Due Diligence Guidelines –
Connected Persons and Connected Transactions
3. Sponsor’s Confirmation in relation to Continuing Connected Transactions for which a Waiver is Sought
The Exchange may waive the announcement, circular and shareholders’ approval requirements for continuing connected transactions entered into by a new applicant or its subsidiaries. The new applicant must disclose in the listing document its sponsor’s opinion on whether the transactions are in the ordinary and usual course of business of the listed issuer’s group, on normal commercial terms or better, are fair and reasonable and in the interests of the shareholders as a whole. [Listing Rule 14A.105]
3.2.1 The expression “ordinary and usual course of business” is defined in the Listing Rules to mean “the entity’s existing principal activities or an activity wholly necessary for its principal activities”.6 The expression “normal commercial terms or better” is defined in the Listing Rules to mean “the terms which a party could obtain if the transaction were on an arm’s length basis or terms no less favourable to the listing issuer’s group than terms available to or from independent third parties”.7
3.2.2 The sponsor is required to confirm whether the terms of the continuing connected transaction are fair and reasonable. This expression is not defined in the Listing Rules and should be given its natural meaning. For many transactions, especially those of a commercial nature such as supply agreements, a transaction is likely to be fair and reasonable if it is on normal commercial terms or better. The question of whether a transaction is fair and reasonable is likely to require greater analysis where the transaction is of an unusual or one-off nature such that it is difficult to assess by reference to comparable transactions.
3.2.3 The sponsor is also required to confirm whether the terms of the continuing connected transaction are in the interests of the shareholders as a whole. This is essentially a test of whether the transaction is beneficial to the listing applicant and the sponsor should consider what the consequences would be if the listing applicant did not enter into the transaction or entered into a transaction with a non-connected person instead (if this is possible).
3.2.4 As well as the statement referred to above, the sponsor is also generally required to include a statement in the listing document that the annual caps for the continuing connected transactions are fair and reasonable and in the interests of shareholders as a whole. Please see paragraph 3.3.7 below for more information on the due diligence relating to annual caps.
3.3 Recommended Steps
3.3.1 Ordinary and Usual Course of Business
The sponsor must obtain an understanding of the listing applicant’s business and operations to assist it in coming to a conclusion as to whether the continuing connected transaction in question is in the ordinary and usual course of the listing applicant’s business. For guidance on due diligence to understand a listing applicant’s business, operations and structure, the sponsor should refer to Chapter 8 “Due Diligence Guidelines – Business Model”.
3.3.2 Transactions with and Quotations from Independent Third Parties
(a) If the listing applicant has entered into the same or similar transactions to the continuing connected transaction with independent third parties, the sponsor should obtain and review the relevant agreements in order to help it to determine whether the terms of the transaction entered into with the connected person are on normal commercial terms and the terms are fair and reasonable. The terms to be reviewed should include, among others, the duration of the agreement, pricing, payment terms and termination events.
(b) If the transactions entered into with independent third parties are not on the same or similar terms as those entered into with connected persons, the sponsor should consider whether the differences are justifiable and can be explained. For instance, if the transaction in question relates to the supply of goods, is the connected person paid more because the goods supplied are better in quality and can this be verified through independent sources?
(c) If the sponsor concludes that the terms of the continuing connected transaction are better than normal commercial terms, this will be helpful in assisting it to come to a conclusion that the continuing connected transaction is in the interests of the listing applicant’s shareholders as a whole.
(d) It may also be possible for the listing applicant to seek quotations from independent third parties to assist it in determining if the terms of the continuing connected transaction are on normal commercial terms or better and are fair and reasonable. If the listing applicant has not entered into any transactions similar to the continuing connected transaction against which its terms can be compared, the sponsor may consider requesting that the listing applicant seek such a quotation for comparison purposes.
(e) Copies of any agreements with independent third parties and quotations obtained should be retained as part of the sponsor’s records of the listing assignment.
3.3.3 Expert Opinion
(a) With respect to certain continuing connected transactions, the sponsor may be able to rely on, or take into account, the work of an expert in assisting it to come to the conclusion that the transaction is on normal commercial terms or better and that the terms are fair and reasonable. For instance, if the continuing connected transaction in question is a property lease agreement, the sponsor may be able to rely on an independent property valuer’s view of the terms of the property lease agreement to support its view that such lease is on normal commercial terms or better and that the terms are fair and reasonable.
(b) When having recourse to an expert, the sponsor should review the assumptions made by the expert and satisfy itself that the bases and assumptions upon which the expert’s conclusion is founded are fair, reasonable and complete. The sponsor should critically review the expert’s opinion and conduct follow-up work to resolve any material discrepancies, irregularities or inconsistencies. The sponsor should also be able to demonstrate that it has considered how the expert’s report could form the basis for the sponsor to discharge its due diligence obligations and whether additional due diligence is required.8 The sponsor should also refer to Chapter 18 “Due Diligence Guidelines – Interaction with Third Parties including Expert Advisers” for more information on seeking assistance from experts.
3.3.4 Market Comparables
(a) The sponsor should also consider whether it is able to obtain information on transactions entered into by other entities that are the same as or similar to the continuing connected transaction. For instance, if the listing applicant is in the property business and the continuing connected transaction in question is a lease of an office, the sponsor may be able to obtain market data on the price per square foot paid by other lessees in the same building or area.
(b) When using market comparables, the sponsor should ensure that the transaction(s) are truly comparable (or make appropriate adjustments if required) and the sponsor should have regard to the following (non-exhaustive) factors in considering this:
(i) Nature of the transaction. For instance, the sponsor should not compare a commercial property management agreement with a hotel management agreement;
(ii) Entity size. In some situations, the size of the listing applicant would matter. For example, an international manufacturer may be able to obtain better terms in a raw materials supply agreement than a similar manufacturer with a regional market share; and
(iii) Duration of the transaction. An agreement with a longer term may have better terms than a short-term agreement.
(c) The sponsor should note any differences in the terms of the continuing connected transaction and the market comparables and decide whether such differences are justifiable before coming to a conclusion that the continuing connected transaction is on normal commercial terms or better and the terms are fair and reasonable.
(d) If there are no or a very limited number of market comparables in the same jurisdiction in which the listing applicant operates, the sponsor should consider whether it is appropriate to look at market comparables in another jurisdiction. In this situation, the sponsor should consider whether market comparables in that other jurisdiction are truly comparable and if adjustments are required to account for the different jurisdiction.
3.3.5 Other Steps
(a) The sponsor should review the agreement(s) relating to the continuing connected transaction and review critically their key terms. The sponsor should discuss the key terms with the listing applicant and, if practicable, the connected person, to assist it in understanding how these terms were reached, as this may be relevant for the purposes of determining whether they are normal commercial terms or better and fair and reasonable. For example, if the transaction was entered into after a tender process that involved independent third parties and on the basis that it provided the best terms out of all proposals submitted, that is likely to be a strong indication that it is on normal commercial terms or better and fair and reasonable. The sponsor should also take into account its understanding of the listing applicant’s business and the industry in which the listing applicant operates in reviewing such agreement(s).
(b) The bases and assumptions upon which the sponsor’s views are founded should be documented and kept as part of the sponsor’s due diligence records.
(c) The sponsor should also assess the system of internal controls to ensure that the individual transactions are indeed conducted within the framework of the agreement.9
(a) Listing Rule 14A.52 provides that agreements entered into by a listing applicant with a connected person in respect of a continuing connected transaction that is not exempt from the reporting, annual review, announcement and independent shareholders’ approval requirements of Chapter 14A, must be for a fixed period and not exceed three years in duration, unless there are special circumstances where the nature of the transaction requires a longer period. In such cases, the sponsor must in the listing document explain why the agreement requires a longer period and to confirm that it is normal business practice for agreements of this type to be of such duration.
(b) Where the listing applicant considers that it is appropriate for an agreement with a connected person to be for a duration exceeding three years (common examples being trademark licence agreements and hotel management agreements), in considering whether such longer duration would be in the interests of the listing applicant’s shareholders as a whole, the sponsor should consider the reasons why a longer duration is appropriate (for example, the longer duration may be necessary to provide stability to the listing applicant’s business), whether it is normal business practice for agreements of this nature to be of such longer duration (see also paragraphs 3.3.2, 3.3.3 and 3.3.4 above) and whether it would be in the interests of the listing applicant’s shareholders if the agreement is for an initial fixed term with an option to renew subject to the approval of the independent shareholders of the listing applicant.10
3.3.7 Pricing Policies
(a) Listing Rule 14A.51 provides that a written agreement entered into by a listing applicant with a connected person in respect of a continuing connected transaction must contain the basis for calculating the payments to be made. If the agreement covers transactions of different nature, the listing applicant should clearly set out the pricing policy for each type of the transactions. The listing applicant should avoid using generic “boilerplate” pricing mechanism where some of the pricing methods are not applicable to certain categories of transactions.11
(b) The sponsor should review the pricing policies set out in the written agreement in respect of a continuing connected transaction and assess whether the pricing policies are sufficiently specific in order to provide a framework for investors and shareholders to properly assess the transaction. The sponsor should also discuss with the management the rationale for adopting such pricing policies and, to the extent possible, compare such pricing policies with those adopted by other companies for the same or similar transactions to understand whether the pricing policies are appropriate for the connected transaction.
(c) If the listing applicant has historically entered into the same or similar transactions with connected persons or independent third parties, the sponsor should obtain and review the relevant agreements to understand whether the same pricing policies have been consistently applied and if not, whether the changes can be justified.
3.3.8 Annual Caps
(a) The sponsor should request and critically review the value of the continuing connected transactions during the listing applicant’s track record period. In considering whether the proposed annual caps are fair and reasonable, the sponsor should compare the historical amounts of the transactions with the annual caps proposed, review the proposed annual caps in light of the listing applicant’s business plan and review the bases and assumptions upon which the proposed annual caps are based to determine whether they are fair and reasonable. The sponsor should also consider whether it is appropriate for an expert to advise on the appropriateness of annual caps and look at available market comparables of the basis for setting the proposed annual caps (see paragraphs 3.3.3 and 3.3.4 above).
(b) For instance, in the context of a continuing connected transaction for the purchase of raw materials, if the listing applicant has recently expanded or will be expanding its production capacity by purchasing more machines or if the listing applicant’s utilisation capacity is expected to increase, the listing applicant may anticipate that its purchase of raw materials would increase in the future.
(c) The sponsor should also consider whether the monetary caps are fair and reasonable from the point of view of the listing applicant’s shareholders and if they are in the interests of the listing applicant’s shareholders as a whole. For example, if the continuing connected transaction is intended to be a transitional arrangement, is the cap set at a level that makes it unlikely that the company would feel the need to seek alternative suppliers in the future?
(d) Where the listing applicant considers that a non-monetary cap would be appropriate for a connected transaction (for example, an annual cap based on a percentage of the listing applicant’s revenue or index-linked), the sponsor should consider the reasons why a monetary cap would not be appropriate and whether the proposed basis for the non-monetary cap would be fair and reasonable and in the interests of the listing applicant’s shareholders as a whole. The sponsor should also consider whether it is appropriate to consider market comparables of the basis for setting the proposed annual caps (see paragraph 3.3.4 above). For example, given volatile fluctuations in the prices of the goods to be supplied to or purchased from the connected person, a non-monetary cap based on the listing applicant’s revenue may be appropriate in the circumstances as it may be difficult for the directors to reasonably estimate the annual cap and it would be prejudicial and disruptive to the listing applicant’s operations if it was required to seek independent shareholders’ approval regularly to approve an increase in the annual cap.12
(e) In relation to listing applicants in the internet technology sector or that have internet-based business models, the Stock Exchange has acknowledged that there may be cases in which it is impractical to accurately estimate the amount of payment required, as the listing applicant may have a short operating history or be in a growth phase such that historical revenues would not be reliable. In such cases, the Stock Exchange proposes to grant to listing applicants in these sectors waivers from strict compliance with the requirement to set a monetary annual cap under the Listing Rules and allow the annual cap to be set as a formula on a case by case basis, provided that the listing applicant demonstrates the necessity for such an arrangement in the circumstances of its case and the formula to be adopted is in line with historical and prevailing commercial practices.13
(f) In addition, if the connected transactions and annual caps are large relative to the listing applicant’s size (i.e., taking into account the listing applicant’s revenue, profits and net assets), such reliance on a connected person for the transaction may affect the listing applicant’s suitability to list.
(g) The sponsor should document its analysis on annual caps.
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.