Due Diligence

The Stock Exchange of Hong Kong Limited ( the “HKEX”) published two consultation conclusions —"The Profit Requirement Consultation Conclusions” and “Disciplinary Consultation Conclusions” on 20 May 2021 with an aim to further raising the quality of the Hong Kong capital market,. Among them, HKEx has decided to increase the profit requirements of the Main Board by 60%, with effect from 1 January 2022. That is, the most recent financial year shall not be less than HK$35,000,000 and, in respect of the two preceding years, be in aggregate not less than HK$45,000,000 (The three-year cumulative profit is not less than HK$80,000,000). At the same time, the HKEX will also grant grace for individual applicants that do not meet the profit distribution, and handle them flexibly.
 
The Profit Requirement is one of the three pivotal financial eligibility tests forming part of the assessment the HKEX performs to determine the suitability of applicants seeking to list on the Main Board. The most recent increase in the market capitalisation requirement was in 2018, from HK$200 million to HK$500 million. However, the profit requirement has not been revised since it was introduced in 1994.
 
The consultation conclusion pointed out that certain cases involving suspected arrangements to artificially satisfy the initial listing requirements. The Securities and Futures Commission of Hong Kong (the “SFC”) stated in a joint statement that certain IPO may allocate shares to controlled placees at a high share price to meet the HK$500 million minimum market capitalisation requirement. Its purpose is to manipulate the relevant shares in the future. For example, through a ramp-and-dump scheme to “ramp” up the share price. Ramp-and-dump scheme is a form of stock market manipulation where fraudsters use different means to “ramp” up the share price of a listed company and then induce unwary investors to purchase the shares that the fraudsters then “dump” at an artificially high price. The schemes are typically conducted using social media platforms.
 
In light of the concerns identified in the joint statement, where a listing application displays one or more of the following features, the SFC and HKEX will make enquiries: 
<ul>
<li>The applicant’s market capitalisation barely meets the minimum threshold under the Listing Rules</li>
<li>Very high price-to-earnings (“P/E”) ratio</li>
<li>Unusually high underwriting or placing commissions or other listing expenses</li>
<li>Shareholding is highly concentrated in a limited number of shareholders</li>
</ul>
 
On the same date, HKEX has also published a disciplinary consultation. It will augment the range of reputational sanctions available.  It will ensure that disciplinary action can be brought against a broader range of individuals, including members of senior management, if they cause or knowingly participate in a contravention of the Listing Rules. The disciplinary consultation conclusions will be implemented with effect from 3 July 2021.
 
Click the below cover images to read the Consultation Conclusions and the Joint Statement. 
 
<a href="https://www.hkex.com.hk/-/media/HKEX-Market/News/Market-Consultations/2016-Present/November-2020-MB-Profit-Requirement/Conclusions-(May-2021)/cp202011cc.pdf?la=en" target="_blank" rel="noopener"> <img src="../../../../../uploads/hkex_consultation_conclusions_cover_1_8576f0a758.jpeg" width="250" height="351" /> </a> <a href="https://www.hkex.com.hk/-/media/HKEX-Market/News/Market-Consultations/2016-Present/August-2020-Disciplinary-Powers/Conclusions-(May-2021)/cp202008cc.pdf?la=en" target="_blank" rel="noopener"> <img src="../../../../../uploads/hkex_consultation_conclusions_cover_2_fa028251b4.jpeg" width="250" height="355" /> </a> <a href="https://www.hkex.com.hk/-/media/HKEX-Market/News/News-Release/2021/210520news/IPOJointStatement_e.pdf?la=en" target="_blank" rel="noopener"> <img src="../../../../../uploads/SFC_joint_statement_b4bf6135be.JPG" width="250" /> </a>

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HKEX Consultation Conclusions on The Main Board Profit Requirement and Review of Listing Rules Relating to Disciplinary Powers and Sanctions

The Stock Exchange of Hong Kong Limited (“HKEX”) published a consultation paper titled ‘Review of Listing Rules Relating to Disciplinary Powers and Sanctions’ (the “Consultation Paper”) in August 2020, which proposed changes in respect of HKEX’s disciplinary regime. The Consultation Paper follows a wide-ranging review of the HKEX’s disciplinary powers and sanctions under Chapter 2A of the Listing Rules, to ensure that the disciplinary regime continues to remain robust and effective. The consultation period had ended on 9 October 2020.
 
The key enhancements to the existing disciplinary regime are set out below. 
<ol>
<li>Lowering existing thresholds for public statements regarding individuals Currently, the HKEX’s power to issue a public statement to the effect that a director continuing to remain in office is prejudicial to the interests of investors (“PII Statement”) can only be exercised where there has been a wilful or persistent failure by the director to discharge his responsibilities under the Listing Rules. The HKEX is proposing to remove this threshold as it is difficult in determining whether an action is wilful. This amendment will provide greater flexibility to the HKEX in being able to issue PII Statements against directors where warranted, without the need to prove that the director’s conduct is wilful or persistent. </li>
<li> Enhancing follow-on actions in relation to public statements regarding individuals and publication requirements Currently, the follow-on actions which the HKEX may direct where an individual subject to a PII Statement remains in office as a director are limited to suspension or cancellation of listing of the issuer’s securities or any class of its securities. In order to bring the compliance attitudes and cultures within listed issuers into sharp focus for the purpose of benefitting the investing public, the following enhancements are proposed in case of serious misconduct: (a) The follow-on actions which the Listing Committee or the Listing Review Committee may direct include the denial of facilities of the market to that listed issuer for a specified period; and (b) The follow-on actions apply where an individual subject to a PII Statement continues to be a director or senior management member of the specified listed issuer. The HKEX also proposes that, after a PII Statement with follow-on actions has been made against an individual, the listed issuer identified in the statement must include a reference to the PII Statement in all of its announcements and corporate communications, unless and until that individual is no longer a director or a senior management member of the relevant listed issuer. </li>
<li>Introducing director unsuitability statements For more serious cases of misconduct where there is a evident or repeated failure by a director to discharge his responsibilities, the HKEX is proposing a new sanction, which would enable it to issue a public statement that, in its opinion, the director is unsuitable to occupy a position as a director or within the senior management of a named listed issuer or any of its subsidiaries. </li>
<li>Introducing secondary liability The HKEX is also proposing to introduce secondary liability for Listing Rule breaches in circumstances where it determines the person “has caused by action or omission or knowingly participated in a contravention of the Listing Rules”. These persons may include directors and senior management, substantial shareholders, professional advisers and their employees, authorised representatives, supervisors and a guarantor of an issuer in the case of a guaranteed issue of debt securities or structured products. Set out below are some examples of how secondary liability would be applied: (a) Chief Financial Officers for failure to obtain auditors’ agreement before publication and material inaccuracy of preliminary results announcement; (b) Chief Operating Officers for failure to disclose share charge in a timely manner and in its interim report; (c) Company Secretaries for material inaccuracy of listed issuer’s announcement of controlling shareholder’s transfer of shares; (d) Substantial Shareholders for breach of maintain minimum public float; (e) Financial Advisers for material inaccuracy of listed issuer’s Circular.</li>
</ol>
 
We believe the proposed enhancements could further enable the HKEX to take timely and effective disciplinary actions, which in turn promote market quality and maintain the integrity of the Hong Kong capital market.

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HKEX Consultation Paper on ‘Review of Listing Rules Relating to Disciplinary Powers and Sanctions’

The Securities and Futures Commission (“SFC”) of Hong Kong has issued a statement on 4 July 2019 (the “Statement”) in which the directors’ duties when considering corporate acquisitions or disposals have been further stressed. The Statement listed out several key types of misconduct and deficiencies of the directors commonly seen in transactions, in particular, lack of independent valuation, lack of due diligence on target entity’s financial position, inappropriate valuation procedures, etc.  Further to the “Guidance note on directors’ duties in the context of valuations in corporate transactions” issued on 15 May 2017, the SFC once again reminds directors that they are liable for ensuring the information in relation to a planned corporate transaction should be compiled with due care. Apart from the financial forecast or profit guarantees, the historical financial position of the target entity also requires a thorough analysis in the process of a proper due diligence.  As an experienced independent valuation and advisory firm, AVISTA has outlined following common queries that corporates might raise when aligning directors’ duties with the SFC’s updated requirements in corporate transactions.
 
What are the appropriate procedures in considering any planned corporate transaction?
 
Although it is not expressly required by statutory law or under the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (the “Listing Rules”), engaging an independent professional valuer, as well as a financial advisor, are recommended for directors in contemplating potential transactions.
 
A professional independent valuer is able to aid the directors in assessing the business performance and prospects of the target entity, so as to protect the interests of the company and its stakeholders.
 
In addition, in case of a connected transaction, an independent financial advisor (“IFA”) is required to be appointed under Chapter 14A of the Listing Rules. IFA will assist the directors in reviewing the overall reasonableness of the transaction, including but not limited to the terms of the potential transaction, the basis of determining the consideration and the valuation report.
 
Independent professional valuation has been obtained. Would that sufficiently fulfill the SFC’s requirements on directors’ duties?
 
Apart from conducting independent valuation, the SFC has also shown increasing concerns about the reliability of the target entity’s financial information.
 
As a matter of fact, financial and legal due diligence is becoming more commonly performed as a part of pre-deal due diligence. In particular, financial due diligence (“FDD”) is an extensive process for a thorough and complete assessment of the target entity's business, assets, capabilities and financial performance.
 
FDD enables the directors to scrutinize the quality of earnings and the financial position of the target entity, which is considered to be a prerequisite for any potential transactions. Such due diligence work allows the directors to identify any potential risk in early stage of the potential transaction, which could possibly enhance directors’ duty to exercise due and responsible care, skill and diligence in the discharge of their duties.
 
Why are the regulators still showing concerns even market approach has been adopted in the valuation? 
 
There has been an upward trend in the applications of market approach. However, the SFC has noted certain cases in which the valuation parameters have been “cherry-picked”.
 
In order to conform with the regulators’ standards, the valuation has to be carried out under a fair and reasonable basis. In adopting market approach, a systematic way of selection of comparable companies constitutes one of the essential parts of the valuation. Factors such as business nature, development stage, geographical location, etc. of the target entity should be considered such that an exhaustive list of comparable companies could be obtained.
 
To read the full statement released by the SFC, please click <a href="https://www.sfc.hk/web/EN/news-and-announcements/policy-statements-and-announcements/statement-on-the-conduct-and-duties-of-directors.html" target="_blank" rel="noopener">here</a>.
 
 
AVISTA’s Professional Services for Corporate Transactions
 
AVISTA provides one-stop financial advisory services that help clients achieve additional growth and ensure their compliance with regulators’ stringent rules and disclosure requirements when implementing business decisions and strategies. 
 
<ul style="text-align: left;">
<li>Valuation Services for Transactions</li>
<li>Financial Due Diligence Service </li>
<li>Risk Advisory Review on Target</li>
</ul>