Due diligence from the issuer's side

Most companies arrive at a Hong Kong listing thinking of due diligence as something done to them. The Listing Rules frame it the other way. The sponsor answers to the Exchange and the Securities and Futures Commission (SFC), and the applicant and its directors answer to the sponsor, in writing, before the work begins¹.

The duty sits with the applicant and its directors

Main Board Rule 3A.05 puts it plainly: a new applicant and its directors must assist the sponsor to perform its role, and must ensure its substantial shareholders and their associates do the same¹. The rule then prescribes the minimum obligations the written engagement agreement required by Rule 3A.02 must contain¹. The duty is contractual, and the sponsor will hold you to it because its own standing with the regulators depends on it.

What the engagement agreement must commit you to

Rule 3A.05 lists seven obligations the agreement must place on the applicant and its directors¹:

• Fully assist the sponsor's due diligence¹.
• Procure full cooperation with the sponsor from everyone engaged for the listing, including financial advisers, experts and other third parties¹.
• Help each sponsor meet its own duty to inform the regulators, including why a sponsor ceases to act¹.
• Give the sponsor access to all relevant records for the application¹.
• Keep the sponsor informed of any material change to information it has been given or has accessed¹.
• Provide or procure every consent needed for that information to reach the sponsor¹.
• Procure supplements to expert engagement letters where needed to meet the access requirement¹.

The fourth is the demanding one. Under Rule 3A.05(4), the terms of engagement with every expert retained for the listing, whether or not for an expert section, must entitle every sponsor to access the expert, the expert's reports, draft reports (written and oral) and terms of engagement, the information provided to or relied on by the expert, the information the expert has given to the Exchange or the SFC, and all correspondence between the applicant or its agents and the expert, and between the expert and either regulator¹.

What the sponsor must be able to say before it files

Paragraph 17.4 of the SFC Code of Conduct answers the timing question: it sets the work a sponsor must complete before submitting an application to the Exchange². Four things must be true at that point.

First, the sponsor must have performed all reasonable due diligence on the applicant and put all material information arising from it into the Application Proof². Second, it must hold a reasonable opinion that the Application Proof is substantially complete². Both allow for matters that by their nature can only be dealt with later².

Third, it must hold a reasonable opinion on four compliance points². The applicant meets the Chapter 8 listing qualifications, except where waivers have been applied for in writing². It has procedures, systems and controls, including accounting and management systems, that let it and its directors comply with the Listing Rules and other legal and regulatory requirements on an ongoing basis, and that give the directors a reasonable basis to assess its financial position and prospects². And the directors collectively have the experience, qualifications and competence to manage the business, and individually to perform their own roles, with an understanding of their obligations under the Listing Rules².

Fourth, on submission it must disclose in writing to the Exchange every material issue known to it that bears on the applicant's suitability for listing, or on whether the listing would be contrary to the interest of the investing public or the public interest².

For the applicant, we read that as the deadline. Whatever the sponsor needs to reach those opinions must be in its hands before submission. Only matters that by their nature cannot be settled earlier may wait².

The inquiries set out in Practice Note 21

Practice Note 21 describes the due diligence the Exchange expects a sponsor will typically perform, not the actual steps for any case, since each applicant is unique and so are the inquiries its listing requires³. The sponsor inquires until it can reasonably satisfy itself on the disclosure in the listing document, and examines what the applicant and its directors tell it with professional scepticism³.

On the numbers, paragraph 13 has the sponsor assess the financial information going into the listing document and obtain the applicant's and directors' written confirmation, given after due and careful inquiry, that figures not already reported on by the reporting accountant were properly extracted from the underlying accounting records³. It tests the business plan and any profit forecast against past performance, from historical sales and payment terms to financing costs, long-term liabilities and working capital needs³. It also asks whether it is reasonable to conclude the proceeds will be used as proposed, judged against existing cash and liquid reserves, projected liabilities, working capital and expenditure controls³.

On people, that assessment would normally include interviewing senior management and would often involve interviewing major suppliers and customers, creditors and bankers³. We would tell those counterparties to expect the call.

On assets and operations, the sponsor physically inspects material assets, owned or leased, including property, plant, equipment, inventory and biological assets, and checks the documentation showing they are appropriately held³. It seeks to understand production methods, marketing, distribution channels, pricing, after-sales service, maintenance and warranties, and the existence and validity of intellectual property, licensing arrangements and other intangible rights³.

On legal matters, it reviews the business aspects of every material contract, and legal proceedings and material disputes that are current, recently resolved (the Note's example is within the previous 12 months) or known to be contemplated³.

On the business itself, it considers the industry and target markets, including geography, segment and competition, the economic, political and legal conditions that may materially affect the business, and the commercial viability of the offering, including obsolescence risk, market controls, regulation and seasonal variation³. It also asks whether anything since the last audited balance sheet date needs disclosure to keep the listing document complete and not misleading³.

The record the sponsor keeps

The Exchange expects a sponsor to document its due diligence planning and any significant deviation from it, showing it turned its mind to which inquiries were necessary and reasonably practicable, and to document its conclusions on the applicant's compliance with every condition in Chapter 8, allowing for any the Exchange has waived³. Those inquiries underpin the declaration in Appendix 19 that Rule 3A.13 requires³.

Read from the issuer's side, that file is a record of what you were able to substantiate, condition by condition and waiver by waiver. A claim the company cannot evidence is not one the sponsor can conclude on, and a conclusion it cannot reach is not one it can file behind.

The next step

Before the sponsor's team begins, have your counsel set the draft sponsor engagement agreement beside every expert engagement letter already signed and mark each against the seven obligations in Rule 3A.05 and the access clauses in Rule 3A.05(4)¹. Where an expert letter falls short, table the supplement Rule 3A.05(7) requires and have it signed before the sponsor relies on that expert's work¹.

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