Due Diligence Guidelines –
Legal and Regulatory Compliance and Legal Proceedings and Disputes
Code of Conduct Paragraphs
Key Stock Exchange Guidance Letters
Other Key References
Exchange Listing Decision LD19-2011
Exchange Listing Decision LD43-3
Exchange Listing Decision LD96-1
Exchange Listing Decision LD97-1
1. Legality and Compliance of Business Operations
Regarding the preparation of a listing document, a sponsor should perform, without limitation, each of the following: … assess the legality and compliance of the business operations [of the listing applicant]. [Paragraph 17.6(d)(vii) of the Code of Conduct]
1.2.1 Listing applicants are subject to laws and regulations specific to the countries, and sometimes also to the industries, in which they operate. The sponsor should therefore familiarise itself with the main laws and regulations governing the Group’s major operations and conduct due diligence to identify any material non-compliance by the Group with applicable laws and regulations.
1.2.2 If non-compliance incidents are serious in nature (for example, involving fraud or deceit by directors or senior management, systematic failure of a listing applicant’s internal controls and/or matters with a significant financial impact on the listing applicant), this can translate into an issue of suitability of the directors and/or suitability for listing of the listing applicant. This may result in the listing application being rejected or the Exchange requesting a demonstration period of compliance from the cessation of the non-compliance incident(s) to demonstrate that the rectification measures and enhanced internal control measures adopted are effective, and that there is no financial impact on the listing applicant. The demonstration period would generally be required to be an audited period.1
1.2.3 The Exchange considers that systematic, intentional, and/or respected breaches of laws and regulations by a listing applicant may affect its suitability for listing. The Exchange will take into account the following factors in determining the impact of non-compliance on an applicant’s listing:
(a) the nature, extent and seriousness of the breaches;
(b) the reasons for the breaches, whether they were intentional, fraudulent, or due to negligence or recklessness;
(c) the impact of the breaches on the listing applicant’s operation and financial performance;
(d) the rectification measures adopted; and
(e) the precautionary measures put in place to avoid future breaches.2
In cases such as non-compliant bill financing arrangements, the Exchange will expect the listing applicant to have demonstrated for a reasonable period (normally 12 months) that: (i) it would be financially sound and could operate without reliance on the non-compliant bill financing arrangements; and (ii) it has effective internal control to avoid future non-compliance of a similar nature.3
In other cases where serious non-compliance incidents do not have a direct impact on the listing applicant’s financial position (e.g. failure to obtain the necessary licence, approval or complete the necessary registration required by law), listing will only be approved after the listing applicant has demonstrated continued compliance for a reasonable period time.4
1.2.4 Where it is determined that non-compliance incidents do not give rise to a suitability issue, the expected level of disclosure in the listing document on the non-compliance incidents and the need for their rectification depends on which of the following three categories the non-compliance incidents fall into:
(a) “Material Impact Non-compliances”: non-compliance incidents which, individually or in the aggregate, have had or may have in the future, a material financial or operational impact on the listing applicant. For example, non-compliance incidents giving rise to significant financial penalties or which may result in the closure of material operating facilities.
(b) “Systemic Non-compliances”: non-compliance incidents which are not Material Impact Non-compliances, but which reflect negatively on the listing applicant’s or its directors’/ senior management’s ability or tendency to operate in a compliant manner. For example, repeated and/ or continuous breaches of laws. Non-compliance incidents which satisfy the test for being Material Impact Non-compliance incidents and which also reflect negatively on the listing applicant’s or its directors’/ senior management’s ability or tendency to operate in a compliant manner, should be categorised as Material Impact Non-compliances.
(c) “Immaterial Non-compliances”: non-compliance incidents which are neither Material Impact Non-compliances nor Systemic Non-compliances.5
1.2.5 In the case of Material Impact Non-compliances:
(a) the following should be disclosed in the listing document, either in the form of a table or plain text (whichever presents the issue in a more comprehensible manner):6
(i) reason(s) for the non-compliance incidents, the nature and extent of the breaches, corresponding risk factors, and the identity and position of the director(s) and/or senior management involved in the non-compliance incidents;
(ii) whether the listing applicant has been or will be charged or penalised for the non-compliance incidents during the track record period and up to the latest practicable date, with confirmation from the competent authorities (and legal opinions confirming the competence of the relevant authorities). Where there are penalties, disclosure should be made of the actual or maximum penalty (including the amounts), whether the listing applicant has made any provision (and if not, the reasons for not making provision), and the potential operational and financial impact on the listing applicant;
(iii) enhanced internal controls to prevent their recurrence (including the identity, position, qualification and experience of the personnel who are responsible for ensuring the compliances). In the event an independent internal control expert has been separately engaged to review the internal controls,i the listing document should include the identity of and the salient terms of engagement of an internal control expert and its findings and recommendations, and the listing applicant’s timing of implementation of any of the internal control expert’s recommendations (and the internal control expert’s follow-up review, if any);
(iv) how and when the rectification actions were taken or will be taken; and
(v) the views of the directors and the sponsor(s), with bases for such views, on whether the listing applicant’s enhanced internal control measures are adequate and effective under Listing Rule 3A.15(5), the suitability of the directors under Listing Rules 3.08 and 3.09, and the listing applicant’s suitability for listing under Listing Rule 8.04;
(b) Material Impact Non-compliances should also be highlighted in the “Summary and Highlights” section of the listing applicant’s listing document;7 and
(c) the Exchange normally expects the rectification of all Material Impact Non-compliances to be completed before listing. Where the Exchange accepts that certain non-compliance incidents can only be rectified within a short period after listing, the listing document should disclose a legal adviser’s view, with the bases for such view, as to whether there is any impediment to rectifying the non-compliance, and a statement that the listing applicant will disclose the progress of the rectification in the interim/annual reports and a detailed explanation for any delay in the rectification.8
1.2.6 In the case of Systemic Non-compliances:
(a) the following should be disclosed in the listing document, either in the form of a table or plain text (whichever presents the issue in a more comprehensible manner):9
(i) the views of the directors and the sponsor(s), with bases for such views, on whether the listing applicant’s internal control measures are adequate and effective under Listing Rule 3A.15(5), the suitability of the directors under Listing Rules 3.08 and 3.09, and the listing applicant’s suitability for listing under Listing Rule 8.04; and
(ii) the disclosures set out in paragraphs 1.2.5(a)(i) to (iii) above, to the extent necessary to enable investors to make an informed assessment of the listing applicant (i.e. where, based on the nature and circumstances of the non-compliance incidents, a disclosure set put in paragraphs 1.2.5(a)(i) to (iii) above would not be material to such assessment, it does not need to be included);
(b) Systemic Non-compliances should also be highlighted in the “Summary and Highlights” section of the applicant’s listing document;10 and
(c) the Exchange does not require Systemic Non-compliances to be rectified. The decision to rectify Systemic Non-compliances rests with the listing applicant and its sponsor(s).11
1.2.7 Immaterial Non-compliances are not required to be disclosed in the listing document or rectified. The decision to rectify an Immaterial Non-compliance rests with the listing applicant’s directors and its sponsor(s), whether or not it is disclosed in the listing document.12
1.2.8 Where compliance issues are cited as a risk factor, the risk disclosure should explain the risk in the context of the listing applicant’s business. For example if the listing document will cite as a risk factor that the listing applicant might not be able to obtain necessary government approvals for its development projects, the risk should be explained in the context of the listing applicant’s business, e.g. by disclosing the materiality and nature of the listing applicant’s projects that are pending government approvals at the time of listing.13 Compliance issues should however only be cited as risk factors if the listing applicant is unable to adequately mitigate the non-compliance. Where mitigation is not difficult, a listing applicant should not include a risk factor mainly because it may not deal with the event adequately. The Exchange has indicated that it is not appropriate to include the listing applicant’s possible failure to comply with legal requirements as a risk factor because listing applicants are expected to be law-abiding and rule compliant unless there is a genuine legitimate reason that gives rise to the uncertainty as to compliance.14
1.2.9 Areas which should be the focus of the legal and regulatory due diligence include:
(a) scope of the business licence and whether the Group’s activities are and will continue to be conducted within the prescribed parameters;
(b) breach of contract and/or infringement of third party intellectual property;15
(c) breach of land use restrictions and other laws and regulations relating to land (e.g., requirement to obtain construction permits in a timely manner);16
(d) exceeding regulatory limits in a regulated business;17
(e) litigation involving the listing applicant and/or its directors;
(f) breach of foreign investment restrictions;18
(g) breach of environmental laws and regulations; and
(h) breach of health and safety laws and regulations.
1.2.10 Where a listing applicant conducts business in the PRC under a Variable Interest Entity (“VIE”) structure, the sponsor should refer to the Exchange’s most recent guidance in relation to VIE structures.19
1.2.11 The SFC expects material litigation and material regulatory breaches to be disclosed in the listing document, irrespective of whether they have been resolved, to enable potential investors to assess the listing applicant’s business, its management and the effectiveness of its internal controls.20 Such disclosure should, in particular, include information that will enable potential investors to assess any potential adverse financial and operational impact on the listing applicant. 21
1.2.12 In appraising the legality of any questionable business practices, sponsors are expected to exercise reasonable judgement rather than simply relying on management representations.22 However, legal and regulatory compliance issues can be complicated and subject to legal uncertainties on which only legal experts can opine. The SFC has commented on the importance of clearly identifying, and bringing to the attention of potential investors, complicated or unfamiliar legal issues, in particular any key aspects which are subject to interpretation.23 Thus, where the sponsor lacks the relevant expertise to assess the Group’s compliance with foreign laws and regulations, the sponsor will need to consult independent lawyers24 and, where appropriate and practicable, obtain clarification from the competent authorities.
1.3 Recommended Steps
1.3.1 The sponsor, with the assistance of lawyers in relevant jurisdiction(s), should identify and assess any material non-compliance by the Group with applicable laws and regulations.
1.3.2 As a starting point for legal and regulatory compliance due diligence, it is common for the sponsor with the assistance of its principal lawyers to seek advice from local lawyers on the laws and regulations governing the Group’s operations in the principal jurisdictions in which it operates.
1.3.3 The sponsor should also discuss with the internal controls consultant any material non-compliance incidents identified.
1.3.4 With the assistance of lawyers in relevant jurisdictions, the sponsor should, where appropriate:
(a) obtain and review all approvals, licences, consents, permits or authorities (together “Approvals”) which are material to the Group’s business;
(b) verify that existing material Approvals are in force and are not about to terminate;
(c) check whether the proposed listing would adversely affect any material Approval. If any material Approval held by a controlling shareholder or parent company of the listing applicant is proposed to be transferred to the listing applicant, the sponsor should check that the Approval is transferable and that the appropriate formalities/procedures for transfer will be followed;
(d) check that there are no Approvals (including Approvals required for any proposed new projects, businesses, products or services) that the Group does not have which it should have which:
(i) are material to the Group’s business; or
(ii) are required for any project to which the listing proceeds will be allocated;
(e) check whether any Approval is required for the listing of the applicant’s assets;25
(f) carry out searches of relevant governmental agencies that have regulatory authority over the listing applicant or any Group member to check that each of the listing applicant and any relevant Group member(s) hold any Approvals which are required in any relevant jurisdiction(s) for the Group’s major operations;
(g) check whether the Group’s major business(es) is/are subject to any regulatory controls, e.g. price controls or consumer credit regulations, and that the Group complies with any such controls or regulations;
(h) obtain and review all material judgements, orders or decrees to which the Group is subject;
(i) obtain and review any reports or documents which are material in the context of the Group’s business that have been filed with governmental and regulatory agencies or bodies having regulatory authority over the Group;
(j) check whether the Group is in compliance with material statutory filing obligations in relevant jurisdictions; and
(k) check whether any material investigations are pending or in progress into the affairs of the Group.
1.3.5 Where appropriate and practicable, the sponsor should seek opportunities to interview relevant government officials or otherwise to obtain regulatory assurance on any points of law or regulation that may raise issues of actual or potential material non-compliance.26 However it is acknowledged that government and regulatory bodies are under no compulsion to cooperate with the interview process and the refusal of officials to participate in an interview or provide any requested regulatory assurance does not mean that the sponsor has failed to perform adequate due diligence. Where practicable, the sponsor should however seek an opinion from lawyers in the relevant jurisdiction with regard to any actual or potential material non-compliance.
1.3.6 Where the listing applicant is a Mineral Company, the sponsor should refer to Chapter 23 “Due Diligence Guidelines – Mineral Companies” for additional guidance on due diligence on the listing applicant’s compliance with host country laws, regulations and permits.27
1.3.7 Where the listing applicant uses or will use biological assets in connection with its business, the sponsor should also follow the specific standards and guidance in Chapter 24 “Due Diligence Guidelines – Biological Assets”.
1.3.8 For specific guidance on due diligence on compliance with anti-corruption and anti-money laundering laws and regulations, reference should be made to Chapter 15 “Due Diligence Guidelines – Anti-Corruption, Anti-Money Laundering and Sanctions”.
1.3.9 The sponsor should also enquire as to any recent or pending legal or regulatory changes in the principal jurisdictions in which the Group operates that are likely to have a material adverse effect on the Group’s business.
1. See paragraph 3.2 of Exchange Guidance Letter GL63-13.
2. See paragraph 3.2(2) of Exchange Guidance Letter GL68-13.
3. See paragraph 3.2(2) of Exchange Guidance Letter GL68-13 and Exchange Listing Decision LD19-2011.
4. See paragraph 3.2(2) of Exchange Guidance Letter GL68-13 and Exchange Listing Decision 97-1.
5. See paragraph 3.1 of Exchange Guidance Letter GL63-13.
6. See paragraph 3.4 of Exchange Guidance Letter GL63-13.
7. See paragraph 3.5 of Exchange Guidance Letter GL63-13. See also Exchange Guidance Letter GL86-16, Appendix 1, Section A (“Summary and Highlights”) which includes material non-compliances and litigation as examples of other significant matters which should be disclosed in the “Summary and Highlights” section of the listing document.
8. See paragraph 3.6 of Exchange Guidance Letter GL63-13.
9. See paragraph 3.7 of Exchange Guidance Letter GL63-13.
10. See paragraph 3.8 of Exchange Guidance Letter GL63-13.
11. See paragraph 3.9 of Exchange Guidance Letter GL63-13.
12. See paragraph 3.10 of Exchange Guidance Letter GL63-13.
13. See SFC Dual Filing Update of July 2012.
14. See Exchange Guidance Letter GL54-13 regarding disclosure in the “Risk Factors” section of IPO listing documents at paragraph 3.7.
15. See SFC Dual Filing Update of August 2011 which refers to a case in which the listing applicant operated an online trading platform for virtual items of third party-operated websites. As part of its trading services, the listing applicant downloaded and used the relevant third party-developed software to transfer the virtual items on behalf of its customers, in potential breach of terms of the third parties’ user agreements with which the listing applicant had agreed to comply. The SFC commented that this mode of operation exposed the listing applicant to potential claims from the website operators, and raised questions as to why the listing applicant’s management would find it appropriate to enter into agreements that it had intended to breach and take on the associated legal risks.
16. See paragraphs 5.1 and 5.2 of Exchange Guidance Letter GL19-10 for the Exchange’s guidance on the disclosure of idle land in the PRC and related disclosure requirements for listing applicants involved in property investment and development in the PRC. These paragraphs refer to the PRC laws and regulations which contain restrictions regarding the construction plans and development timeframe for land granted to property developers. The Notice on Promoting Economization of Land Use issued by the State Council on 3 January 2008 is stated to strictly enforce the policies for dealing with idle land. Paragraph 5.2 of the guidance letter requires that if a listing applicant’s business involves property investment and development in the PRC, the following information should be included in the listing document:
(a) whether the listing applicant has failed to comply with the relevant PRC laws and regulations, including breach of agreed development plans, payment obligations, construction timeframe or other terms under the land grant contracts which may lead to risks of forfeiture of idle land, land grant deposits or other penalty;
(b) details of the PRC land and regulations on idle land, and whether there will be any impact on the listing applicant given the tightened enforcement measures on property developers relating to regulations on forfeiture of idle land and/or land grant deposits;
(c) the listing applicant’s remedial actions or the reasons for not taking any remedial action;
(d) a risk factor associated with idle land and the quantitative impact on the listing applicant in relation to (a), (b) and (c) above, where material; and
(e) whether there is any other matter which needs to be brought to the Exchange’s attention.
See also SFC Dual Filing Update of August 2011 which refers to a case relating to a listing applicant, a property developer, whose only property project development during the track record period, a commodity trade centre complex with residential apartments and office premises, appeared to have breached the terms of the relevant land use rights which permitted warehouse and storage use only. See also SFC Dual Filing Update of January 2010 which refers to a case in which the listing applicant did not obtain the construction permit before commencing construction of a property project and in the worst case could have been liable to penalty or forfeiture of land. The same Dual Filing Update also refers to a case concerning a listing applicant which delayed construction and was in breach of land grant contracts signed with the local regulatory authorities, but whose listing document failed to analyse the potential adverse financial and operational impact on the business.
17. See also the following SFC Dual Filing Updates:
(a) SFC Dual Filing Update of June 2009 which refers to a case in which a Mainland property developer’s initial draft listing document omitted the listing applicant’s long history of regulatory breaches, which had exposed it to severe penalties and potential disruption of operations, and various legal proceedings relating to the timeliness and quality of properties it developed.
(b) SFC Dual Filing Update of January 2010 which refers to a case in which 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 have been the loss of the listing applicant’s business licence, the very basis on which the listing was sought.
(c) SFC Dual Filing Update of January 2011 which refers to a case in which the listing applicant was required by law to sell all of its production output to certain designated government-owned entities, except to affiliated entities for their own use. However, the business model of the applicant changed as a result of the corporate restructuring just before the proposed listing such that its major customers would be neither government-owned nor affiliated with the applicant. The application was allowed to lapse before the issue concerning the legality of the applicant’s business model could be addressed.
(d) SFC Dual Filing Update of July 2010 which refers to a listing applicant, a substantial portion of whose profits was derived from customer fees which exceeded and breached the limits imposed by the relevant regulatory requirements.
18. See SFC Dual Filing Update of June 2009 which refers to a case in which the listing applicant operated its principal business in an overseas jurisdiction which prohibited foreign controlling ownership in that business. The applicant claimed to have control because of an arrangement with a local employee from that jurisdiction but failed to disclose that the relevant law explicitly prohibited “nominee” arrangements and that there had been a number of investigations against companies suspected of breaching the relevant law. This piece of key information was only revealed following persistent enquiries by the regulators about inconsistent explanations from the sponsor and successive revisions of the legal opinions by the applicant’s legal advisers on the laws of the foreign jurisdiction. It also transpired that certain key elements of the arrangement might not be legally enforceable. The potential result could have been the listing applicant losing control over its principal business, the very basis on which the listing was sought.
19. See Exchange Listing Decision LD43-3 for its detailed requirements for VIE structures. In its review in 2011, the Exchange’s Listing Committee confirmed the practice of allowing VIE structures on a case-by-case basis after full consideration of the reasons for adopting such arrangements, but stated that where non-restricted businesses (with respect to foreign investment) are involved, the Listing Division will normally refer the case to the Listing Committee. The Listing Decision was further revised in August 2015 following the publication of the consultation draft of the new PRC Foreign Investment Law by the Ministry of Commerce in January 2015. That draft has given rise to heightened concerns as to the legality and validity of VIE structures to hold interests in Chinese businesses. The revised Listing Decision therefore encourages listing applicants which use VIE structures to hold interests in Chinese businesses to contact the Exchange to seek informal and confidential guidance.
20. See SFC Dual Filing Update of January 2010 which refers to a case in which the draft prospectus omitted the listing applicant’s past record of production without valid permits, which had led to the temporary suspension of operations during the track record period. In a similar case, the listing applicant’s various major litigation and regulatory breaches, which had exposed it to penalties and potential disruption of operations, were omitted from the draft prospectus. The SFC commented that “Potential investors must have relevant information such as material litigation and regulatory breaches, whether resolved or not, to assess the applicant’s business, its management and the effectiveness of its internal controls. Sponsors should ensure the proper disclosure of such information.”
21. See SFC Dual Filing Update of January 2010 in which the SFC criticised two listing applicants whose draft listing documents failed to disclose basic information in relation to breaches of Chinese central government measures or provide any analysis of the potential financial and operational impact on the listing applicants.
22. See SFC Dual Filing Update of August 2011 in which the SFC states “It is important that sponsors identify all material risks associated with the listing applications and ensure that the risks are properly addressed or disclosed before submitting the listing applications. Illegal or dubious business practices could lead to legal claims, regulatory actions and even business cessation. Sponsors are expected to exercise reasonable judgement in appraising the legality of any questionable business practices, rather than simply relying on management representations.”
23. SFC Dual Filing Update of June 2009.
24. SFC Dual Filing Update of July 2010.
25. See Dual Filing Update of July 2010 which refers to a case in which key mining assets of a listing applicant were located in a jurisdiction where government approval was required for the listing of such assets. The listing applicant had not obtained such approval, without which, it risked losing its key mining assets and it may not have been possible to deal with that risk by disclosure alone. The listing application was withdrawn.
26. See Exchange Listing Decision LD43-3 (referred to at Endnote 12 above) which at paragraph 13(d), in the context of a VIE structure, stated that “subject to availability and practicability, appropriate regulatory assurance should be obtained from the relevant regulatory authorities”. The decision stated further that in the absence of such regulatory assurance, the Exchange would accept a legal opinion from the listing applicant’s lawyers that all possible actions or steps taken to enable it to reach its legal conclusions had been taken.
27. See Listing Rule 18.05 which requires a Mineral Company’s listing document to include, if relevant and material to the Mineral Company’s business operations, information on compliance with host country laws, regulations and permits.
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