Due Diligence Guidelines –
2.1 Due Diligence Standards
2.1.1 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 is in compliance with all relevant listing qualifications under Chapter 8 of the Listing Rules (except to the extent that waivers from compliance with those requirements have been applied for to the Stock Exchange in writing). [Paragraph 17.4(c)(i) of the Code of Conduct]
2.1.2 Listing Rule 9.03(3) stipulates that an Application Proof must be substantially complete except in relation to information that by its nature can only be finalised and incorporated at a later date.
2.1.3 A sponsor should take reasonable due diligence steps in respect of a listing application; before submitting a listing application a sponsor should complete all reasonable due diligence on a listing applicant except in relation to matters that by their nature can only be dealt with at a later date. [Paragraph 17.2(b) of the Code of Conduct]
2.1.4 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]
2.1.5 Regarding the preparation of a listing document, a sponsor should examine and consider the accuracy and reliability of the financial information, including reviewing the financial statements of major subsidiaries, internal financial records, tax certificates, regulatory filings and public records. [Paragraph 17.6(d)(v) of the Code of Conduct]
2.1.6 Regarding the preparation of a listing document, a sponsor should assess the business performance, financial condition, development, prospects and any financial projection or profit forecast. [Paragraph 17.6(d)(vi) of the Code of Conduct]
2.1.7 Regarding the preparation of a listing document, a sponsor should assess whether there has been any material change since the date of the last audited balance sheet, including any matter that might impact upon the listing applicant’s business model, performance, prospects or financial condition. [Code of Conduct Paragraph 17.6(d)(viii)]
2.1.8 As a reporting accountant performs audit procedures on information received from a listing applicant under applicable professional standards, a sponsor is not expected to carry out any further due diligence on this information. [Note 1 of Paragraph 17.7(b) of the Code of Conduct]
2.1.9 Nevertheless if a sponsor is aware of any matters which raise concerns relating to the information underlying the accountants’ report, the sponsor should conduct further enquiries necessary to satisfy itself that these concerns are addressed; these enquiries may involve obtaining relevant supporting information and documents. [Note 1 of Paragraph 17.7(b) of the Code of Conduct]
2.2.1 The requirement for reasonable due diligence by sponsors should be read in conjunction with Listing Rules 3A.111 , 3A.122, 3A.13 and paragraphs 12(b)3, 13 (a)-(d)4, 14(b)5, 156 in Practice Note 21 to the Listing Rules.
2.3 Liability Standards: Expert Content and Generally
2.3.1 The Companies Ordinance provides for civil and criminal liability for misstatements in a listing document which is a prospectus.
2.3.2 At the time of publishing this guidance, proposals to clarify liability of sponsors for prospectuses await definitive clarification/finalisation.
2.3.3 Paragraph 17.5(a) of the Code of Conduct stipulates that at the time of the issue of a listing document, a sponsor, after reasonable due diligence, should have reasonable grounds to believe and should believe that the listing document contains sufficient particulars and information to enable a reasonable person to form as a result thereof a valid and justifiable opinion of the shares and the financial condition and profitability of the listing applicant.
2.3.4 Paragraph 17.5(b) of the Code of Conduct stipulates that at the time of issue of a listing document, a sponsor, after reasonable due diligence, should have reasonable grounds to believe and should believe that (i) the information in the non-expert sections of the listing document is true, accurate and complete in all material respects and not misleading or deceptive in any material respect; and (ii) there are no matters or facts the omission of which would make any information in the non-expert sections of a listing document or any other part of the listing document misleading in a material respect.
2.3.5 Paragraph 17.5(c) of the Code of Conduct stipulates that at the time of issue of a listing document, a sponsor, as a non-expert, after performing the relevant due diligence stipulated in the Code of Conduct, should have no reasonable grounds to believe and should not believe that the information in the expert reports is untrue, misleading or contains any material omissions. See further Chapter 18 “Due Diligence Guidelines – Interaction with Third Parties including Expert Advisers”.
2.3.6 Listing Rule 3A.13 sets out the requirement for sponsors to submit a declaration in the form of Appendix 19 to the Listing Rules.
2.3.7 In this declaration, a sponsor is required to confirm, among other things, that the sponsor, having made reasonable due diligence inquiries, has reasonable grounds to believe and does believe that:
(a) the company is in compliance with the conditions for listing in Chapter 8 of the Listing Rules;
(b) the information in the non-expert sections of the listing document (i) contains all the information required by relevant legislation and rules; (ii) is true, accurate, and complete in all material respects and not misleading or deceptive in any material respect or, to the extent it consists of opinions or forward looking statements by the listing applicant’s directors or any other person, such opinions or forward looking statements have been made after due and careful consideration and on bases and assumptions that are fair and reasonable; and (iii) does not omit any matters or facts the omission of which would make any information in the non-expert sections of a listing document or any other part of the listing document misleading in a material respect;
(c) there are no other material issues bearing on the listing applicant’s application for the listing of and permission to deal in its securities, which in the sponsor’s opinion, should be disclosed to the Exchange;
(d) in relation to each expert section in the listing document, having made reasonable due diligence inquiries, the sponsor has reasonable grounds to believe and does believe (to the standard reasonably expected of a sponsor which is not itself expert in the matters dealt with in the relevant expert section) that:
(i) where the expert does not conduct its own verification of any material factual information on which the expert is relying for the purposes of any part of the expert section, such factual information is true in all material respects and does not omit any material information;
(ii) all material bases and assumptions on which the expert sections of the listing document are founded are fair, reasonable and complete;
(iii) the expert is appropriately qualified, experienced and sufficiently resourced to give the relevant opinion;
(iv) the expert’s scope of work is appropriate to the opinion given and the opinion required to be given in the circumstances (where the scope of work is not set by a relevant professional body);
(v) the expert is independent from the Company and its directors and controlling shareholder(s); and
(vi) the listing document fairly represents the views of the expert and contains a fair copy of or extract from the expert’s report; and
(e) in relation to the information in the expert reports, the sponsor, as a non-expert, after performing reasonable due diligence inquiries, has no reasonable grounds to believe and does not believe that the information in the expert reports is untrue, misleading or contains any material omissions.
2.4 Summary of Processes Key to this Chapter
2.4.1 Financial due diligence is a process driven exercise.
2.4.2 Within the scope and for the purposes of this chapter, it normally encompasses the following component processes:
(a) Enquiries to obtain materials and input for preliminary financial review:
(i) Information request list(s);
(ii) Preliminary (desk top) review (including underlying financial statements of group entities); and
(iii) Review of the listing applicant against peers and competitors.
(b) Management presentation(s) (to provide core information on business and finances, and responsive to the sponsor’s preliminary questionnaire).
(c) Settling core financial content of the listing document.
(d) Detailed “line-item” discussions with the listing applicant’s management to elucidate the listing applicant’s financial position and performance, and to ascertain the information relevant to preparation of the Management Discussion & Analysis (“MD&A”) commonly contained within a section of the listing document captioned “Financial Information”.
(e) Evaluation of the listing applicant’s accounting policies and subjective aspects of the application of those policies.
(f) Review and discussion of any unaudited interim financial statements to be included in the listing document, and general evaluation of unaudited financial content.
(g) Focused discussion and evaluation of the period (commonly known as the “change period”) subsequent to the latest audited balance sheet date.
(h) Detailed review of the listing applicant’s forecasts and projections.
(i) Accountants’ interview(s) and deliverables (see below “Interaction with the Reporting Accountant”).
(j) Tax due diligence.
(k) Bring-down procedures.
2.4.3 The process is subject to overriding considerations arising in any case where a “red flag” appears (see section 12 “Red Flags and Similar Irregularities” below).
2.5 Interaction with Accountants
2.5.1 The sponsor is not an accounting firm and, as a result:
(a) The sponsor is not an expert in accounting matters for purposes of prospectus laws or in terms of its due diligence exercise; and
(b) The sponsor does not participate in the audit.
2.5.2 Moreover, the accounting firm (the “Reporting Accountant”) which serves as auditor or reporting accountant has much greater access to financial and accounting information, and will have significantly more and closer knowledge of the listing applicant’s accounting systems, policies and financial affairs generally.
2.5.3 As a result, effective interaction with the Reporting Accountant is generally regarded as key to good due diligence. However, this is dependent upon the Reporting Accountant’s preparedness to embrace the process consistent with prevailing industry practices and terms of engagement.
2.5.4 In practice, the Reporting Accountant’s interaction with the sponsor will normally be governed by a detailed professional reporting standard, usually Hong Kong Standard on Investment Circular Reporting Engagements 400 “Comfort Letters and Due Diligence Meetings” issued by the Hong Kong Institute of Certified Public Accountants (and related Technical Bulletin – AATB 3).
2.5.5 Beyond preparation of the Reporting Accountants’ report(s) on historical and any substantive pro forma financial statements, the primary areas of input from the Reporting Accountant would normally comprise:
(a) Discussing core financial content of the listing document (see further below section 3.5 “Financial Content of the Listing Document – Guidance on Core Historical Financial Content, and Recommended Steps”);
(b) Participation at drafting meetings including MD&A drafting sessions (see further below section 5 “Detailed Financial Review Process”);
(c) Discursive interview(s) and oral due diligence (see further below sections 7 “Accounting Review Process” and 8 “Audit Review Process”);
(d) Discussing and agreeing procedures for providing “comfort” on the listing applicant’s financial condition and performance in the “change period” subsequent to the date to which the latest audited financial statements are prepared (see further below section 11 “Changes Subsequent to the Latest Balance Sheet Date”);
(e) Providing “circle-up” comfort (which refers to the copy pages annexed showing the “circled” data which has been checked by the Reporting Accountant) on identified financial data included in the body of the listing document (see further below section 10 “Unaudited Financial Content”);
(f) Providing certain key advance deliverables at the time of (and in connection with) the filing of the Application Proof and Form A1, most importantly comprising:
(i) a confirmation from the Reporting Accountant (in the form set out in the Appendix to Exchange Guidance Letter GL58-13) that no significant adjustment is expected to be made to the Reporting Accountant’s draft report or reports in the Application Proof;
(ii) draft(s) of the proposed primary comfort letter(s) (in the form in which they are anticipated to be delivered in due and normal course and at the appropriate time(s) when (and assuming that) the transaction proceeds) together with “circle-up” pages indicating the data in the Application Proof which has been checked according to the exercise described at paragraph (e) above; and
(iii) forms of the various other comfort letters (and related arrangement letters) duly executed or (where applicable) in the form in which they are anticipated to be delivered in due and normal course and at the appropriate time(s) when (and assuming that) the transaction proceeds (on the basis that (i) letters to which the sponsor is party will be received direct from the Reporting Accountant and (ii) other relevant letters will be received via the listing applicant);
(g) Providing conventional support services in relation to a number of common technical features of the listing (see further below section 3 “Financial Content of the Listing Document – Typical Financial Content”), normally including:
(i) Reporting in support of the indebtedness disclosure (see further below section 3 “Financial Content of the Listing Document – Guidance on Indebtedness Statement, and Recommended Steps”);
(ii) As part of the Reporting Accountants’ overall participation in the comfort letter and due diligence exercise, considering and discussing the listing applicant’s profit forecast and cash-flow memorandum (see further below sections 3 “Financial Content of the Listing Document – Guidance on Profit Forecast and Working Capital Statement, and Recommended Steps” and 14 “Forecasts and Projections”);
(iii) Comfort on the working capital statement (again, see further below sections 3 “Financial Content of the Listing Document – Guidance on Profit Forecast and Working Capital Statement, and Recommended Steps” and 14 “Forecasts and Projections”);
(iv) Reporting on any profit forecast (again, see further below sections 3 “Financial Content of the Listing Document – Guidance on Profit Forecast and Working Capital Statement, and Recommended Steps” and 14 “Forecasts and Projections”); and
(v) Reporting on calculations of pro forma financial statistics commonly including net tangible assets and earnings per share (see further below section 3 “Financial Content of the Listing Document – Technical Pro Forma Content”).
2.5.6 On occasions depending on scope and relative materiality (but not always), an appropriate expert (which is commonly the tax department of the Reporting Accountant’s firm, but does not necessarily need to be) may be engaged to issue a formal letter in support of the general tax disclosure normally included (by way of discrete appendix) in the listing document (see further below section 15 “Tax”).
2.5.7 Interaction with accountants is the subject of separate due diligence guidance (Chapter 20 “Due Diligence Guidelines – Accountants”), and detailed reference should be made to that chapter.
2.5.8 Certain specific cross-references to that chapter are contained within this chapter given the close interdependency of Reporting Accountant interaction and financial due diligence generally.
2.5.9 It is to be noted that it has not historically been (and, at the time this guidance is published, continues not to be) the practice in Hong Kong to commission long-form Accountants’ Reports according to (for example) reporting practices traditionally followed in the UK. (Compare and contrast practice in relation to internal controls reports as described in Chapter 13 “Due Diligence Guidelines – Internal Controls”.)
2.6 Quantitative Qualifications for Listing
2.6.1 Chapter 8 of the Listing Rules sets out the qualifications for listing on the main board of the Hong Kong Stock Exchange.
2.6.2 Within the criteria to be met there are quantum based and holistic considerations based on financial condition, nature of the listing applicant’s business and prospects.
2.6.3 This chapter considers the due diligence work to be conducted by sponsors on (i) the financial condition and financial information of a listing applicant (as described in section 1 above (“Scope & Key InterDependencies”)) and (ii) the steps to be taken in relation to verification of the quantitative tests for suitability in Chapter 8 of the Listing Rules.
1. Listing Rule 3A.11 provides that a sponsor must:
(i) be closely involved in the preparation of the new applicant’s listing documents;
(ii) conduct reasonable due diligence inquiries to put itself in a position to be able to make the declaration in Listing Rule 3A.13 and Appendix 19 to the Listing Rules;
(iii) ensure the requirements in Listing Rules 9.03 and 9.05 to 9.08 are complied with;
(iv) use reasonable endeavours to address all matters raised by the Exchange in connection with the listing application including providing to the Exchange, in a timely manner, such information as the Exchange may reasonably require for the purpose of verifying whether the Exchange Listing Rules are being or have been complied with by the sponsor, the new applicant and the new applicant’s directors;
(v) accompany the new applicant to any meetings with the Exchange unless otherwise requested by the Exchange, and attend any other meetings and participate in any other discussions with the Exchange as requested by the Exchange; and
(vi) comply with the terms of the undertaking and statement of independence given to the Exchange by the sponsor under Listing Rule 3A.03 and Appendix 17 to the Listing Rules.
2. Listing Rule 3A.12 states that in determining the reasonable due diligence inquiries a sponsor must make for the purposes of Listing Rule 3A.11(2), a sponsor must have regard to the due diligence practice note at Practice Note 21 to the Listing Rules and Paragraph 17 of the Code of Conduct.
3. Paragraph 12(b) of Practice Note 21 to the Listing Rules states that typical due diligence inquiries in relation to the new applicant’s compliance with the qualifications for listing include reviewing material financial information, including:
(i) financial statements of the new applicant;
(ii) financial statements of all subsidiaries of the new applicant and other companies that are material to the group’s financial statements; and
(iii) the internal financial records, tax certificates and supporting documents to the tax certificates for the trading record period.
Such review would in most cases include interviewing the new applicant’s accounting staff and internal and external auditors and reporting accountants and, where relevant, obtaining comfort from the new applicant’s external auditors or reporting accountants based upon agreed procedures.
4. Paragraph 13(a)-(d) of Practice Note 21 to the Listing Rules states that typical due diligence inquiries in respect of each new applicant and the preparation of its listing document and supporting information include:
(a) assessing the financial information to be published in the listing document including:
(i) obtaining written confirmation from the new applicant and its directors that the financial information (other than that already reported upon by a reporting accountant) has been properly extracted from the relevant underlying accounting records; and
(ii) being satisfied that the confirmation referred to at paragraph (i) has been given after due and careful inquiry by the new applicant and its directors;
(b) assessing the new applicant’s performance and finances, business plan and any profit forecast or estimate, including an assessment of the reasonableness of budgets, projections and assumptions made when compared with past performance, including historical sales, revenue and investment returns, payment terms with suppliers, costs of financing, long-term liabilities and working capital requirements. This would normally include interviewing the new applicant’s senior management and would often involve interviewing the new applicant’s major suppliers and customers, creditors and bankers;
(c) assessing whether there has been any change since the date of the last audited balance sheet included in the listing document that would require disclosure to ensure the listing document is complete and not misleading; and
(d) assessing whether it is reasonable to conclude that the proceeds of the issue will be used as proposed by the new applicant, taking into account the outcome of the sponsor’s assessment of, in particular, the new applicant’s existing cash and liquid reserves, projected liabilities, working capital requirements and expenditure controls.
5. Paragraph 14(b) of Practice Note 21 to the Listing Rules states that typical due diligence inquiries in relation to the expert sections of the listing document include reviewing the expert sections of the draft listing document to form an opinion as to whether the following are disclosed and commented on appropriately:
(i) the factual information on which the expert relies;
(ii) the assumptions on which the expert opinion is based; and
(iii) the scope of work performed by the expert in arriving at his/her opinion.
6. Paragraph 15 of Practice Note 21 to the Listing Rules states that typical due diligence inquiries in relation to the new applicant’s accounting and management systems and in relation to the directors’ appreciation of their and the new applicant’s obligations include:
(a) assessing the new applicant’s accounting and management systems that are relevant to:
(i) the obligations of the new applicant and its directors under the Listing Rules and other legal and regulatory requirements, in particular the financial reporting, disclosure of notifiable and connected transaction and inside information requirements; and
(ii) the directors’ ability to make a proper assessment of the financial position and prospects of the new applicant and its subsidiaries, both immediately before and after listing.
This assessment should cover the new applicant’s compliance manuals, policies and procedures including corporate governance policies and any letters from the reporting accountants to the new applicant commenting on the new applicant’s accounting and management systems or other internal controls; and
(b) interviewing all directors and senior managers with key responsibilities for ensuring compliance with the Exchange Listing Rules and other legal and regulatory requirements (including the staff responsible for the accounting and financial reporting function, company secretary and any compliance officers) to assess:
(i) their individual and collective experience, qualifications and competence; and
(ii) whether they appear to understand relevant obligations under the Exchange Listing Rules and other relevant legal and regulatory requirements and the new applicant’s policies and procedures in respect of those obligations.
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