Due Diligence Guidelines –
Code of Conduct Paragraphs
Key Stock Exchange Guidance
Paragraph 13(h) of Practice Note 21 to the Listing Rules
Paragraph 52 of Part A of Appendix 1 to the Listing Rules
1. Understanding the Listing Applicant
1.1.1 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]
1.1.2 Regarding the preparation of a listing document, a sponsor should … :
(ii) achieve a thorough understanding of the listing applicant, including its business, history, background, structure and systems; and [Paragraph 17.6(d)(ii) of the Code of Conduct]
(vi) 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]
1.2.1 The sponsor should identify and review the business aspects of, and its lawyers should consider any legal issues arising from, all material contracts entered into by any member of the listing applicant, in particular those entered into by the listing applicant during the track record period as well as those entered into before the track record period which have an on-going impact on the listing applicant, as part of its due diligence of the listing applicant particularly with respect to its business and performance as well as its financial condition and prospects.1
1.2.2 The sponsor should not confine its due diligence review to only “material contracts” as they are, narrowly, defined in paragraph 52 of Part A of Appendix 1 to the Listing Rules since that definition only addresses the requirements to disclose contracts entered into outside the ordinary course of business.2 Rather, for due diligence purposes, “material contracts” should include all contracts entered into both in or outside the ordinary course of business that are material to the business, financial condition or prospects of the listing applicant.
1.2.3 Whether certain contracts are “material contracts” depends on the nature of the contract, the industry in which the listing applicant operates and the size of the listing applicant. As such, the criteria for determining whether a contract is a “material contract” will vary on a case-by-case basis.
1.2.4 Non-exhaustive examples of material contracts include contracts relating to pre-IPO investments, loan and security documents, business combination agreements, agreements relating to the acquisition or disposal of substantial assets, and structured contracts relating to VIE corporate structures.3
1.3 Recommended Steps
1.3.1 The Listing Rules do not prescribe a materiality threshold for purposes of determining “material contracts”. As such, the sponsor should set out specifically both the qualitative and quantitative criteria for determining “material contracts” in its due diligence request list.
1.3.2 In setting the criteria for determining which contracts are “material contracts”, the sponsor should consider “materiality” in the following aspects:
(a) Size of the contract – the value of the contract relative to the assets or revenue of the listing applicant.
(i) The sponsor and its lawyers should discuss and come up with an appropriate threshold above which a contract would be classified as a “material contract”.
(ii) For instance, such threshold could be expressed as a percentage of total revenue or total assets of the listing applicant.
(b) Dependency – the degree of reliance of the listing applicant on the subject matter and its significance to the listing applicant’s business.
(i) Examples of such contracts include major customer and supplier contracts. Consideration should be given as to whether a supplier could be easily replaced, if at all, and whether the need to replace such supplier, or the absence of such supplier would have a material adverse effect on the business of the listing applicant. Similarly, contracts with customers that represent a significant proportion of the listing applicant’s sales or revenue should also be reviewed.
(ii) For contracts which reveal reliance by the listing applicant on any person, the sponsor should perform additional due diligence steps set out in section 5 of Chapter 8 “Due Diligence Guidelines – Business Model”.
(iii) For contracts with connected persons which may constitute continuing connected transactions after listing, the sponsor should perform additional due diligence steps set out in Chapter 11 “Due Diligence Guidelines – Connected Persons and Connected Transactions”.
(c) Financial impact on the listing applicant – the strategic importance of a contract to the listing applicant from an investor’s perspective.
(i) Examples of such contracts include those which may:
(A) generate significant future cashflow or revenue;4
(B) affect the listing applicant’s profit forecast (if any);
(C) commit the listing applicant to substantial financial obligations which may affect the ability of the listing applicant to realise its business plans;
(D) impose any impediments on the listing applicant’s ability to participate in any future fund-raising exercises; and/or
(E) impose financial covenants with significant restrictions on what the listing applicant can do, e.g., pay dividends, make acquisitions, dispose of assets, raise new financings, make investments or undertake a change of control in debt instruments.
(ii) For additional due diligence steps which the sponsor should take in relation to financial due diligence, please see also Chapter 12 “Due Diligence Guidelines – Financial”.
(d) Corporate structure – contracts which relate to the restructuring of the listing applicant.
(i) Examples of such contracts include business combination agreements, agreements relating to the acquisition or disposal of substantial assets, subscription and investor rights agreements involving pre-IPO investors, and structure contracts relating to VIE corporate structures.5
(ii) The sponsor should consider whether the transfers of shares or equity interests in the listing applicant’s corporate restructuring are complete and legally valid.
(e) Onerous obligations – contracts which impose onerous or restrictive covenants which must be observed by the listing applicant.
(i) Examples of such contracts include contracts containing indemnities, change of control or confidentiality provisions.
(ii) The sponsor should consider whether committing to such onerous obligations (contingent or otherwise) is in line with market practice in the relevant industry and, if not, the rationale for entering into such commitment.
1.3.3 Upon receipt of the contracts provided by the listing applicant in response to the due diligence request, the sponsor should work with its lawyers to ascertain whether such contracts constitute “material contracts” and further request for review documentation which is relevant to the material contracts in question.6
1.3.4 To the extent that the material contracts reveal any circumstances that cast doubt on the completeness and accuracy of the information provided by the listing applicant relating to its history and background, business and performance, financial condition and prospects, operations and structure, procedures and systems as disclosed in its draft listing document, the sponsor should undertake additional due diligence or independent verification to ascertain the truth and completeness of the matter and the information concerned.7 Such steps include independently interviewing relevant persons who are knowledgeable about the matter and information or hiring third-party investigators to verify such matters and information.
1.3.5 The extent of due diligence on the identities and background of the parties to the contract will depend on the size and nature of the contract.
(a) For guidance on due diligence relating to major business stakeholders, see also section 2 of Chapter 7 “Due Diligence Guidelines – Knowing the Listing Applicant and its Management”.
(b) For guidance on due diligence relating to major customers, suppliers and other major stakeholders, see also Chapter 9 “Due Diligence Guidelines – Interviews of Major Business Stakeholders”.
1.3.6 Given the responsibilities of the sponsor, the listing applicant should not withhold any material contracts for review. In particular, the entire copy including supplemental agreements or any amendments should be provided and should not be withheld from the sponsor on the ground of the purported sensitivity or confidential nature of a contract.8 The listing applicant should not refuse to allow the sponsor to interview any relevant persons in connection with the material contracts.9 For guidance relating to the sponsor’s access to all information, including confidential information, see paragraph 2.2.2 of Chapter 3 “Due Diligence Guidelines – Approach and Scope”.
1.3.7 Any reluctance or significant delay on the part of the listing applicant to provide details of the material contracts and the names, titles and contact details of the persons with knowledge of the relationship between a counterparty to a material contract and the listing applicant whom the sponsor wishes to interview should be noted.
1. Paragraph 13(h) of Practice Note 21 to the Listing Rules requires the sponsor to conduct due diligence enquiries which include reviewing the business aspects of all contracts material to the listing applicant’s business. By “business aspects”, the Stock Exchange means non-legal aspects.
2. Paragraph 52 of Part A of Appendix 1 to the Listing Rules requires disclosure of the dates of and parties to all material contracts (not being contracts entered into in the ordinary course of business) entered into by any member of the group within the two years immediately preceding the issue of the listing document.
3. In the case of a listing applicant being a party to certain contractual arrangements designed to confer various rights on the listing applicant in light of certain regulations applicable to the industry sector of a foreign jurisdiction in which the listing applicant operates that is subject to limited foreign investment, the sponsor should refer to Exchange Listing Decision LD43-3 for issues which should be raised including the related risk factors. See also Exchange Listing Decision LD33-2012 where the standard of review on the use of structured contracts in Exchange Listing Decision LD43-3 was applied.
4. See SFC Dual Filing Update of December 2008 in which the SFC comments that “(s)ufficient explanations on future funding requirements and sources of funding are essential for investors’ assessment of listing applicant’s prospects and the relevant business risks. Sponsors play an important role in assisting listing applicants to disclose sufficient relevant information.”
6. See SFC Dual Filing Update of September 2007 in which the SFC criticised that the listing applicants failed to comprehensively disclose the implications if the parties do not perform their obligations in accordance with certain contractual agreements or if the legality and enforceability of the contractual arrangements are questioned, and the sponsors performed further due diligence on the legality of the structures only after queries were raised by the regulators.
7. Paragraphs 17.6(c) and 17.6(d)(ix) of the Code of Conduct.
8. To address the concern of the listing applicant about the disclosure of material contracts pursuant to paragraph 53 of Part A of Appendix 1 to the Listing Rules, the Stock Exchange may allow confidential wording in material contracts to be redacted in the copies to be made available for public inspection. See also paragraphs 3.4 and 3.5 of the Exchange Guidance Letter GL21-10: The Stock Exchange expects sponsors to have access to all information of the listing applicant, including highly confidential information, to enable them to complete their due diligence process. The listing applicant’s internal policy restricting access to confidential information to directors, auditors and reporting accountants only does not justify refusing sponsors access to such information. The Stock Exchange will also not accept a sponsor confirming completion of the due diligence process with a qualification that it is not provided access to the listing applicant’s confidential information even if alternative due diligence work has been performed. The Stock Exchange ordinarily expects at least one senior officer of the sponsor to be allowed access to the listing applicant’s confidential information.
9. Listing Rule 3A.05: The listing applicant and its directors must assist the sponsor to perform its role. To facilitate the sponsor to meet its obligations under the Listing Rules and the Code of Conduct, the written engagement agreement appointing the sponsor must contain certain obligations for the listing applicant and its directors which include, inter alia, obligations to: (i) fully assist the sponsor to perform its due diligence work (Listing Rule 3A.05(1)); and (ii) enable the sponsor to gain access to all relevant records in connection with the listing application (Listing Rule 3A.05(4)).
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.