Due Diligence Guidelines –
Controlling Shareholders’ Relationship with the Listing Applicant
2. Independence, Delineation and Competition Issues
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]
2.2.1 The SFC and the Stock Exchange take the view that a sponsor should consider and resolve issues concerning the qualifications for listing of the listing applicant before making a listing application.4 The key issues relating to a controlling shareholder’s relationship with a listing applicant’s business include:
(a) whether the listing applicant’s business is carried on independently and is delineated from a controlling shareholder’s business, which may affect its suitability for listing.5 This may also be affected by any relationship the controlling shareholder has with key suppliers, customers or other stakeholders of the listing applicant; and
(b) whether a controlling shareholder has an interest in a competing business, which may require additional disclosure in the listing document or the appointment of sufficient independent non-executive directors to ensure that the interests of the shareholders will be adequately represented.6
When reviewing whether a listing applicant can carry on business independently of a controlling shareholder, the sponsor should consider the financial independence, operational independence and management independence of the listing applicant. Where the degree of dependence is excessive, this may raise concerns about the listing applicant’s suitability for listing.7 The sponsor should assist the listing applicant in considering and addressing the issue of reliance prior to submitting the listing application.8 Where a significant business relationship exists between a controlling shareholder and the listing applicant, the sponsor will be expected to perform more in-depth due diligence on the controlling shareholder in relation to such business relationship and the controlling shareholder’s ability to perform its obligations than would usually be the case if the listing applicant’s counter-party was a third party (see also paragraph 1.3.2(b)(ii)(B) above).
(a) Financial Independence
(i) The sponsor should examine any loans, guarantees or other financing provided by the controlling shareholder(s), and assess whether the listing applicant is able to demonstrate how it could sustain its operations after listing without undue reliance on its controlling shareholder(s).9 Examples of measures that have been adopted to demonstrate a listing applicant’s financial independence include:
(A) repaying or capitalising all outstanding loans due to, or releasing guarantees provided by, its controlling shareholder(s) before listing;
(B) using IPO proceeds to repay shareholder loans;10
(C) assessing whether the listing applicant had a record of fund-raising on a stand-alone basis without any credit support from the controlling shareholder(s);
(D) where there are existing loans that are secured by a controlling shareholder’s guarantees, assessing whether the listing applicant had received firm offers from independent financial institutions to provide equivalent finance facilities, on a stand-alone basis, to refinance the loans; and
(E) assessing whether the listing applicant has a strong financial position.11
(ii) The Stock Exchange had previously allowed a listing applicant to ask its controlling shareholder(s) for a secured loan facility to refinance existing loans if the terms offered by independent third parties were considered by the directors to be less favourable where it was satisfied that the listing applicant was financially independent.12
(b) Operational Independence
(i) The sponsor should consider the following in assessing the operational independence of the listing applicant:
(A) whether there is independent access to sources of supplies and raw materials for production.13 The sponsor should consider, for example:
(1) in evaluating the extent to which the listing applicant relies on a controlling shareholder for supplies and raw materials, whether the business is required by law to remain with a controlling shareholder.14 The listing applicant may consider obtaining a call option to acquire the relevant business from the controlling shareholder if the law subsequently allows the acquisition, to reduce reliance on the controlling shareholder;15 and
(2) in evaluating the extent to which the listing applicant relies on a supplier with which a controlling shareholder has a relationship, whether there are any reasons for maintaining the relationship. If possible, the controlling shareholder may consider removing the relationship with the supplier so that the listing applicant can have access to supplies and raw materials from sources that are not related to the controlling shareholder;
(B) whether there is independence of production and operational capabilities.16 Where a controlling shareholder holds a key asset necessary for the listing applicant’s business, it may consider transferring the asset to the listing applicant.17 If the asset must remain with a controlling shareholder, the sponsor should enquire into the reasons for doing so. For example, it is common for H-share companies that were previously part of large state-owned enterprises to rely to a certain extent on services, and land and properties provided by a controlling shareholder. Reliance may be dealt with by way of disclosure in the listing document where:
(1) there are sound commercial reasons for continuing the arrangements and they are common for these types of companies;
(2) the arrangements are designed to ensure the listing applicant’s access to the facilities and services on a long-term basis at the listing applicant’s discretion; and
(3) the properties are not so crucial to the operation of the listing applicant that it should obtain ownership;18 and
(C) whether there is independence of access to customers.19
(ii) The sponsor should assess whether the issues of reliance could be adequately addressed through disclosure in the listing document, or whether the structure of the listed parts, as opposed to the whole, of an integrated operation would result in significant risks to the listing applicant, to the extent that the protection of shareholders’ interests would be a concern, which could render the listing applicant not suitable for listing.20
(c) Management Independence
(i) The sponsor should assess the management teams at the listing applicant and controlling shareholder at both executive and operational levels to ensure that there is an independent management structure. The sponsors should consider factors including:
(A) the number of common directors between the listing applicant and the controlling shareholder(s), in particular, executive directors;
(B) whether the common directors are in charge of the daily operations or general management of the listing applicant;
(C) whether there is a clear delineation of business of the listing applicant and the controlling shareholder(s); and
(D) whether the senior management of the Group and that of the controlling shareholder(s) and its/their subsidiaries are independent of each other.21
The sponsor should assess whether the business of the listing applicant is delineated from the business of the controlling shareholder(s), to ensure that independence and competition issues are not too excessive so as to impact on the listing applicant’s suitability for listing. Considerations should include the following:
(a) the degree of segregation of businesses and technologies;
(b) geographical markets;
(c) product classification;
(d) situation of product facilities of the two businesses;
(e) separation of staff;
(f) separate customer and supplier bases; and
(g) independent sales and marketing activities.22
(a) Competition is normally regarded as a disclosure issue, and the disclosure of competing interests is one of the qualifications for listing.23 The sponsor should assess whether the arrangements to manage conflicts of interest and delineation of businesses between the listing applicant and other businesses under common control are adequate such that the competing interests would not impact on the listing applicant’s suitability for listing.24
(b) The giving by a controlling shareholder of any voluntary undertaking not to compete with the business of the listing applicant25 is a relevant factor but is not decisive. Non-competition undertakings may or may not effectively contain competition within acceptable boundaries, and enforceability is dependent on factors including:
(i) the effect of exemption clauses on non-competition undertakings;
(ii) how independently a listing applicant can exercise its right to enforce the non-competition undertakings in light of its own corporate governance; and
(iii) the degree to which the management of the listing applicant and its controlling shareholders are closely connected.
(c) If there are indications that a non-competition undertaking may not function effectively in light of the facts and circumstances of the case, the Stock Exchange may disregard the agreement when determining whether the requirements of the Listing Rules are satisfied.26
2.2.5 Other Relevant Due Diligence Guidance
The sponsor should also refer to section 5 of Chapter 8 “Due Diligence Guidelines – Business Model”.
2.3 Recommended Steps
2.3.1 Background Checks
(a) The sponsor should conduct a public search to obtain and review information (such as financial statements and regulatory filings) regarding a controlling shareholder’s businesses.
(b) The sponsor should obtain lists of directors, senior management, employees and key customers and suppliers of the controlling shareholder(s) and compare them against the corresponding lists for the listing applicant to identify the extent of any overlap.
(c) The sponsor should obtain and review any material agreements between a controlling shareholder and the listing applicant, including those relating to the following:
(i) business activities;
(ii) financing and guarantees;
(iii) provision of support services;
(iv) supply of raw materials;
(v) sales of products and services;
(vi) leases of key equipment and property;
(vii) licensing of intellectual property rights; and
(viii) non-competition undertakings and negative confirmations on competing interests and/or conflicts of interests from the controlling shareholder(s).
As a controlling shareholder would also be a connected person of the listing applicant, the transactions covered by the above agreements would constitute connected transactions. The sponsor should also review the agreements in light of the connected transaction requirements (for further guidance, please refer to Chapter 11 “Due Diligence Guidelines – Connected Persons and Connected Transactions”).
(d) The sponsor should obtain and review information on any competing business or business where a controlling shareholder acts as a customer or supplier so that these businesses may be accurately described in the listing document, including:
(i) reviewing any licences or permits required to be obtained for its operations;
(ii) reviewing any regulatory or contractual restrictions that prevent the competing business from being transferred to the listing applicant;
(iii) obtaining an opinion on its legal status; and
(iv) reviewing any corporate governance policies on managing conflicts of interest or competition between the listing applicant’s business and the controlling shareholder’s business.
In the interview with the controlling shareholder(s), the sponsor should discuss the following in order to identify any independence, delineation and competition issues for the purpose of assessing whether the listing qualifications are satisfied (including whether the listing applicant is suitable for listing) and determining the extent of disclosure in the listing document:
(a) any reliance of the Group on a controlling shareholder or its close associates for its operational, financial and management needs; and
(b) any interests of a controlling shareholder group that compete or are likely to compete directly or indirectly with the business of the Group.
1. Listing Rules 1.01 and 19A.14.
2. In SFC Dual Filing Update of June 2009, the SFC noted an instance where an initial draft listing document disclosed that the listing applicant had no controlling shareholders, but following enquiries by the regulators, the sponsors submitted that two shareholders, including one previously described as a passive investor, were at all material times acting in concert and should have been disclosed as the controlling shareholders throughout the track record period. The SFC commented that the deficient disclosure in the draft listing document suggested that the sponsor might not have exercised due care in advising on the preparation of the initial listing application.
3. Exchange Guidance Letter GL68-13 (at paragraph 3.2(1)).
4. Paragraph 54 of the Consultation Paper on the Regulation of Sponsors.
6. Listing Rules 8.10(1) and (3).
7. Exchange Guidance Letter GL68-13 at paragraph 3.2(4), Exchange Listing Decision LD51-2, Exchange Listing Decision LD51-3 and Exchange Listing Decision LD69-1.
8. In Exchange Listing Decision LD46-1, the Stock Exchange rejected the listing application on the ground of unsuitability for listing due to excessive reliance on the controlling shareholder group, and required the listing applicant to take concrete steps to address the issue of reliance before it would consider any further review.
9. SFC Dual Filing Update of July 2010. The SFC noted an instance where a mining company would have been unable to continue as a going concern without the continuing financial support of its controlling shareholder. The SFC considered that the initial draft listing document failed to disclose prominently its liquidity problem and how the applicant would be able to improve its liquidity position or to meet its financial obligations independently after listing.
10. In Exchange Listing Decision LD69-1, the Stock Exchange referred to a case in which it allowed the repayment of the loan with IPO proceeds, with clear disclosure in the listing document of the application of the proceeds including an irrevocable instruction to apply part of the proceeds to release the loan.
11. Exchange Listing Decision LD69-1.
12. Exchange Listing Decision LD69-1.
13. Exchange Listing Decision LD46-1, Exchange Listing Decision LD46-2 and Exchange Listing Decision LD51-1. In an enforcement action, the SFC found that the sponsor had not paid sufficient attention to recommendations of their professional suppliers or did not perform adequate due diligence in various areas including the relationship between the shareholders of the listing applicant and its suppliers (SFC press release dated 7 March 2006).
14. In Exchange Listing Decision LD46-2, the controlling shareholder operated its business in the media industry in the PRC. The industry was heavily regulated and the business must remain with the controlling shareholder.
15. Exchange Listing Decision LD46-2.
16. Exchange Listing Decision LD46-1, Exchange Listing Decision LD46-2 and Exchange Listing Decision LD51-1.
17. In SFC Dual Filing Update of January 2010, the SFC noted a case where the listing applicant represented to the regulators that the reason why the ownership of a key asset had been entrusted to the listing applicant, rather than transferred from the controlling shareholder to the listing applicant, was a prolonged regulatory approval process. However, it was later revealed that the controlling shareholder’s interest in the key asset was in fact subject to a lock-up. The SFC stated that this would render previous reasons submitted as potentially false and misleading, and raised concerns as to the adequacy of due diligence performed by the sponsor.
18. Exchange Listing Decision LD51-1.
19. Exchange Listing Decision LD46-1, Exchange Listing Decision LD46-2 and Exchange Listing Decision LD51-1.
20. Exchange Listing Decision LD46-1. In relation to reliance issues, although the Stock Exchange ordinarily interprets the requirements on reliance as disclosure based, where the operating structure of the listing applicant is highly dependent on its controlling shareholder (for example, on purchases from or sales to the controlling shareholder), the Stock Exchange may raise concerns as to:
(b) conflicts of interests between the listed and unlisted parts of the operation and their respective investors;
(c) substantial reliance on the protection mechanisms offered by the connected transaction requirements under the Listing Rules; and
(d) how performance of the listed part of the company may be independently evaluated.
21. Where the listing applicant conducts its business through contract-based structures with a controlling shareholder and operating companies that are owned by the controlling shareholder, the Stock Exchange has in Exchange Listing Decision LD43-3 stated specific requirements on: (a) the structure and legal documentation to ensure sound and proper operation of the arrangements; and (b) the disclosure of the arrangements in the listing document.
22. Exchange Listing Decision LD52-2.
23. Exchange Listing Decision LD51-2.
25. Exchange Listing Decision LD51-2 and Exchange Listing Decision LD51-3. Exchange Listing Decision LD51-3. The undertaking may include a right of first refusal of the listing applicant to exploit any business opportunity that could be exploited by either the listing applicant or the controlling shareholder.
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.