Chapter 12

Due Diligence Guidelines –

Financial

18. Quantitative Qualifications for Listing

18.1 Standards

18.1.1 Before submitting an application on behalf of the 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]

18.1.2 Paragraph 12(c) of Practice Note 21 provides that due diligence inquiries in relation to the new applicant’s compliance with the qualifications for listing include assessing the accuracy and completeness of the information submitted by the new applicant to demonstrate that it satisfies the trading record requirement.

18.1.3 Paragraph (b) of the formal Sponsor’s Declaration (contained in Appendix 19 to the Listing Rules) requires each sponsor to confirm that having made reasonable due diligence inquires, the sponsor has reasonable grounds to believe and does believe that the listing applicant is in compliance with all conditions in Chapter 8 of the Listing Rules (except to the extent that compliance with those rules has been waived by the Exchange in writing).

18.1.4 Listing Rule 8.04 states that both the listing applicant and its business must, in the opinion of the Exchange, be suitable for listing.

18.1.5 Listing Rule 8.05 sets out three quantitative financial tests for a proposed listing applicant:

(a) A profits test (Listing Rule 8.05(1));

(b) A market capitalisation / revenue / cash flow test (Listing Rule 8.05(2)); and

(c) A market capitalisation / revenue test (Listing Rule 8.05(3)).

A listing applicant must satisfy at least one of these tests.

18.1.6 Under Listing Rules 8.05A and B and 18.04, a Mineral Company that is unable to satisfy either the profit test in Rule 8.05(1), the market capitalisation/revenue/cash flow test in Rule 8.05(2), or the market capitalisation/revenue test in Rule 8.05(3), may still apply to be listed if it can establish to the Exchange’s satisfaction that its directors and senior managers, taken together, have sufficient experience relevant to the exploration and/or extraction activity that the Mineral Company is pursuing.9

18.1.7 Under Listing Rule 8.05B, dispensations are also available for certain newly formed project companies and to address exceptional circumstances.

18.1.8 A number of Listing Decisions provide further guidance on the application of Listing Rule 8.05.

18.1.9 Listing Rule 8.09 sets out criteria to be met by new listing applicants for expected minimum market capitalisation and initial public float.

18.2 Guidance

18.2.1 This overriding suitability requirement encompasses a combination of holistic and quantitative criteria. The holistic criteria are discretionary (but applied according to established principles and guidelines). The quantitative criteria are formulaic. The holistic suitability test under Listing Rule 8.04 has been applied by the Stock Exchange to consider whether factors like operational and financial reliance on parent company, sustainability of the listing applicant’s business, VIE structures (or other arrangements for achieving economic benefit otherwise than through conventional direct ownership interests in an underlying business), material dependencies (such as management overlap with parent company, reliance on major customer, and reliance on connected parties) and historical regulatory non-compliance may render a listing applicant unsuitable for listing. Certain factors affecting listing applicants’ suitability are referred to in Chapter 4 “Due Diligence Guidelines – Submission Readiness” and Chapter 8 “Due Diligence Guidelines – Business Model”.

18.2.2 Each of the three quantitative tests in Listing Rule 8.05 comprises:

(a) A stipulated numeric “hurdle”; plus

(b) Associated requirements with respect to continuity of management and ownership; and

(c) Normally, a requirement for a “trading record” of at least three complete financial years.

18.2.3 Management and ownership continuity are outside the scope of this Chapter.

18.2.4 As indicated above, the tests are alternatives based on (respectively):

(a) Profits (Listing Rule 8.05(1));

(b) Market capitalisation / revenue / cash flow (Listing Rule 8.05(2)); and

(c) Market capitalisation / revenue test (Listing Rule 8.05(3)).

18.2.5 The profits test in Listing Rule 8.05(1) requires profit10 attributable to shareholders of:

(a) at least HK$20,000,000 in the most recent financial year; and

(b) at least HK$30,000,000 in aggregate in respect of the two financial years preceding that year.

18.2.6 The market capitalisation / revenue / cash flow test in Listing Rule 8.05(2) requires:

(a) a market capitalisation at the time of listing of at least HK$2,000,000,000; plus

(b) revenue for the most recent audited financial year of at least HK$500,000,000; plus

(c) positive cash flow of at least $100,000,000 in aggregate for the three financial years preceding listing.

18.2.7 The market capitalisation / revenue test in Listing Rule 8.05(3) requires:

(a) a market capitalisation of at least HK$4,000,000,000 at the time of listing; plus

(b) revenue for the most recent audited financial year of at least HK$500,000,000.

18.2.8 For purposes of the latter two revenue based tests, Listing Rule 8.05(4) stipulates that only revenue arising from the principal activities of the new applicant will be recognised.

18.2.9 For larger companies which satisfy the market capitalisation/revenue test in Listing Rule 8.05(3), the Exchange will accept management continuity of less than three years provided that:

(a) The listing applicant has been under substantially the same management for at least the most recent financial year; and

(b) Management can demonstrate sufficient and satisfactory business and industry experience.

18.2.10 The Exchange also has residual discretion under Listing Rule 8.05B to grant dispensations in “exceptional circumstances” for companies which (among other things) have a trading record of at least two years.

18.2.11 Listing Rule 8.09 requires:

(a) A minimum market capitalisation of a new applicant at the time of listing of at least HK$200,000,000; and

(b) A minimum value of shares held by the public (known as the “public float”) of at least HK$50,000,000.

18.3 Recommended Steps

18.3.1 The sponsor should perform calculations necessary to demonstrate the listing applicant’s performance / status relative to each of the three test criteria.

18.3.2 If dispensations are required, or if there is any uncertainty over the appropriate categorisation / recognition of profits or revenues for these purposes, this should normally be the subject of early discussions with the Exchange, and applications to the Exchange made ahead of filing Form A1.

18.3.3 In addition to ensuring that the listing applicant meets the specific financial benchmarks to qualify for listing, the sponsor should ascertain from its financial due diligence on the listing applicant that the profit, revenue and/or cash flow of the listing applicant used to meet the relevant criteria is accrued in the ordinary course of business and in line with the general business of the listing applicant and the accounting treatment adopted is in line with industry norm.11

18.3.4 The sponsor should understand the listing applicant’s business model in order to have identified any unusual items taken into account by the listing applicant to meet the financial qualifications for listing. Reference may be made to the industry norms of the listing applicant’s business.12

18.3.5 The sponsor should therefore interview the management of the listing applicant and its Reporting Accountant as part of its overall financial diligence (see sections 4 and 5 above) to confirm that income used to qualify for listing has arisen in the ordinary course of business and is actively derived from the listing applicant’s principal business rather than from a source incidental to it.

18.3.6 Timing of when the income is taken into account by the listing applicant should also be considered. Where timing is arbitrary or mainly at the discretion of management, the sponsor should make further inquiries.

18.3.7 Accounting treatment and accounting policies should also be taken into consideration when determining whether further inquiries should be made. Examples of cases previously considered by the Stock Exchange include treatment of unrealised profits in the profit and loss account,13 treatment of deferred tax credits and tax refunds,14 treatment of compensation made to the listing applicant for early termination of contract and treatment of convertible preference shares.15

18.3.8 Special considerations may apply in cases where there have been acquisitions by the listing applicant during or subsequent to the trading record period and prior to the listing date, or where acquisitions are under consideration (or have been agreed to) but not yet completed at the time of listing.16

Endnotes

9. From Exchange Guidance Letter GL22-10. Please also note that Paragraph 41(6) of Part A of Appendix 1 to the Listing Rules provides that where the listing applicant is a Mineral Company and wishes to apply for a waiver of the profit or other financial standards requirements under Listing Rule 18.04, it must disclose the management expertise and experience of the persons described in paragraph 41(1) relevant to the exploration and/or extraction activity that the Mineral Company is pursuing. The Note to Listing Rule 18.04 states that a Mineral Company relying on this rule must demonstrate that its primary activity is exploration for and/or extraction of Natural Resources.

10. See Exchange Listing Decisions LD45-2 (whether tax deferred tax credits and tax refunds could be counted as satisfying the profit requirement) and LD48-2 (whether compensation income arising from one-time early termination of a contract could be counted towards the satisfaction of the profit requirement).

11. See Exchange Guidance Letter GL26-12. This guidance letter provides guidance on business models with significant forfeited income from prepayments. The guidance states that income for services and/or products not rendered and/or utilised may be regarded as revenue generated in the usual and ordinary course of business for the purpose of Listing Rule 8.05 if it is an industry norm to include forfeited income in business operations. However, if an applicant has a short history of operating a business with forfeited income, its reliance on forfeited income is significantly above the industry norm, and/or if the operation is associated with a high level of complaints or legal claims, these factors taken together may warrant significant concern. Accordingly, a heightened standard of review will be adopted. Further, the Exchange might not consider the applicant suitable for listing, if, after considering the totality of the facts, continued reliance on forfeited income would potentially render the business not sustainable, its business model relies on unethical selling methods, or there is concern about the applicant’s capacity to provide contracted services/products. Where the facts and circumstances of an individual case warrant, the Exchange will request specific disclosure in the listing document and a detailed submission on the basis upon which the sponsor and the directors consider that the applicant’s business satisfies Listing Rule 8.05(1)(a) and Listing Rule 8.04.

12. See Exchange Listing Decision LD66-1. This listing decision provides decision on whether the gain/loss from changes in the fair value of the conversion option in relation to the Company’s redeemable convertible preferred shares should be excluded from the computation of profit under Listing Rule 8.05(1)(a). The Exchange takes the view that the profit requirement under Listing Rule 8.05(1)(a) indicates the management’s past performance during the track record period. The profit requirement, and appropriate disclosure, should enable investors to make an informed assessment of the applicant as contemplated by Listing Rule 2.03(2). When reviewing whether an applicant satisfies Listing Rule 8.05(1)(a), the Exchange ordinarily considers the burden of proof to be on the sponsor and applicant to demonstrate compliance. In view of the importance of this standard, where the judgment of directors or their reporting accountants is expected to have a significant impact on compliance with Listing Rule 8.05(1)(a), the Exchange does not rely solely on the judgment of the directors and/or accountants in reaching its conclusions. Instead, it may reach its own conclusion based on the information presented to ensure that the eligibility standards of Listing Rule 8.05(1)(a) are interpreted consistently and not unduly affected by the views of individual boards and/or reporting accountants. Taking all the factors into account, in particular the factors favouring the inclusion of the conversion option changes and the factors favouring the exclusion of the conversion option changes, the Exchange determined that the conversion option changes were not demonstrably related to activities in the ordinary and usual course of the Company’s business. Therefore, it was appropriate to exclude these from the computation of profit under Listing Rule 8.05(1)(a). In addition, the Exchange noted there was an increasing number of applicants issuing preferred shares. The treatment of the fair value changes for them would be dealt with case by case for Listing Rule 8.05(1)(a).

13. See Exchange Listing Decision LD45-2. This listing decision provides a decision on whether (a) deferred tax credits arising out of netting off the tax effect from bad debt provisions; and (b) tax refunds arising out of capitalisation of retained profits and statutory surplus reserves, in the financial statements of the company could be counted towards satisfaction of the profit requirement of Listing Rule 8.05(1)(a). In determining whether any income can be counted towards satisfaction of the profit requirement of Listing Rule 8.05(1)(a), the Exchange must be satisfied that, based on the facts and circumstances of a particular case, the income arises from the ordinary and usual course of business. Based on the facts and circumstances of the case and the Exchange’s analysis of the Listing Rules, the Exchange determined that: a) the deferred tax credits arising out of netting off the tax effect from bad debt provisions were related to activities within the ordinary and usual course of the company’s business and therefore, could be counted towards satisfaction of the profit requirement of Listing Rule 8.05(1)(a); and b) the tax refunds arising out of capitalisation of retained profits and statutory surplus reserves were capital restructuring activities rather than activities relating to the operation of the business of the company, and the circumstances under which the tax refunds were recognised were discretionary. Consequently, the Exchange determined that such tax refunds were not demonstrably related to activities within the ordinary and usual course of the company’s business for the purpose of Listing Rule 8.05(1)(a).

14. See Exchange Listing Decision LD48-2. This listing decision provides a decision on whether compensation income arising from the one-time early termination of a contract could be counted towards satisfaction of the profit requirements under Listing Rule 8.05(1)(a). In determining whether an item of income can be counted towards satisfaction of the profit requirement of Listing Rule 8.05(1)(a), the Exchange must be satisfied that, based on the facts and circumstances of a particular case, the income arises from the ordinary and usual course of business. On the basis of the facts and circumstances of the company’s case, including the fact that both the sponsor and the reporting accountants considered that the compensation income was generated from activities within the ordinary and usual course of the company’s business, the Exchange allowed the income associated with the one-time early termination of a contract to be counted as profit for the purpose of Listing Rule 8.05(1)(a). Based on the material facts and circumstances of the company’s case, the Exchange determined that the relevant income was related to activities within the ordinary and usual course of the company’s business, and therefore could be counted towards satisfaction of the profit requirements of Listing Rule 8.05(1)(a).

15. See Exchange Listing Decision LD66-1 (see above).

16. Refer to Practice Note 3 to the Listing Rules and related Exchange Listing Decisions.

Disclaimer

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.

Trading Record Requirement for Listing

Quantitative Qualifications for Listing

Accuracy and Completeness of Information Submitted by New Applicant to Demonstrate it Satisfies Trading Record Requirement

Financial Quantitative Qualifications for Listing

Three Quantitative Tests in Listing Rule 8.05

Associated Requirements With Respect to Continuity of Management and Ownership

Paragraph 17.4(c)(i) of the Code of Conduct

Paragraph 12(c) of Practice Note 21

Hong Kong Stock Exchange Listing Rule 8.04

Stipulated Numeric Hurdle
Requirement for a Trading Record of at Least Three Complete Financial Years

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