engaging with regulators if there are prospective changes to environmental regulations that might have a significant impact on the listing applicant’s activities.
However, it is acknowledged that regulators are under no compulsion to respond to sponsors’ enquiries and any failure to do so on the part of a regulator does not mean that the sponsor has failed to perform adequate due diligence with respect to the listing applicant’s environmental compliance. Where there is uncertainty as to the listing applicant’s environmental compliance and the regulator does not clarify the situation, the sponsor should seek advice from a suitably qualified third party such as an environmental consultant or lawyer as to the listing applicant’s compliance and the potential impact of any non-compliance.
2.3.9 Commissioning an expert environmental report
In cases where the sponsor believes there is a high risk of environmental issues impacting the listing applicant and its activities, financial condition and prospects, consideration should be given to commissioning an expert environmental report to review the listing applicant’s activities generally or those aspects of its activities that give rise to concern.
Where an environmental report is commissioned, the sponsor should also discuss the inclusion of the report in the listing document with the proposed author of the report prior to its engagement.
An environmental report which is included in a listing document with its author’s consent, and any other part of a listing document which is an extract from an environmental consultant’s report, opinion or statement where the consultant has consented to the inclusion of such extract in the listing document (“Extracted Information”), will be an expert report for the purposes of Paragraph 17 of the Code of Conduct. The sponsor should therefore perform the procedures set out in Paragraph 17.7 of the Code of Conduct with respect to the environmental consultant, the environmental report and any Extracted Information (including being satisfied with the consultant’s competence, qualification, experience and independence and its scope of work). After performing those procedures to the standard of a sponsor which is not itself an expert in environmental matters, the sponsor should have no reasonable grounds to believe and should not believe, that the information in the environmental report or any Extracted Information is untrue, misleading or contains any material omissions. See the guidance on the due diligence the sponsor should conduct in respect of experts and expert reports in Chapter 18 “Due Diligence Guidelines – Interaction with Third Parties including Expert Advisers”.
Where an environmental consultant is not the author of an expert report for the purposes of Paragraph 17.7 of the Code of Conduct, but the listing document includes information which is derived from statements made by an environmental consultant which is within its professional competence, the sponsor should treat the environmental consultant as a non-expert third party for the purposes of Paragraph 17 of the Code of Conduct and should perform the procedures set out in Paragraph 17.6(g) in relation to the environmental consultant and its work. After performing those procedures, the sponsor should have reasonable grounds to believe and should believe that the information included in the listing document which is derived from statements made by the environmental consultant is true, accurate and complete in all material respects and not misleading or deceptive in any material respect. See the guidance on the due diligence the sponsor should conduct in respect of non-expert third parties and their work in Chapter 18 “Due Diligence Guidelines – Interaction with Third Parties including Expert Advisers”.
2.3.10 Identifying indirect and cumulative environmental risks
EDD may also include consideration of indirect and cumulative environmental factors where these might have a significant impact on the listing applicant. Indirect environmental factors might include the environmental compliance status of suppliers, contractors and customers, the sources of principal raw materials and the acceptability of the listing applicant’s products in its markets. Cumulative environmental factors are those which result from the incremental impact of past, present or foreseeable environmental factors, whether from individual or multiple sources. For example, the redevelopment of land often consists of individual projects with no adverse consequence when viewed in isolation, but the cumulative effect of numerous separate redevelopment projects within one area may negatively impact on the area’s environment and ecosystem.
2.3.11 Sources of due diligence
In addition to reviewing due diligence responses and documents provided by a listing applicant, the following sources may also be considered:
(a) public searches and news checks;
(b) publications and media articles;
(c) third party enquiries – such as from commercial information providers, professional societies, NGOs, trade bodies or even through specific enquiries of local NGOs, customers, suppliers, business partners, sub-contractors or of other industry participants depending on the industry and potential risk involved; and
(d) site visit by sponsor or environmental consultants (where necessary).
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.