Hong Kong Sponsor Due Diligence Guidelines

Chapter 13.6 – Steps to be Taken When Material Deficiencies Remain Outstanding

Chapter 15.1 – Acquire a Thorough Understanding of the Listing Applicant and Assess the Legality and Compliance of its Business Operations

Due Diligence Guidelines –

Distributors, Franchisees and Consignees

1. Understanding a Listing Applicant and its Business, Performance, Financial Condition and Prospects

1.1 Standards

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 … gain a sufficient understanding of the industry in which the listing applicant operates, including reviewing key characteristics of the industry and data about competitors. [Paragraph 17.6(d)(iii) of the Code of Conduct]

1.1.3 Regarding the preparation of a listing document, a sponsor should …assess the legality and compliance of the business operations and whether the listing applicant is subject to any material legal proceedings or disputes. [Paragraph 17.6(d)(vii) of the Code of Conduct]

1.2 Guidance

Understanding the business model

1.2.1 Distributorship, franchising and consignment may take many different forms. Given that sellers may have different arrangements and degrees of control over their distributors, franchisees or consignees, the consequential risks could be very different. 1 The sponsor should, therefore, gain a detailed understanding of the business model of the listing applicant in order to identify the specific risks associated with its operations and to ensure that the true nature of the listing applicant’s business is accurately described in the listing document. 2

1.2.2 The following is a description of how a distributorship, franchise and consignment may typically be structured. It is not intended to be exhaustive:

(a) Distributorship

Distributorship refers to the business model where a distributor purchases goods from a supplier or manufacturer and resells them as principal to customers. There is no contractual relationship between the supplier or manufacturer and the customers. There are different types of distributorships, including exclusive distributorship, sole distributorship, non-exclusive distributorship and selective distributorship. 3 Suppliers or manufacturers may, in the distributorship agreement, impose varying degrees of control over the distributors in areas such as product pricing, restrictions on the territories in which the products may be distributed, and minimum purchase commitments or sales targets.

(b) Franchise

In a franchise, the franchisee operates its business under the franchisor’s trade name or trade mark under licence by the franchisor. The franchisor exercises continuing and substantial control over the franchisee (such as requiring franchisees to adopt standardised marketing strategy, after-sales services, pricing and sales model) and provides assistance to the franchisee (such as management and employee training). The franchise may also involve the licensing of exclusive technical knowhow or bespoke operating systems (such as inventory control systems) by the franchisor to the franchisee during the term of the franchise. There are different types of franchising, including direct franchising, master franchising, development arrangements and subordinated equity arrangements. 4 Typically, the franchisee has to pay the franchisor a one-off fee at the time when the franchise is granted and royalty payments on a recurring basis, which are typically tied to the level of revenue generated by the franchisee. The franchisee is usually obliged to purchase all products from the franchisor and is often required to contribute to the costs of marketing or advertising campaigns being conducted by the franchisor.

(c) Consignment

Under a consignment, products are placed by the consignor with the consignee for sale at the consignee’s premises but ownership remains with the consignor until the products are sold to the customers. The consignee is typically not responsible for loss or damage of the products during transportation or delivery or while they are in the consignee’s custody. The consignor pays the consignee a fee, which is usually calculated as an agreed percentage of the price of the consigned products which have been sold. When manufacturers of consumer goods sell their products at third party retail outlets (such as a department store), it is often done on a consignment basis.

1.2.3 Distributors, franchisees and consignees will normally enter into a specific written agreement with the listing applicant setting out the terms of their business relationship with the listing applicant, but this may not invariably be the case. Where there is any suggestion that the listing applicant may be selling its products through third party intermediaries, it is essential that the sponsor should identify and understand the exact nature of the relationship between the listing applicant and those intermediaries, particularly where such relationship is not evidenced by a written agreement. It is important, for instance, to draw the following distinctions in considering whether this due diligence guideline is applicable and hence, the recommended steps described below should be followed:

(a) Distributors, franchisees and consignees all operate as intermediaries and are not the end customers of the products being sold by the listing applicant. In the case of a distributorship or franchise, the distributors or franchisees will typically be purchasing products from the listing applicant as principal for on-sale to end customers or further levels of sub-distributors or sub-franchisees and hence, from the listing applicant’s perspective, those distributors or franchisees will also be its customers. It is important, therefore, to distinguish between distributors and franchisees (who may also be customers) and “normal” customers, particularly where the listing applicant sells its products both directly to end customers and through distributors or franchisees. In the case of a consignment, the consignees do not typically purchase products from the listing applicant and sales of those products should only be recognised by the listing applicant when they are sold by the consignees on behalf of the listing applicant. It is important to be alert to situations where e.g., the listing applicant purports to treat parties who are in substance consignees as customers and on such basis, to recognise sales when the products are delivered to the consignees when those sales should only be recognised when the products are sold by the consignees on behalf of the listing applicant.

(b) Distributors, franchisees and consignees should also be distinguished from agents of the listing applicant. Distributors, franchisees and consignees typically have a principal to principal relationship with the listing applicant and not one of agency. Distributors, franchisees and consignees would not normally have the power to enter into contracts on behalf of or otherwise to create any binding obligation on the listing applicant and the listing applicant would not normally become vicariously liable for their acts, both of which are common features of an agency relationship. An agency relationship (such as in the context of a property agency business) gives rise to different risks and due diligence considerations, which are not within the scope of this due diligence guideline.

1.2.4 For a business involving distributorship, it may operate with a distribution network that comprises a combination of the different types of distributorship arrangement described in paragraph 1.2.2(a) above and/or which comprises a vertical chain of distributors where one distributor resells the goods to a sub-network of distributors. In the latter case, the sponsor should consider performing different levels of due diligence on the different tiers of distributors reflecting the nature and extent of the relationship between the listing applicant and the distributors, and the number of distributors at different tiers in the chain.

Understanding the risks involved

1.2.5 The Stock Exchange has issued Exchange Guidance Letter GL36-12 (the “Guidance Letter”), 5 which deals specifically with risks and disclosure in listing documents for listing applicants whose business models involve multi-level distributors, franchisees or consignees (collectively, “distributors”). In the Guidance Letter, the Stock Exchange highlighted the following risks:

(a) Inventory risk

(i) Where there has been a sharp increase in sales during the track record period, there is a risk that these are artificially inflated sales unsustainable by an actual rise in demand from ultimate end-users. Goods may be shipped to distribution channels and not to end customers (channel stuffing). The excess inventory may be stocked in multiple warehouses and retail outlets throughout the distribution chain over which the listing applicant has no information and control, thereby making it difficult to determine and manage the amount of excess inventory.

(ii) A minimum purchase condition in the listing applicant’s distribution agreement with its distributors may be translated into a risk of inventory accumulation.

(iii) The presence of one or more of the following features may require delay in revenue recognition:

(A) the applicant retains significant ownership risks of ownership although legal title has been passed to the distributors;

(B) sales to distributors on a “right of return” basis and payment is delayed or otherwise different from typical sales agreements;

(C) the applicant is required to repurchase the product at a price with adjustment that covers the distributor’s cost of holding the product, including financing cost; and

(D) the applicant guarantees a minimum resale value.

(b) Cannibalisation

Where aggressive growth in sales is achieved by sales made to a rapidly increasing number of distributors, there is a risk that such growth in sales, or profits arising from royalty payments (if any) received from distributors for initial set up, may not be sustainable if there are too many distributors in the market.

(c) Recoverability of accounts receivables

Where a substantial increase in sales is coupled with a substantial increase in accounts receivable and debtors’ turnover days, issues arise about the recoverability of these receivables and the sustainability of the listing applicant’s business.

(d) Independence of distributors

Goods may be sold to (1) distributors or sales representatives who were previously employees of the listing applicant or (2) sales partners who trade under the listing applicant’s name but who are owned or controlled by related parties of the listing applicant. This gives rise to uncertainty as to the independence of the customers of the listing applicant and the authenticity of its sales.

1.2.6 In addition to the risks highlighted by the Stock Exchange in the Guidance Letter, other operational risks associated with distributorships, franchises and consignments may include:

(a) Inadequate monitoring or control

The ability of the listing applicant to monitor and control the performance of its distributors, particularly in the case of a franchise where the franchisees will be using the trade name and/or trade mark(s) of the listing applicant to carry on business, is critical. The type and degree of monitoring and control which may be imposed on distributors may vary among different industries but typically, would cover areas such as competition control (by for instance, imposing limits on territory of operation), pricing control, inventory control, disposal of obsolete or unsold stock, regular reporting of sales and market feedback, minimum purchase commitments and sales performance targets. In the case of a consignment, it is important for the listing applicant to have an effective inventory record system to track the products which are being placed on consignment from time to time (including items which have been sold, those which have not yet been sold but have remained in the consignee’s custody and those which have been returned) and an effective cash management system to monitor the sales proceeds collected by the consignees on sale of the products placed on consignment. The sponsor should review whether the listing applicant has put in place adequate mechanisms to enable it to monitor and control the performance of its distributors.

(b) Inadequate protection of intellectual property rights

Where any intellectual property right (such as the right to use any trade name, trade mark or patent) is being licensed by the listing applicant to any of its distributors, the terms of the licence should impose control that would prevent the misuse of the relevant trade name, trade mark or patent by the distributor (such as specifying the purpose for which and the territory in which it may be used). The sponsor should review whether the listing applicant has put in place adequate mechanisms to enable it to protect any intellectual property right that has been licensed to its distributors.

(c) Conflict of interests

The listing applicant may sell its products entirely through a network of distributors or franchisees or it may sell its products partly through distributors or franchisees and partly through self-owned sales channels. In the latter case, the sponsor should review whether the listing applicant has put in place adequate mechanisms to ensure that competition will not arise between any of its distributors or franchisees and its self-owned sales channels.

(d) Reliance

If, in the opinion of the sponsor, the listing applicant derived a significant portion of its revenue from a small number of distributors over the track record period, the sponsor should review the consequential risks, such as the risk of any of those distributors discontinuing its business relationship with the listing applicant and the ability of the listing applicant to find a suitable replacement in such event.

(e) Corruption

(i) The risk of corruption exists generally in any business but the sponsor may need to be particularly vigilant where for instance:

(A) the market for the listing applicant’s products is dominated by a limited number of distributors or is particularly competitive;

(B) the listing applicant operates in an industry or market that is subject to a high degree of government regulation or control (e.g., pharmaceuticals); or

(C) the listing applicant has achieved what may appear to the sponsor to be an unusually high rate of growth in its sales within a relatively short period of time during the track record period.

(ii) The risk of corruption may exist in both (1) dealings between the listing applicant and the sales representatives or employees of its distributors, particularly where the arrangement includes the payment of incentives or where the listing applicant is responsible for reimbursing any marketing or other costs or has agreed to provide any other form of financial support; and (2) dealings between the distributors and representatives or employees of their sub-distributors or end customers, such as where the listing applicant is a pharmaceutical manufacturer and its distributors offer illegitimate benefits to doctors or procurement staff at hospitals in the course of selling the listing applicant’s products. In the latter case, even if the listing applicant was not involved in such conduct, this could have an indirect impact on the listing applicant as it could result in the loss of its distributors as well as reputational damage in the market.

(iii) The sponsor should review the internal control measures adopted by the listing applicant with respect to the risk of corruption (see also paragraph 1.3.6 below).

(f) Legal or regulatory restrictions

In certain jurisdictions, there may be specific laws or regulations governing franchising or distributorships (such as the Regulations on the Administration of Commercial Franchise in the People’s Republic of China). Certain clauses in franchise or distribution agreements which have the effect of reducing entry opportunities for other suppliers or distributors may be in breach of competition laws in the jurisdiction where the listing applicant or its distributors operate. The sponsor, in conjunction with legal advisers, should ascertain whether the listing applicant may be subject to any such legal or regulatory requirements and review the risk of any non-compliance.

(g) Transportation, logistics and quality control

For certain types of goods such as pharmaceutical products, there is a potential risk of the goods becoming defective due to improper handling by the distributors when they are passing through the distribution chain or stored at the distributors’ premises before being sold to the end customers. The listing applicant may be subject to product liability to the end customers without fault on its part. The sponsor should review the transportation and logistics arrangements and quality control measures adopted by the listing applicant and the relevant terms in the distribution/franchise/consignment agreements (e.g., indemnification by distributors) to assess whether such risk is adequately addressed.

(h) Insurance

Where the listing applicant sells its products by way of consignment and, under the terms of the consignment, retains ownership of the products which have been placed with the consignee and remains responsible for any loss or damage of those products during transportation or delivery or while they are in the consignee’s custody, the sponsor should review whether the listing applicant has taken out appropriate insurance cover for loss of or damage to its products. The risk may be particularly pertinent if the products are of high value, such as jewellery.

1.2.7 If one or more of the risks described above is/are identified during the due diligence process, the sponsor should assess, on the basis of the nature of the risk and its materiality, whether the risk(s) may be addressed by way of disclosure in the listing document, or they are so fundamental as to affect the listing applicant’s suitability for listing.

1.3 Recommended Steps

Materiality

1.3.1 If the listing applicant has a small number of distributors and none are immaterial in importance (e.g., less than 10 distributors), the sponsor should carry out the recommended steps described in paragraphs 1.3.5 to 1.3.16 below on all those distributors.

1.3.2 If (i) the listing applicant has a large number of distributors and it is not practicable for due diligence to be carried out with respect to all of them; or (ii) distributorship is not the primary sales channel of the listing applicant, the sponsor may consider carrying out the recommended steps described in paragraphs 1.3.5 to 1.3.16 below on selected distributors (the “key distributors”) rather than on all of them. The selection of key distributors may be based on factors such as:

(a) revenue contribution over the track record period (It would be a reasonable approach to seek where feasible to interview distributors accounting for at least approximately 50% of the Group’s revenue, except where there are more than approximately 20 distributors, in which case consideration should be given to selecting distributors for interview on a statistical sampling basis, taking into account geographical sub-sets, where relevant. Whilst every listing applicant should be evaluated individually, there may be cases where it would be unreasonable on balance, even taking into account the need for thoroughness in due diligence, to interview more than approximately 20 distributors 6 );

(b) revenue contribution by region over the track record period (e.g., distributors within any region where the aggregate revenue contribution is higher than other regions);

(c) length of relationship with the listing applicant (e.g., distributors who have the longest relationship with the listing applicant and distributors who have only recently established a relationship with the listing applicant but whose revenue contribution has increased significantly over a short period of time);

(d) “high risk” distributors, such as those described in paragraph 1.3.5(a)(v) below;

(e) distributors whose transaction volume with the listing applicant is subject to unusual fluctuations over the track record period;

(f) distributors who are parties to transactions with unusual or special characteristics (e.g., transactions whose terms are unique or much more favourable to a particular distributor and transactions which are not adequately documented).

1.3.3 In accordance with paragraphs 1.3.1 and 1.3.2 above, the distributors with respect to whom due diligence is to be carried out are hereafter referred to as “relevant distributors”.

Sub-distributors

1.3.4 The sponsor should enquire as to whether one or more levels of sub-distributors have been appointed by any of the distributors to sell the products of the listing applicant. Where one or more levels of sub-distributors are involved, and any of those sub-distributors or those sub-distributors together account for what the sponsor considers to be a material portion of the products sold or being sold by the listing applicant, the sponsor should consider what additional due diligence has to be carried out with respect to those sub-distributors. The sponsor may consider (i) requesting the listing applicant to provide a list of the key sub-distributors, selected on the basis of their respective attributable contributions to the revenue of the listing applicant over the track record period; (ii) carrying out public searches, interviews and site visits with respect to those sub-distributors as described in paragraphs 1.3.7 to 1.3.16 below. It is acknowledged, however, that sub-distributors are under no compulsion to cooperate in the interview process or site visits and the refusal of a sub-distributor to participate in an interview or site visit does not mean that the sponsor has failed to perform adequate due diligence, although the sponsor should assess the materiality of not conducting the interview or site visit to the veracity of the due diligence process as a whole. If access to any key sub-distributor for interview is refused by the listing applicant or the distributor, the sponsor should seek to understand the reasons for the refusal and assess whether those reasons are legitimate. In such situation, the sponsor may need to consider what additional steps should be taken to verify the genuineness of such sub-distributor (e.g., making enquiries in the market to see if the sub-distributor is known as a distributor of the listing applicant’s products or the sub-distributor has only been operating for a short period of time).

Review of documents

1.3.5 The sponsor should request the listing applicant to provide the following documents and information for review:

(a) List of relevant distributors

(i) The sponsor should request the listing applicant to provide a list of its relevant distributors during the track record period and up to the latest practicable date for operational data in the listing document (or for such other periods as the sponsor may request where e.g., a large number of new distributors were engaged to replace existing distributors shortly before the beginning of the track record period, in which case the sponsor should request a list of distributors covering also those significant distributors whose relationship with the listing applicant was terminated before the track record period). The listing applicant should be asked to include the following information with respect to each distributor in the list:

(A) name of distributor;

(B) where the distributor is a corporate entity, name(s) of its shareholder(s);

(C) type of distributor (if there are different types);

(D) business address(es);

(E) contact person at distributor and contact details;

(F) revenue contribution during the track record period;

(G) length of business relationship with the listing applicant;

(H) any special relationship with the listing applicant (e.g., whether any director or substantial shareholder or current or ex-employee of the listing applicant or any of its subsidiaries has any ownership interest in or is able to exercise any control over the distributor);

(I) prior instances of business interruption and the cause(s);

(J) any prior breach of any of the terms of the distributorship, franchise or consignment agreement by distributor; and

(K) past and current disputes or litigation or arbitration or mediation proceedings with the listing applicant or with third parties relating to the listing applicant’s products or intellectual properties.

(ii) Given the responsibilities of a sponsor it would not be appropriate for the listing applicant to withhold the identity of a distributor from a sponsor. In particular, the identity should not be withheld on the basis of the purported commercial sensitivity or confidential nature of the information. 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”.

(iii) The sponsor should take steps to verify the integrity of the information on the list of relevant distributors provided by the listing applicant as part of the interview with those distributors (see paragraph 1.3.10 below).

(iv) The sponsor should also consider whether it is appropriate to ask the reporting accountants to cross-check the revenue contribution of the relevant distributors provided by the listing applicant with the amounts in the listing applicant’s accounting records. This can serve both to check the reliability of the names of relevant distributors on the list provided to the sponsor and the reliability of information about the amount of business done with a particular distributor.

(v) Where any of the following parties appear as a distributor, the sponsor should be particularly alert to the need to assess critically and verify the independence of that party and the arm’s length nature of the listing applicant’s dealings with that party:

(A) any former employee 7 of the listing applicant (or any of its subsidiaries), particularly where such former employee, who received only a small salary under his former employment with the listing applicant (or the relevant subsidiary), was required to make sizeable upfront payments to the listing applicant to become its distributor; 8

(B) any controlling shareholder, director, senior management member or employee (former or current) of the listing applicant (or any of its subsidiaries) or their respective associates (as defined in the Listing Rules); 9

(C) any previous subsidiary or associated company of the listing applicant; 10

(D) any person which has granted to or has received from the listing applicant (or any of its subsidiaries) any loan or guarantee other than trade credit in the ordinary course of business; or

(E) any person who has been appointed as a distributor shortly after the last audited balance sheet date (but before the listing) and became the largest/major distributor(s) of the listing applicant.

(vi) Where the listing applicant had been relying on a few distributors during the track record period, the sponsor should discuss with the management of the listing applicant to understand the reasons for the reliance, if any, and evaluate any measures adopted or to be adopted by the listing applicant to reduce such reliance.

(vii) The sponsor should also obtain information from the listing applicant on the turnover rate of its relevant distributors and movements in the number of its relevant distributors during the track record period, as well as the reasons for their termination or replacement or any other major change, in order to assess whether the listing applicant’s revenue is the result of cannibalisation among distributors. 11

(b) Distribution/franchise/consignment agreements

(i) The sponsor should obtain copies of the distribution/franchise/consignment agreements entered into by the listing applicant with its relevant distributors (including any sub-distribution/franchise agreements) and review their principal terms, including:

(A) the nature of the relationship (such as whether it is a principal-to-principal or a principal-to-agent relationship);

(B) the effective term and any right to renewal;

(C) geographic or other exclusivity;

(D) the rights and obligations of the parties;

(E) sales and pricing policies;

(F) obsolete or unsold stock arrangements;

(G) goods return arrangements;

(H) sales and expansion targets;

(I) sales and inventory reports and estimates;

(J) any minimum purchase amounts;

(K) sharing of advertising or marketing expenses;

(L) payment and credit terms;

(M) conditions for terminating and renewing the agreements (including any penalties or compensation payable); 12 and

(N) where the appointment of any sub-distributor is permitted, whether any payment, goods return or other arrangements between the listing applicant and the distributor is tied to corresponding arrangements between the distributor and its sub-distributor (e.g., is the obligation on the distributor to pay the listing applicant dependent on the distributor having received payment from its sub-distributor?).

(ii) The sponsor should look out for any terms which may appear to be a deviation from the market norm (provided a market norm can reasonably be determined to exist by looking at industry comparables – see paragraph 1.3.19 below) and terms which may cast doubt on the arm’s length nature of the agreement, such as unusually long credit periods or favourable fee arrangements.

(iii) The sponsor should also review the extent to which the terms of the agreement enable the listing applicant to monitor the performance of and to exercise control over the distributor in aspects such as competition control, pricing control, inventory control, disposal of obsolete or unsold stock, regular reporting of sales and market feedback, minimum purchase commitments and sales performance targets. 13

(iv) Where the listing applicant imposes minimum purchase requirements on any of its distributors in the agreement, the sponsor should assess whether the sales growth of the listing applicant over the track record period is supported by real demand. 14 The sponsor should obtain information from the relevant distributors during their interviews on sales of the listing applicant’s products by the relevant distributors to the end customers (see paragraph 1.3.10 below). 15

(v) The sponsor should request the listing applicant to confirm if there has been any prior breach of the terms of the distribution/franchise/consignment agreement by any of its relevant distributors over the track record period. Where there was any prior breach, the sponsor should request the listing applicant to confirm in writing how the instance was discovered, whether the listing applicant’s measures to monitor compliance were effective, how the dispute was settled, and whether any aspect of the listing applicant’s control mechanism on distributors was revised as a result.

(vi) If the distribution/franchise/consignment agreement with any of the relevant distributors is due to expire within a relatively short period of time (the sponsor should exercise its discretion to determine what should be considered “a relatively short period of time” as this may vary among different kinds of businesses), the sponsor should obtain information from the listing applicant on whether it intends to renew the agreement, whether the distributor has indicated its intention to renew the agreement (and if and how any major terms may be varied) and the impact on the listing applicant’s business or results of operations if such agreement is not renewed.

(vii) Where the distribution/franchise/consignment agreement has clauses which may have the effect of reducing entry opportunities for other suppliers or distributors, the sponsor should obtain opinions from legal advisers in the jurisdictions in which the listing applicant and its distributors operate to ensure compliance with applicable competition laws.

(viii) The sponsor should review the transportation and logistics arrangement provided for in the distribution/franchise/consignment agreements and any provisions on indemnity by the relevant distributors in favour of the listing applicant in the event of product liability arising out of the improper handling of goods by the distributors.

(ix) In the case of a consignment, the sponsor should, in particular, review the provisions on: (1) who retains ownership of the products being placed on consignment; (2) who is responsible for taking out insurance cover when the products are in transit and when they are in the custody of the consignee (the sponsor should consider requesting the listing applicant to provide copies of such insurance policy for review); and (3) control over cash receipts arising from sales through the consignee (e.g., how cash from sales is handled, frequency of reporting, system for cross-checking).

(x) The sponsor should, in conjunction with legal advisers, verify whether the listing applicant has complied with all consent requirements and other terms of the distribution/franchise/consignment agreements, such as change of control or confidentiality.

(c) Licence agreements relating to the licensing of intellectual property rights

(i) In the case of a franchise or distributorship, where the listing applicant has licensed the use of any intellectual property right (such as trade name, trade mark or patent) to any of the franchisees or distributors, the sponsor should review the principal terms of the licence as set out in the distribution or franchise agreement or if a separate licence agreement has been entered into, obtain a copy of that agreement (and if any sub-licence has been granted by the franchisee or distributor, a copy of such sub-licence agreement) and review its principal terms, including:

(A) the scope of the licence;

(D) the rights and obligations of parties involved;

(E) payment terms; and

(F) conditions for terminating and renewing the agreements (including any penalties or compensation payable). 16

(ii) The sponsor should look out for any terms which may appear to be a deviation from the market norm (provided a market norm can reasonably be determined to exist by looking at industry comparables – see paragraph 1.3.19 below) and terms which may cast doubt on the arm’s length nature of the agreement, such as unusually favourable fee arrangements.

(iii) The sponsor should also review the extent to which the terms of the agreement enable the listing applicant to prevent the misuse of the relevant trade name, trade mark or patent by the distributor (such as specifying the purpose for which and the territory in which it may be used).

(iv) The sponsor should request the listing applicant to confirm if there has been any prior breach of the terms of the licence by any of its distributors over the track record period. Where there was any prior breach, the sponsor should request the listing applicant to confirm in writing how the instance was discovered, whether the listing applicant’s measures to monitor compliance were effective, how the dispute was settled, and whether any aspect of the listing applicant’s control mechanism on distributors was revised as a result.

(v) If the licence with any of the relevant distributors is due to expire within a relatively short period of time (the sponsor should exercise its discretion to determine what should be considered “a relatively short period of time” as this may vary among different kinds of businesses), the sponsor should obtain information from the listing applicant on whether it intends to renew the agreement, whether the distributor has indicated its intention to renew the agreement (and if and how any major terms may be varied) and the impact on the listing applicant’s business or results of operations if such agreement is not renewed.

(vi) The sponsor should, in conjunction with legal advisers, verify as to whether the listing applicant has complied with all consent requirements with respect to provisions in the licence agreements on e.g., confidentiality.

(d) Regulatory approvals

The sponsor should, in conjunction with legal advisers, ascertain whether the distribution, franchise or consignment arrangement entered into by the listing applicant with any of its relevant distributors, franchisees or consignees is subject to any approval of any governmental or regulatory authorities and if so, request the listing applicant to provide copies of such approvals. The sponsor should request the listing applicant to confirm if there has been any prior breach of any of the terms or conditions of such approval.

(e) Financial information

(i) In reviewing the financial information of the listing applicant over the track record period, the sponsor should focus, in particular, on any unusual trend in the sales volume, revenue, stock/inventory or volume of goods returned during the track record period. The effects of any seasonality should be taken into account.

(ii) If any of the features described in paragraph 1.2.5(a)(iii) above exist in any of the distributorship/franchise/consignment agreement entered into by the listing applicant, the sponsor should discuss with the reporting accountants as to whether the method of revenue recognition adopted by the listing applicant is appropriate. When making the assessment, the sponsor should work with the reporting accountants to examine the listing applicant’s returned goods policy and the amount of goods returned from distributors during the track record period. 17

(iii) Where there has been a persistent increase in accounts receivables and debtors’ turnover days during the track record period, the sponsor should discuss with the listing applicant and satisfy itself that the listing applicant’s credit management policy is appropriate and the provisions for trade receivables are adequate. 18

(iv) Where the listing applicant distributes its products through (i) its own sales representatives who are employees and (ii) its sales partners (e.g., corporate entities) using the listing applicant’s name in their trading, the sponsor should analyse the listing applicant’s financial information with respect to sales through the sale representatives on the one hand and those through the sales partners on the other separately. 19

(f) Standards and policies applicable to distributors

(i) The sponsor should review all standards and policies adopted by the listing applicant that are applicable to its distributors with respect to areas such as selection of distributors, sales, pricing, credit control, inventory control, disposal of obsolete or unsold stock, return of unsold stock, cash management, transportation and logistics arrangement, quality control, use of any trade name, trade marks, patents or other intellectual property rights licensed by the listing applicant, control of conflict of interests and competition between different levels of distributors (e.g. use of non-compete undertaking in agreements with distributors, policy on the minimum distance between stores), and anti-corruption.

(ii) The sponsor should review internal control measures adopted by the listing applicant to monitor the performance of its distributors, their compliance with the terms of the relevant distribution/franchise/consignment agreement and the standards and policies referred to in paragraph 1.3.5(f)(i) above. 20

(iii) Where the listing applicant distributes its products through (i) its own sales representatives who are employees and (ii) its sales partners (e.g., corporate entities) using the listing applicant’s name in their trading, the sponsor should review measures adopted by the listing applicant to address the potential conflict of interests between the sales representatives and the sales partners. 21

Review of internal control system

1.3.6 As part of the overall review of the internal control system of the listing applicant to be carried out in compliance with Practice Note 21 to the Listing Rules, the sponsor should request the internal control consultant to review the following aspects of the listing applicant’s internal control measures with respect to its distributors:

(a) inventory control;

(b) credit control;

(c) corruption control; and

(d) (in the case of a consignment) cash management with respect to sales proceeds collected by the consignees.

Conduct public searches

1.3.7 It may be possible to carry out various types of public searches on relevant distributors. In determining whether to commission lawyers to perform such searches, the sponsor should address its mind to the relative level of additional comfort that might be gained from such searches against the feasibility and costs of doing so. For example, the sponsor is more likely to commission such searches if some form of “red flag” has been raised. The sponsor should also take into account that while company searches can often be performed relatively cheaply in a centralised registry, in many jurisdictions no centralised records are kept of matters such as insolvency/bankruptcy or litigation thus often making such searches impractical and very expensive and accordingly only justified in special circumstances. Against this background, public searches may include the following:

(a) company search in the place of incorporation of the distributor: for the purpose of verifying the due incorporation and continued existence of the distributor and (if available) information on its directors and shareholders (e.g., to see if these are the same as any persons known to be connected with the listing applicant); 22

(b) winding up or bankruptcy search in the place of incorporation of the distributor or the principal location(s) where it carries on its business: for the purpose of checking, if the distributor is a corporate entity, whether it is subject to winding up proceedings or if the distributor is an individual, whether he is subject to bankruptcy proceedings;

(c) litigation search in the principal location(s) where the distributor carries on its business: for the purpose of checking whether the distributor is subject to any litigation proceedings or outstanding judgements; 23 and

(d) trade mark or patent registry search: where the listing applicant has licensed the use of any trade mark or patent to any of the distributors, for the purpose of verifying that the listing applicant is the registered holder of such trade mark or patent (and in jurisdictions where there is a requirement for a security interest created or licence granted over trade marks or patents to be registered, checking whether any such security interest has been created and whether such licence has been properly registered).

1.3.8 The sponsor should consider carrying out news checks on the relevant distributors with a view to identifying any negative news coverage on any of them. News checks refer to searches of proprietary databases (e.g., World-Check) or using public search engines such as Google and/or any relevant home-country equivalents such as Baidu and Sohu.

1.3.9 The sponsor should keep proper records of all searches conducted against the distributors. 24

Interview relevant distributors

1.3.10 The sponsor should interview the relevant distributors with a view to independently verifying matters such as:

(a) ownership of the distributor;

(b) length of business relationship with the listing applicant;

(c) legal relationship with the listing applicant (seller/buyer or principal/agent, when title to goods pass);

(d) contractual terms governing their business relationship, particularly listing applicant’s control over the distributors, sales and inventory reporting system, goods returned arrangements, minimum purchase amounts, control over cash receipts, payment and credit terms, insurance;

(e) prior instances or allegations by the listing applicant of any breach of the distribution/franchise/consignment agreements or violation of the listing applicant’s standards or policies;

(f) performance of the distributors during the track record period in terms of, for example, (in the case of distributors) volume of purchases from the listing applicant, (in the case of franchisees) amount of payment made to the listing applicant on joining franchise and subsequent purchase or (in the case of consignees) gross sales amount of the listing applicant’s products, stock/inventory, sales volume to end customers, amount of returned goods, accounts receivable;

(g) prior instances of business interruption and the cause(s);

(h) quality control measures;

(i) past and current claims under any insurance policies relating to the listing applicant’s products or, where relevant, intellectual properties; and

(j) past and current disputes with the listing applicant, or with third parties relating to the listing applicant’s products or intellectual properties.

1.3.11 If there are any peculiar circumstances with respect to any distributor, such as where the distributor has little or no experience in carrying on a distribution business other than acting as the listing applicant’s distributor or the distributor has only been established for a short period of time (e.g., less than 12 months), the sponsor should consider undertaking further due diligence on that distributor to confirm the bona fides of the arrangement.

1.3.12 The sponsor should conduct interviews with the relevant distributors in accordance with Chapter 9 “Due Diligence Guidelines – Interviews of Major Business Stakeholders”.

Conduct site visits

1.3.13 The sponsor should visit the premises where the relevant distributors carry on their business if it has not had the chance to do so during the interviews. If there are a large number of e.g., retail outlets or showrooms, the sponsor should consider visiting those retail outlets or showrooms with more significant sales and verifying the existence of the others by, for example, anonymously calling the telephone numbers in order to see if they answer and by asking a question that someone doing business with them might normally ask and see if the answer is consistent with how a genuine distributor might be expected to answer (e.g., “Can I confirm your address as I would like to visit your showroom?” or “Can you confirm the opening times of your showroom?”).

1.3.14 In the case of franchises and distributorships where detailed operational standards may have been prescribed by the listing applicant for its franchisees or distributors, such as the manner in which the retail outlet has to be designed and the licensed trade name or trade mark has to be displayed, the sponsor should observe whether these standards have been complied with during the site visits.

1.3.15 Where distributors or franchisees keep stocks of the listing applicant’s products on their premises, except where impracticable to do so the sponsor should also observe the volume of the stocks being kept and their physical condition during the site visits. Where distributors or franchisees do not keep stocks of the listing applicant’s products on their premises (but e.g., in a storage facility located elsewhere instead) and there is any particular concern as to e.g. channel stuffing, the sponsor may consider requesting site visit(s) to the place(s) where the stocks are kept.

1.3.16 To the extent possible e.g., in the case of retail outlets or showrooms open to the public, the sponsor should arrange site visits independently of the listing applicant.

Review industry comparables

1.3.17 The sponsor should discuss with the management of the listing applicant to understand the benefits of the listing applicant using the particular distributorship/franchise/consignment model, and assess whether it is an industry norm. 25

1.3.18 The sponsor should compare the listing applicant’s business model, the terms of its distribution, franchise or consignment agreements, and its financial performance with industry comparables. Further due diligence should be conducted where, for example, the listing applicant achieved growth in sales during the track record period that significantly exceeded the industry average, or the listing applicant’s level of gross profit margin was particularly high when compared to its peers. 26

1.3.19 Industry comparables may include/be found from: (a) companies in the same industry which are already listed; (b) industry publications; (c) general discussion with competitors of the listing applicant; and (d) discussion with industry consultants (particularly where one is engaged to prepare an industry report for use in the listing document).

1. In May 2012, the Stock Exchange issued the Guidance Letter on Distributorship Business Model – Risks and Disclosure in Listing Documents ( Exchange Guidance Letter GL36-12 ), in which it sets out its observations on the risks involving distributors, franchisees and consignees and guidance on the disclosure of such risks in listing documents.

2. Paragraph 13(g) of Practice Note 21 to the Listing Rules. Typical due diligence enquiries include “reaching an understanding of the manner in which the new applicant manages its business…including distribution channels, pricing policies, after-sales service, maintenance and warranties”.

3. Distributorships Low Risk Expansion into New Markets , by Michael Arnold, PLC March 1993.

Exclusive distributorship is an exclusive appointment that has the effect of precluding the supplier from actively seeking sales in the appointee’s territory, whether through his own efforts or by appointing other distributors.

Sole distributorship is a sole appointment such that the supplier cannot appoint any other distributor, but may continue actively selling into the territory.

Non-exclusive distributorship is a non-exclusive appointment that gives the appointee no degree of protection in his territory from the supplier’s or other distributors’ activities.

Selective distributorship is a selective distributorship arrangement which exists where, although the supplier does not give exclusivity to the distributor, he does limit the number of distributors which he appoints.

4. A cquiring Franchise Businesses: Knowing What to Look Out For , by Joachim Sander, John McLaughlin and Babette Märzheuser-Wood, PCL September 2007.

Direct franchising is the most straightforward structure commonly adopted in domestic franchising. In a direct franchise, the franchisor grants unit franchisees the right to operate individual units of the franchise in the relevant territory.

Master franchising extends most of the advantages of franchising into the international arena. The franchisor grants the master franchisee the right to grant unit franchises to independent third parties in a particular territory.

Development arrangements. In larger territories, franchisors often grant a developer the right to operate unit franchises itself and to introduce third parties to the franchisor as unit franchisees without being able to grant a sub-franchise itself. In other words, the developer promotes the franchise in a particular territory but any unit franchisees are direct sub-franchisees of the franchisor.

Subordinated equity arrangements. Also referred to as joint venture arrangements, in subordinated equity arrangements the franchisor and a local business become shareholders in a master franchisee vehicle. The master franchisee vehicle then grants sub-franchises to unit franchisees.

5. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

6. Paragraph 26(1)(b) of Appendix 1 Part A to Listing Rules requires disclosure of the five (5) largest customers in the listing document.

7. In Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents, the Stock Exchange cited a case where the listing applicant encouraged its employees to become its independent distributors during the track record period, and when the Stock Exchange raised concerns on the independence of those distributors, the sponsor confirmed, after performing its due diligence, that the sales to those distributors had been on normal commercial terms which were fair and reasonable to the listing applicant and consistent with the terms offered to other non-employee distributors, that no employees had acted as distributors while still being employees and that the listing applicant would cease such practice after listing. Full disclosure was made in the listing document.

8. In SFC Dual Filing Update of July 2010, the SFC cited a case where the initial draft prospectus provided limited information on the sales of the listing applicant made to certain distributors who were its former employees. Upon the SFC’s enquiries, it was revealed that the listing applicant’s significant turnover growth during the track record period was mainly attributable to sales conducted through these distributors. The sponsor failed to critically assess how these distributors, who received only a small salary under their former employment with the listing applicant, were able to finance their initial purchases from the applicant, who required sizeable upfront payments from its distributors. The reason was explained only after repeated requests by the regulators and upon additional due diligence work by the sponsor at a very late stage of the listing process. The SFC commented that the lack of professional scepticism by the sponsor in its due diligence in that case led to inefficiencies and unnecessary delay in the listing process.

9. (i) In Update on SFC Dual Filing of 28 December 2006, the SFC cited a case where the listing applicant’s customers were distributors which in turn sell the products to retail stores. It was only revealed upon the regulators’ enquiries that some of the distributors, including one of the listing applicant’s top five (5) customers, were previously the listing applicant’s subsidiaries or associated companies, or were companies held by the company’s senior management during the track record period. The sponsor offered inconsistent explanations when asked about such relationships, which further suggested a lack of due diligence and understanding regarding the relationship between the listing applicant and its customers. (ii) In SFC Dual Filing Update of July 2010, the SFC cited a case where the initial draft prospectus suggested that the listing applicant’s distributors and their ultimate owners had no relationship with the listing applicant. Upon the regulators’ enquiries, it was revealed that some of the listing applicant’s employees were the shareholders of a majority of these distributors. This raised concerns on the terms of sales made to these distributors and potential conflict of interest on the part of such employees. The disclosures on the listing applicant’s relationship with these distributors were clarified only upon the regulators’ further enquiries.

10. SFC’s Update on Dual Filing of 28 December 2006 (see endnote 9 above).

11. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

12. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

13. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

14. In SFC Update on Dual Filing of 17 June 2008 , the SFC cited a case whether the listing applicant sold its products to a large number of franchisees. It was only revealed after the SFC’s enquiries that the listing applicant imposed minimum purchase requirements on each franchisee. A substantial proportion of the listing applicant’s revenue during the track record period came from the initial minimum purchases made by new franchisees upon their joining the network. Against the substantial growth in overall sales, a significant percentage of the franchisees failed to meet the prescribed minimum monthly purchases. It raised the question whether the listing applicant’s sales growth is supported by real demand.

15. Opinion on Further Improving Quality of Disclosure of Financial Information of Companies in Initial Public Offering issued by China Securities Regulatory Commission on 23 May 2012.

16. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

17. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

18. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents. The Stock Exchange also requires the listing document to include (i) a commentary on the recoverability of accounts receivable and the subsequent settlement of the balance as at the latest practicable date; and (ii) the impact of the increase in accounts receivable and debtors’ turnover days on the liquidity and cash flow of the listing applicant.

19. In Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents, the Stock Exchange cited a case where the listing applicant distributed its products either directly through its own sales representatives who were part-time employees or indirectly through its sales partners that were corporate entities using the listing applicant’s name in their trading. Some of the listing applicant’s sales representatives or their associates also held equity interests in the sales partners. The Stock Exchange suggested in that case that the listing applicant should clearly delineate its sales between the sale representatives and the sales partners.

20. In Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents, the Stock Exchange stated that in addition to the general disclosure for listing applicants with distributorship models, the listing applicant’s listing document should contain:

(a) the terms of the agreement with the sales partners, including conditions of use of the listing applicant’s name;

(b) measures to address the potential conflict of interests between the sales representatives and the sales partners;

(c) internal controls and corporate governance measures to monitor the listing applicant’s sales activities to detect potential abuses; and

(d) management of the sales partners using the listing applicant’s trading name and the associated risks that the applicant’s overall business could be adversely affected by improper use of the listing applicant’s name by the sales partners.

21. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents (see note 19 above).

22. The company search will not be able to reveal any trust arrangement and hence the real ultimate beneficial owner(s) of the distributors.

23. Not all jurisdictions maintain publicly available record of proceedings. The litigation search will not be able to reveal any pre-proceedings claims or arbitration.

24. In the SFC’s press release “SFC fines and revokes the licence of Mega Capital (Asia) Company Limited” dated 22 April 2012, SFC set out its findings on the due diligence work conducted by Mega Capital (Asia) Company Limited as the sponsor for the listing of Hontex International Holdings Company Limited, one of which was the lack of records showing what background or other due diligence searches Mega Capital had conducted on the franchisees of the group.

25. Exchange Guidance Letter GL36-12 on Distributorship Business Model – Risks and Disclosure in Listing Documents.

26. (i) In SFC Update on Dual Filing of 17 June 2008 , the SFC cited a case where the listing applicant sold its products to a network of distributors which then resold the products to retail outlets for sales to the final customers. The listing applicant achieved growth in sales that significantly exceeded the industry average, but the initial draft prospectus failed to provide clear information about its distribution network, such as where the listing applicant’s products attracted high demand or whether the growth in sales was supported by actual sales to retail customers. It was only upon the SFC’s repeated requests that the listing applicant provided more information about the sales and inventory level of its distribution network. (ii) In Exchange Listing Decision LD48-2013 published in January 2013, the Stock Exchange cited a case where it returned the listing application of a distributor of certain products for failure to include in the draft prospectus an explanation on what value-added services the listing applicant provided to its distributor customers to sustain its level of gross profit margin which was particularly high when compared to its peers.

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.

Distributorship Franchising and Consignment

Understanding distributorship business model of listing applicant to identify risk, understanding a listing applicant and its business, performance, financial condition and prospects, preparation of a listing document, business relationship with listing applicant, risks and disclosure in listing documents exchange guidance letter gl36-12, operational risks associated with distributorships, franchises and consignments, review of agreements with distributors, franchisees and consignees, distributors, franchisees and consignees.

Hong Kong Sponsor Due Diligence Guidelines

2020 edition

Published by HKCFEF Limited

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Hong Kong SFC Fines IPO Sponsors for Due Diligence Failures

Hong Kong SFC Fines IPO Sponsors for Due Diligence Failures

In October 2021, Hong Kong’s Securities and Futures Commission ( SFC ) reprimanded and fined two sponsors – Ample Capital Limited ( Ample ) 1 and Yi Shun Da Capital Limited ( Yi Shun Da Capital ) 2 – for their respective breaches of their sponsor due diligence obligations on two separate Hong Kong listing applications. In both cases, the sponsor was found to have failed to conduct adequate due diligence of third-party payments which the SFC alleged raised red flags – in the Ample case of channel stuffing in the context of a distributorship business model, and in the case of Yi Shun Da Capital, of a circular flow of funds potentially indicative of an attempt to disguise the original source of funds and facilitate a deceptive or fraudulent scheme.

The latest disciplinary actions come as a reminder of the SFC’s determination to crack down on substandard sponsor due diligence, even in cases where the listing applicants do not proceed to listing and the sponsor’s failure to conduct adequate due diligence causes no financial loss to investors. The decisions underline the onerous and extensive nature of IPO sponsors’ obligation to carry out all reasonable due diligence on a listing applicant under Paragraph 17 of the SFC Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission 3 (the SFC Code of Conduct ). They provide sponsor principals, in particular, with a timely reminder of the need to be alert to the existence of red flags and to conduct independent due diligence by reference to sources external to the listing applicant to ascertain the facts, rather than accept statements or documents provided by the listing applicant’s representatives at face value. Key takeaways from the cases are:

  • As demonstrated by the Securities and Futures Appeals Tribunal’s ( SFAT ) confirmation of the SFC’s findings of breach of sponsor duties by Yi Shun Da Capital, the existence of red flags (in that case, the extensive use of third-party payments) requires sponsors to conduct additional independent due diligence to ascertain the rationale for circumstances that are suspicious on their face.
  • The SFAT accepted that had proper due diligence been conducted, the sponsor might have come to the conclusion that the third-party payments were not suspicious (there was no allegation that the payments were fraudulent or fictitious) or were justified in the circumstances. What was not acceptable was for the sponsor to accept at face value representations of the listing applicant’s representatives: the situation required independent due diligence into the reasons for the extensive use of indirect payments which, without proper explanation in the listing document, risked raising concerns among potential investors.
  • To merely verify the existence of the dominant third-party payment method did not constitute the conduct of “all reasonable due diligence” required by the SFC Code of Conduct. And therein lay the sponsor’s breach of its due diligence obligations. The potential red flags obliged the sponsor to look in-depth into the payments and their rationale and this meant that the sponsor should have interviewed relevant customers and third-party payers as to why the listing applicant was paid indirectly.
  • In the Ample case, the sponsor failed to conduct independent enquiries into the relationship between the listing applicant and a distributor accounting for a significant portion of its sales, despite the HKEX specifically questioning the listing applicant’s sales to the distributor.
  • Ample also failed to critically assess the reliability of shipping documents provided by the listing applicant, failing to conduct the necessary independent due diligence despite obvious signs that the documents were not reliable.

The SFC has made no secret of its intention to stamp out substandard sponsor due diligence work. These latest decisions underline the need for sponsors to comply strictly with the requirements of Paragraph 17, even where the circumstances do not in fact, but could potentially, indicate fraud or misconduct on the part of the listing applicant or its directors.

SFC’s Disciplinary Powers under sections 194 and 196 of the SFO

The SFC’s disciplinary actions against Ample and Yi Shun Da Capital relied on the SFC’s powers under Part IX of the SFO. Sections 194 and 196 have become the primary mechanisms used by the SFC to “punish” (for want of a better word) sponsors for due diligence failures. They entitle the SFC to fine and/or revoke or suspend the licence or registration of “regulated persons” (i.e. sponsors, their responsible officers and licensed representatives (in the case of licensed corporations) and executive officers and registered individuals (in the case of registered institutions). These powers arise where:

  • a regulated person is guilty of misconduct (i.e. has breached any provision of the Securities and Futures Ordinance (the SFO ), the Companies (Winding Up and Miscellaneous Provisions) Ordinance ( C(WUMP)O ) prospectus provisions, or certain provisions of the Companies Ordinance or anti-money laundering legislation); or
  • the SFC considers a regulated person to not be a fit and proper person to be or to remain licensed or registered.

The maximum fine that can be imposed by the SFC is HK$10 million or three times the amount of the profit gained or loss avoided as a result of the misconduct or other conduct which led the SFC to consider the regulated person not to be fit and proper.

The provisions have been used to impose significant fines, for example a fine of HK$375 million imposed on UBS AG and UBS Securities Hong Kong Limited as one of the joint sponsors of three listing applications (China Forestry Holdings Company Limited, Tianhe Chemicals Group Limited ( Tianhe ) and China Metal Recycling (Holdings) Limited) and a fine of HK$224 million imposed on Morgan Stanley Asia Limited as a co-sponsor of Tianhe’s 2014 listing. To date, the SFC has revoked the licence of just one sponsor, Mega Capital Asia Limited ( Mega Capital ), in relation to its sponsorship of the 2009 listing of Hontex International Holdings Limited ( Hontex ). The case marked a turning point in SFC enforcement actions against sponsors in a number of respects:

  • it also saw the SFC use section 213 of the SFO for the first time to obtain an order from the Court of First Instance to require a listed issuer to compensate investors, by way of a HK$1.03 billion offer to buy back the shares from Hontex’s 7,700 public shareholders (both IPO subscribers and secondary market purchasers of the shares). 4 The Court of First Instance’s jurisdiction in the case was based on Hontex’s admission for the purposes of the section 213 proceedings that it had contravened section 298 of the SFO, the criminal offence of disclosing, authorising or being concerned in the disclosure or dissemination of information which is false or misleading and is likely to induce subscriptions or purchases of shares, where the person knows, or is reckless as to whether, the information is false or misleading.
  • Inadequate and substandard due diligence work;

Its failure to act independently and impartially by agreeing to Hontex’s request not to contact the group’s customers, suppliers and franchisees directly for interviews and instead allowing Hontex to arrange the sponsor’s interviews and its representatives to attend the interviews. Mega Capital further accepted Hontex’s representations that certain parties refused face-to-face interviews and allowed Hontex to set up telephone interviews instead. These actions on the part of Mega Capital were taken by the SFC to demonstrate Mega Capital’s “inappropriate reliance” on Hontex in conducting due diligence on customers, suppliers and franchisees. This was the case notwithstanding that Practice Note 21 to the Listing Rules “Due Diligence by Sponsors in Respect of Initial Listing Applications” (the only guide to expected sponsor due diligence at the time) specifies only that the sponsor’s assessment of the listing applicant’s performance and business plan:

“would normally include interviewing the new applicant’s senior management and would often involve interviewing the new applicant’s major suppliers and customers, creditors and bankers” (at paragraph 13(b) of Practice Note 21 to the Listing Rules) (emphasis added).

The requirements of Paragraph 16.6(f) of the SFC Code of Conduct regarding sponsors’ interview practices 5 were not in force or contemplation at the time of Mega Capital’s 2009 sponsor due diligence work on Hontex, nor were they in force when the SFC disciplined Mega Capital in April 2012. It seems somewhat unfair that Mega Capital appears to have been disciplined in 2012 for failure to comply with sponsor due diligence standards (in particular the requirements for conduct of interviews of suppliers, customers and distributors) which only applied to listing applications submitted on or after 1 October 2013 and were actually designed to prevent listing applicants’ involvement in the arrangement and conduct of sponsor interviews of customers and suppliers as seen on the Hontex listing.

  • Mega Capital’s failure to maintain an adequate trail of its due diligence planning and various aspects of its due diligence work. Again the obligation to have and keep a due diligence plan was only introduced in October 2013.
  • The failure of Mega Capital’s responsible officers to adequately supervise junior staff in conducting due diligence on Hontex.
  • Breach of the sponsor’s undertaking and declaration to the HKEX confirming that Mega Capital had made reasonable due diligence enquiries and believed the information in Hontex’s IPO prospectus to be true in all material respects.

In the SFC’s disciplinary action against UBS Securities Hong Kong Limited (discussed above), the SFC partially suspended its Type 6 licence – prohibiting it from conducting sponsor work for one year.

Lack of stated basis for section 194 and 196 disciplinary proceedings

Surprisingly, the various Statements of Disciplinary Action relating to IPO sponsors published on the SFC website (see for example the Statement of Disciplinary Action relating to Ample 6 ) state only that the actions are brought in reliance on sections 194 and 196 of the SFO, without mention of the basis for the disciplinary action under section 194(1) or 196(1) – i.e. whether the sponsor is guilty of a breach of one of the “relevant provisions” or considered by the SFC to not be “fit and proper” to be licensed or registered. As the disciplinary action statements then cite the sponsors’ failure to discharge their obligations as sponsors – and primarily their failure to conduct all reasonable due diligence in some detail, it’s probably fair to assume that the SFC has deemed the sponsor not to be “fit and proper” to conduct sponsor work. This seemingly fundamental statement is however absent from all the SFC’s disciplinary statements relating to IPO sponsors. Assuming that this is the case, the logical question is then why, if the SFC considers a sponsor not to be “fit and proper”, does it not revoke, or at least suspend, its licence? With the exceptions noted above (Mega Capital and UBS Securities Hong Kong), licence revocation or suspension is not part of the SFC’s standard sponsor “penalty” package. On the contrary, as we have seen, the SFC’s “go to” disciplinary actions are the imposition of a substantial fine on the sponsor under section 194 or 196 plus a restorative order against the issuer and its directors under section 213 of the SFO to compensate the public shareholders for their loss. This has now provided a well-worn, and perhaps rather convenient route, for the SFC for dealing with fraudulent or misleading prospectus information.

Section 194 and 196 proceedings are disciplinary proceedings against sponsors in which the SFC determines whether it considers the sponsor to be fit and proper. There is a right of appeal against the SFC’s decision to the Securities and Futures Appeal Tribunal. In section 213 proceedings, the SFC applies to the Court of First Instance to make orders (either injunctive orders (such as freezing orders to prevent disposal of the issuer’s assets in Hong Kong) and/or remedial orders such as restoration orders to compensate investors and/or an order for damages. As confirmed by the Court of Final Appeal’s decision in the Tiger Asia case, the Court of First Instance has jurisdiction to make orders sought by the SFC under section 213 notwithstanding that there has been no prior finding by a criminal court or the Market Misconduct Tribunal that the defendant has contravened the criminal or civil market misconduct provisions of Part XIII or XIV of the SFO or the prospectus liability provisions under the C(WUMP)O (sections 40 and 40A for Hong Kong companies and sections 342E and 342F for companies incorporated outside Hong Kong). Further, section 213 proceedings are civil proceedings to which the lower civil burden of proof applies even where the Court is determining whether a criminal provision of the SFO (e.g. section 298 or 384) or the C(WUMP)O (section 40A or 342E) has been breached.

In sum, the section 194/196 disciplinary action plus section 213 issuer proceedings package could be seen to offer a fairly convenient and speedy method for the SFC to penalise sponsors and obtain compensation for investors compared to the alternative of bringing criminal or civil proceedings under the C(WUMP)O’s prospectus liability provisions or the market misconduct regime under Part XIII or XIV of the SFO. Proposals to amend the statutory liability provisions of the C(WUMP)O to clarify who is within the scope of “persons who authorise the issue of a prospectus” and to deal with the lack of mens rea requirement for the criminal provisions, which have been the subject of two SFC public consultations, have come to nought. MMT proceedings against issuers and sponsors have been commenced but are slow and rather cumbersome compared to the disciplinary process under sections 194 and 196 and obtaining orders under section 213 from the Court of First Instance.

SFC Reprimands and Fines Ample Capital Limited for breaches of sponsor due diligence obligations

SFC Disciplinary Proceedings under section 194 of the SFO

On 18 October 2021, the SFC reprimanded and fined Ample HK$5.5 million 7 under section 194 of the SFO for its failure to discharge its sponsor due diligence obligations between 2016 and 2017 in relation to the listing application of COCCI International Limited ( COCCI ) on the GEM of the Stock Exchange of Hong Kong ( HKEX ). A copy of the Statement of Disciplinary Action is available on the SFC’s website . 8

The SFC found that Ample had failed to conduct all reasonable due diligence on COCCI prior to submitting the listing application in breach of the SFC Code of Conduct. In particular, the sponsor failed to:

  • carry out adequate due diligence on cash payments made by a major wholesale distributor ( Distributor ) to COCCI through third parties and keep proper records of its due diligence work;
  • ascertain the background and independence of the Distributor and its associates; and
  • assess the reasonableness of COCCI’s sales to the Distributor.

In addition, the SFC found that Ample had failed to critically assess the reliability of the shipping documents provided to Ample by COCCI before relying on them as part of its due diligence.

The SFC also suspended the SFC licence of Tang Ho Wai Howard ( Tang ) for 17 months starting 15 October 2021 through to 14 March 2023 for his failure to discharge his duties as a responsible officer and sponsor principal of Ample in charge of supervising the execution of COCCI’s listing application.

COCCI’s Application to List on HKEX

COCCI and its subsidiaries engaged in the design, marketing, retail sales and distribution of ladies-wear products under its self-owned “COCCI” brand, selling ladies-wear through various retail outlets and franchisees, online retail websites and wholesale distributors.

COCCI’s 2015 revenue was almost double its 2014 revenue, mainly because of its sale of out-of-season products at a discount to the Distributor, which re-distributed COCCI’s products principally to Saudi Arabia. The sales to the Distributor accounted for approximately 50% of COCCI’s total revenue in 2015 and approximately 23% of its revenue for the first four months of 2016.

COCCI appointed Ample as its sole sponsor in January 2016, and its first listing application was submitted in September 2016. Between October 2016 and March 2017, the SFC and the HKEX commented on COCCI’s wholesale business and other matters. As more than six months had lapsed since the first application, COCCI re-submitted a listing application in April 2017 with Ample continuing to act as its sole sponsor. The SFC and HKEX made further comments following the submission of the second listing application: the regulators considered that the revised prospectus still failed to explain and provide sufficient information on various aspects of COCCI’s wholesale business. Ample did not respond to the comments and the second application lapsed in October 2017.

Failure of Sponsor to Conduct Adequate Due Diligence on Suspicious Cash Settlements

Between March and June 2016, 24 deposits totalling more than RMB9.7 million were made by five third parties to COCCI’s Mainland bank account to settle payments owed by the Distributor to the principal operation branch of COCCI in the Mainland ( Mainland Branch ). Ample had learnt from COCCI’s directors that the sole shareholder and director of the Distributor ( Ms A ) made cash settlements in Hong Kong dollars to the Mainland Branch on behalf of the Distributor by meeting with, and handing over the cash payments to one or more of the third parties previously chosen by COCCI’s chairman, and meeting at locations arranged by Ms A and COCCI’s chairman or the third parties. The third parties then converted the cash into Renminbi and physically carried the cash to the Mainland and deposited it into the Mainland Branch’s bank account. This arrangement was adopted because the Mainland Branch did not have a Hong Kong bank account in Hong Kong for direct deposit of cash by Ms A and the Distributor’s payments directly to the Mainland Branch would have been subject to Chinese foreign exchange control regulations.

The SFC contended that a customer’s settlement of payments through third parties raises a red flag, because third-party payments can be used to disguise the source of funds and be part of a fraudulent scheme. This was particularly so in this case as one of the third parties was an employee of COCCI’s major supplier. The SFC considered that Ample breached its sponsor due diligence obligations under the SFC Code of Conduct in failing to critically assess the reasons for the third-party payments, and failing to conduct independent due diligence to ascertain the truth and completeness of COCCI’s representations on the matter. The sponsor also failed to maintain any records to demonstrate its conduct of due diligence, including its alleged discussions with COCCI’s directors and reporting accountants relating to the third-party payments.

Failure of Sponsor to Ascertain the Background and Independence of the Distributor and its Associates

Ample knew that the Distributor’s business activities were conducted by Ms A and staff members from her jewellery company. There was also information suggesting a connection between the jewellery company and COCCI, for instance: (i) a co-owner of the jewellery company was a company solely owned by a COCCI shareholder; and (ii) a director of the jewellery company was also a director of COCCI’s major supplier as well as a director and sole shareholder of a company which is a franchisee of COCCI and a management agent of certain self-operated COCCI retail outlets.

However, the sponsor did not satisfy its due diligence obligations required by the SFC Code of Conduct. It did not carry out any further due diligence to ascertain the involvement of the jewellery company’s co-owner and director in the Distributor’s business activities, nor did it verify the independence of the Distributor or Ms A from COCCI and its supplier.

Failure of Sponsor to Assess the Reasonableness of COCCI’s Sales to the Distributor

The SFC considered that given the substantial increase in COCCI’s revenue in 2015 due to its sales of products to the Distributor which it then sold in Saudi Arabia, it was crucial that the sponsor carry out sufficient due diligence to determine whether the sales were reasonable.

Ample carried out only minimal due diligence on the Saudi Arabian sales prior to the listing application submission. Despite attending a telephone interview (conducted by COCCI’s reporting accountants) with a major Saudi Arabian customer of the Distributor, Ample failed to seek any objective data to verify the information provided by the customer, nor did it conduct any independent search of the customer’s background and scale of operations in Saudi Arabia.

Following comments from the SFC and the HKEX after the first listing application submission, the sponsor carried out additional due diligence, including interviewing the Saudi Arabian customer and visiting its retail store in Saudi Arabia.

The SFC refers in its Statement of Disciplinary Action to the HKEX’s Guidance Letter GL36-12 (May 2012) 9 on “Distributorship business model – risks and disclosure in listing documents” in which the HKEX states that sponsors are expected to have performed sufficient due diligence work in relation to the fairness and reasonableness of sales to distributors recorded during the track record period. Guidance Letter GL36-12 also highlights the risk of channel stuffing in a distributorship business model, stating that:

“[w]hile a sharp increase in sales during the track record period may indicate a vibrant business, there is a risk that these are artificially pumped-up sales, unsustainable by an actual rise in demand from ultimate end-users.”

It is noted that the guidance letter (now known as “Guidance on due diligence to be conducted by the sponsor and disclosure in the listing document relating to a distributorship business model”) was revised in February 2020, and that these statements were removed.

Failure of Sponsor to Critically Assess the Reliability of the Shipping Documents provided by COCCI

COCCI provided Ample with 25 sets of shipping documents relating to the shipment of its products from the Distributor to the Saudi Arabian customer. The SFC found that the sponsor breached its due diligence obligations in failing to: (i) critically assess the reliability of these documents before relying on them as part of its due diligence; and (ii) identify the red flags which cast doubt on the documents’ reliability. For example, the container identification for all 25 sets of bills of lading were labelled “ABCD/111111/TBA”, and the dates in most of the bills of lading did not correspond with the sailing schedules of relevant vessels that could be found in publicly available sources.

SFC Disciplinary Action

The SFC concluded in its Statement of Disciplinary Action that Ample breached the following requirements:

  • General Principle 2 (Diligence) of the SFC Code of Conduct and paragraph 5.1 (Due skill and care) of the SFC Corporate Finance Advisor Code of Conduct – failure to act with due skill, care, and diligence and observe proper standards of market conduct, in the best interests of its clients and the integrity of the market;
  • Paragraphs 17.2(b) and 17.4(a) (Reasonable due diligence) of the SFC Code of Conduct – failure to complete all reasonable due diligence on COCCI prior to the listing application submission;
  • Paragraph 17.6(a) (Reasonable judgment) of the SFC Code of Conduct – failure to exercise reasonable judgment on the nature and extent of due diligence work required in relation to COCCI taking into account to all relevant facts and circumstances;
  • Paragraph 17.6(b) (Professional scepticism) of the SFC Code of Conduct and paragraph 2 of Practice Note 2 to the Rules Governing the Listing of Securities on GEM of the HKEX – failure to examine with professional scepticism the accuracy of information provided by COCCI and be alert to information that contradicted or brought into question the reliability of such information;
  • Paragraph 17.6(c) (Appropriate verification) of the SFC Code of Conduct – failure to conduct additional due diligence to ascertain the truth and completeness of the information provided by COCCI, after becoming aware of circumstances that could cast doubt on the information provided to it or otherwise indicated a potential problem or risk;
  • Paragraph 17.6(e) (Independent due diligence steps) of the SFC Code of Conduct – failure to carry out independent due diligence steps to inquire directly of knowledgeable persons within or external to the listing applicant and in respect of material matters, independently acquire information from sources external to the listing applicant; and
  • Paragraphs 17.2(e) and 17.10 (Proper records) of the SFC Code of Conduct – failure to maintain proper records relating to the due diligence conducted (together with its results) in respect of the listing application so as to demonstrate to the SFC its compliance with the SFC Code of Conduct.

The SFC considered that Ample’s failure to satisfy its sponsor due diligence obligations to be a result of Tang’s failure to discharge his duties as a sponsor principal, a responsible officer, and a member of the senior management of the sponsor. In particular, Tang failed to: (a) exercise due skill, care and diligence in handling the listing application; (b) diligently supervise the transaction team to carry out the sponsor work undertaken by Ample; and (c) ensure that appropriate standards of conduct were maintained by Ample.

In fining Ample HK$5.5 million and suspending Tang for 17 months, the SFC took into account that: (a) substandard sponsor due diligence work could facilitate the listing of companies that are unsuitable for listing; (b) no harm had been caused to the investing public as the listing application had lapsed; (c) two previous compliance advice letters issued to Ample by the SFC should have put it on heightened alert of the need to improve its sponsor due diligence work; (d) Ample has no previous SFC disciplinary record; (e) Ample’s financial situation; and (f) Ample and Tang’s cooperation with the SFC.

SFAT affirms SFC decision to reprimand and fine Yi Shun Da Capital Limited for sponsor due diligence failures

On 19 October 2021, the SFC reprimanded and fined Yi Shun Da Capital HK$3 million 10 for its failures to discharge its sponsor due diligence obligations in the listing application of Imperial Sierra Group Holdings Limited ( Imperial Sierra ) in 2017. This disciplinary action followed a review of the SFC’s original decision to sanction Yi Shun Da Capital by the Securities and Futures Appeals Tribunal ( SFAT ) . 11 The SFAT upheld the SFC’s original decision to sanction Yi Shun Da Capital, but reduced the original fine of HK$4.5 million to HK$3 million.

Imperial Sierra’s Application to List on the HKEX Main Board

Imperial Sierra was engaged in commercial property consultancy services, with its main operations centred in the Pearl River Delta area of the Mainland. Its principal revenue came from advisory services on a project-to-project basis, with its top five customers in 2016 contributing to around 76% of its revenue that year. In contrast, its property management services, which provided a regular income stream, accounted for 1.1% of its 2016 revenue. Yip Wik, Aric ( Aric Yip ) was the founder, board chairman, an executive director and the controlling shareholder of Imperial Sierra.

In December 2016, Imperial Sierra, which was seeking to list on the HKEX’s Main Board, appointed Yi Shun Da Capital, then known as Zhaobangji International Capital Limited, 12 as its sole sponsor. In March 2017, Imperial Sierra’s listing application was submitted to the HKEX. The vetting process gave rise to a number of concerns relating to financial issues; in particular, that there may have been a circular flow of funds. In exchanges with the HKEX, the sponsor was unable to demonstrate that it had conducted reasonable due diligence in respect of the concerns.

In January 2020, by which time the listing application had lapsed, the SFC informed Yi Shun Da Capital that it intended to bring disciplinary action against it for its failure to exercise reasonable due diligence in its role as the sole sponsor based on three main areas of contention:

  • during the three years prior to the listing application, a very high percentage of payments to Imperial Sierra had been made by third parties on debtors’ behalf. The third-party payments were extensive: in the first two of the three-year period, third-party payments exceeded 50% of Imperial Sierra’s total revenue, and amounted to almost 40% of its total revenue in the third year. Third-party payments were thus close to being the dominant method of payment. The SFC viewed this as highly unusual and given its concern that this method of payment might have been used to disguise the original source of funds and facilitate a deceptive or fraudulent scheme, the SFC considered that the third-party payment arrangements required explanation. However, the evidence indicated that the sponsor’s transaction team had made only minimal enquiries. For example, none of Imperial Sierra’s major customers involved in the third-party payments were questioned as to why they entered into these arrangements.
  • there were two sets of suspicious transactions indicating the possibility of a circular flow of funds. Firstly, a company acting as a third-party (Guangdong Qitian) paid RMB2.3 million to Imperial Sierra on behalf of a major customer. Two days later, Imperial Sierra remitted RMB2 million back to Guangdong Qitian by way of a personal loan advanced by Aric Yip. Secondly, Imperial Sierra remitted RMB2.2 million to a company (Guangzhou Chengzhi) by way of a personal loan advanced to it by Aric Yip. On the same day, a major customer of Imperial Sierra paid RMB2.7 million to Imperial Sierra. Both Guangzhou Chengzhi and the major customer were beneficially owned by the same person.
  • Over the same period of time, Aric Yip entered into financial arrangements with various “acquaintances”, many of whom may have been connected with the third-party payers. Evidence demonstrated that in the financial years ending 2014, 2015 and 2016, Aric Yip withdrew HK$6.3 million, HK$16.5 million and HK$18.8 million, respectively, and as at 31 January 2017, he had made further withdrawals of HK$35 million. The funds were used to facilitate financial arrangements (apparently for loans or investments) between Aric Yip and 11 acquaintances. One of these acquaintances made third-party payments to Imperial Sierra. Another had close relations with a company that was a customer of Imperial Sierra (the acquaintance’s beneficial owner was also the customer’s beneficial owner).

According to the SFC, the draft prospectus did not disclose any of the above, meaning that if the prospectus had been approved, potential investors would have been ignorant of these matters. The SFC therefore alleged that the sponsor had failed to comply with the regulatory requirements for sponsors: in particular, Paragraphs 17.2 – 17.7 of the SFC Code of Conduct and Practice Note 21 to the Listing Rules (Due Diligence by Sponsors in respect of Initial Listing Applications).

The SFC also considered that the sponsor had breached other provisions of the SFC Code of Conduct and the SFC Corporate Finance Adviser Code of Conduct.

In June 2020, the SFC made its final decision. It found Yi Shun Da Capital guilty of misconduct and not to be a fit and proper person to remain licensed by the SFC. 13 It also publicly reprimanded Yi Shun Da Capital and fined it HK$4.5 million under section 194 of the SFO.

The SFC also prohibited Fabian Shin Yick , 14 a former responsible officer, sponsor principal and chief executive officer of Yi Shun Da Capital, from re-entering the industry for 20 months from 15 September 2020 until 14 May 2022 for his breaches of the SFC Code of Conduct and the Additional Fit and Proper Guidelines for Corporations and Authorized Financial Institutions applying or continuing to act as Sponsors and Compliance Advisers ( Sponsor Guidelines ). The SFC found that he had failed to: exercise due skill, care and diligence in handling the listing application; diligently supervise his subordinates to carry out the sponsor work; and ensure that Yi Shun Da Capital maintained appropriate standards of conduct.

The SFC’s Case against the Sponsor

The SFC’s concerns related to whether Yi Shun Da Capital, as sole sponsor, had carried out all reasonable due diligence in relation to the financial issues that were troubling on their face. The SFC did not allege that the third-party payments were either fictitious or fraudulent. Rather, the issue was whether a legitimate risk of a circular flow of funds existed which required the sponsor to conduct a more incisive investigation in conducting due diligence. According to the SFC, given the particular circumstances, the sponsor’s discharge of its due diligence obligations under the SFC Code of Conduct required it to look in greater depth at the third-party payments. The SFC considered it essential that the sponsor understood and critically assessed the reasons for the payments, and understood the relationships between the third-party payers and Imperial Sierra’s customers. The SFC accepted that after conducting such due diligence, Yi Shun Da Capital might have come to the conclusion that there was no circular flow of funds, or that they could be justified. However, in failing to conduct reasonable due diligence, Yi Shun Da Capital breached its obligations as sponsor.

The SFC also maintained that Yi Shun Da Capital must have known that the issue of third-party payments and other associated transactions would give rise to concerns, since the draft prospectus had allocated several passages to dealing with the issue. This showed that the sponsor had failed to investigate the issues giving rise to concerns and instead had merely relied on a few generalised statements from Imperial Sierra’s representatives. It was on this basis that the SFC came to a finding that the sponsor was in breach of the SFC Code of Conduct.

The Sponsor’s Appeal to the SFAT

In July 2020, Yi Shun Da Capital sought a review of the SFC’s decision.

The sponsor contested the SFC’s finding that it failed to conduct all reasonable due diligence. Third-party payments of that nature existed in the PRC. A number of earlier successful HKEX listings revealed the receipt of third-party payments, although they were less extensive than in the present case. Regarding the fact that the third-party payments were not occasional but amounted to a dominant practice, the sponsor’s counsel emphasised that the SFC did not allege nor had any evidence to suggest that the third-party payments were fictitious or fraudulent. The sponsor considered an investigation into why the third-party payments were made to be irrelevant. Since the suggestion that the third-party payments were engineered to create the impression that Imperial Sierra’s revenues were greater than they actually were was purely speculative, they did not merit extensive investigation.

Regarding the two suspicious transactions, Yi Shun Da Capital submitted that there was nothing inherently suspicious about them and that any suggestion of a scheme involving an engineered flow of funds was purely speculative.

As to Aric Yip’s finance arrangements with the 11 acquaintances, Yi Shun Da Capital asserted that their details were revealed, and that the sponsor’s due diligence work was presented to the SFC. They did not give rise to concerns provided the withdrawals were properly booked in the company accounts, which they were. The sponsor asserted that as it had ascertained the genuineness and existence of these financial arrangements, it did not need to carry out any further investigation.

The SFAT’s Decision

The SFAT’s Deliberations

Referring to its decision in Sun Hung Kai International limited v SFC , 15 the SFAT noted the overriding obligation on sponsors to ensure that all information placed before the HKEX and investors generally is “ fully, fairly, and accurately presented ”. It reiterated the need for sponsors to adopt an attitude of professional scepticism in assessing representations made by the listing applicant’s representatives. In particular, sponsors need to be alert to information that casts doubt on the reliability of representatives’ statements and are required to carry out additional due diligence if they become aware of information which suggests that information provided by the applicant may be unreliable or indicates a potential problem or risk. When seeking to verify information that appears to be problematic, undue reliance on management representations, particularly representations that are bland and lack detail, cannot be considered to be reasonable due diligence.

The SFAT considered that:

  • if the sponsor’s transaction team considered the issue of third-party payments to be sufficiently important to be identified in the draft prospectus, it must then follow that it should have considered the matter to be sufficiently important to warrant due verification;
  • if the listing had gone ahead, there would have been a real risk of concern in the market regarding the fact that the indirect form of payment was the dominant form of payment;
  • if the third-party payments were looked at in the context of Aric Yip’s advances to business acquaintances and the two suspicious transactions, questions would likely arise as to why the listing was allowed to proceed without full and clear explanation of the third-party payments.

The SFAT noted that the draft prospectus failed to mention the possibility that extensive third-party payments might indicate the existence of some form of circular cash flow designed to create the appearance of a higher business turnover than was actually the case. The SFAT found it strange that while this was the SFC’s chief concern – it did not appear to have caused concern to Yi Shun Da Capital’s transaction team.

Failure of IPO Sponsor to Exercise Due Diligence in Relation to the Third-Party Payments

The sponsor submitted that there had been earlier successful HKEX listings where the prospectus disclosed the receipt of third-party payments; however, according to the SFAT, it was never the SFC’s case that third-party payments should always be viewed with suspicion. Rather, the SFC considered that, on its face, this dominant practice clearly constituted more than random commercial happenstance. There was a pattern of people asking others to make third-party payments which raised a question as to the reasons for indirect payment. The SFAT found it insufficient to merely state the fact of the third-party payments. In the circumstances, the conduct of reasonable due diligence required an explanation for why payments were made indirectly.

The sponsor further submitted that it was allowed to rely on the accountants’ report, which confirmed that the financial statements gave a true and fair view of Imperial Sierra’s financial affairs. However, the SFAT pointed out that the accountants’ report did not seek to explain how the financial affairs came into being, nor could the sponsor wash its hands of the issue on the basis that the reporting accountants had found nothing that required it to qualify its report.

The evidence obtained by the SFC further revealed that Yi Shun Da Capital had interviewed only seven out of the 23 third-party payers which had made payments on behalf of 18 customers. Although it had interviewed 10 major customers who made payments through third parties, none of the major customers were asked about the third-party payments. Seven third-party payments were made pursuant to ‘private arrangements’ without any further explanation. The SFAT said that this left open the very obvious question as to the nature of the private arrangements and the reasons for them. The SFAT considered it regrettable that these questions were not asked by the sponsor. The SFC pointed to a number of anomalies which suggested that four companies that had made substantial third-party payments in 2014 may not have been conducting genuine businesses. These also warranted further investigation, but were not investigated.

In finding that the SFC had demonstrated a lack of reasonable due diligence on the part of Yi Shun Da Capital, the SFAT concluded that:

  • how the practice had arisen:
  • why it had prevailed over three years, and
  • why it was a legitimate practice and not one formulated to give a false impression to the market;
  • sponsor due diligence obligations required a more incisive investigation into the legitimacy of the third-party payment practice, especially given that the sponsor’s transaction team was clearly aware that the issue of third-party payments would be of concern to the market, as indicated by its setting aside passages in the draft prospectus to deal with the matter; and
  • while the SFAT did not have any doubts as to the transaction team’s good faith, the failure to look in greater depth at the dynamics of the third-party payment practice clearly amounted to a failure to carry out reasonable due diligence.

The SFAT was therefore satisfied that there was a failure on the part of the sponsor to exercise reasonable due diligence as required by the SFC Code of Conduct.

Failure of Sponsor to Exercise Due Diligence in Relation to Two Sets of Suspicious Transactions

In relation to the two sets of suspicious transactions, SFC asserted that no effective enquiry had been made with the customers and the third-party payers as to the transactions, and that Yi Shun Da Capital failed to review the transactions’ underlying documents. In respect of the suspicious transactions, the sponsor submitted that any allegation of a circular flow of funds was purely speculative. Further, for the first suspicious transaction, it was submitted that there was nothing inherently suspicious in the transaction and that it did not require the level of due diligence suggested by the SFC.

The SFAT was satisfied that, in light of the broader context of the third-party payments, these transactions should have been further investigated and that the sponsor had therefore failed to carry out its due diligence obligations.

Failure of Sponsor to Exercise Due Diligence in Relation to Payments Made by Aric Yip to ‘Acquaintances’

There was evidence of substantial withdrawals of funds during the track record period by Aric Yip. These were made apparently to facilitate various loan and investment arrangements between Aric Yip and his ‘acquaintances’. The draft prospectus disclosed the withdrawals, but no further details were provided regarding their purpose. It was only in response to queries from the regulators that the purpose of the withdrawals was disclosed. The SFC noted that certain acquaintances were third-party payers or entities with connections to Imperial Sierra’s customers and it was therefore important to verify the transactions’ true nature and purpose.

With respect to the due diligence work conducted, six out of the 11 acquaintances were interviewed enabling the sponsor to obtain confirmation of the reasons for each transaction, the amounts involved, and the fact of the acquaintances’ independence from Imperial Sierra and its customers. However, two of the companies interviewed stated that the funds were obtained for ‘business needs’ – effectively saying nothing.

In addition, although background searches were carried out for ten of the acquaintances, there were discrepancies with two of the interviews. The sponsor considered the discrepancies trivial, but the SFC determined they demanded follow-up action as they related to the ‘primary nature of the finance arrangements’.

It was also submitted by Yi Shun Da Capital that the financial arrangements by Aric Yip should not have given rise to any concern as long as the withdrawals were properly booked in the company accounts thus guaranteeing their genuineness. The SFAT disagreed, stating that if, looking at the overall picture, there was a legitimate reason for concern that there may have been a circular flow of funds, then all relevant matters had to be considered, including the significant loan/investment transactions between Aric Yip and the various acquaintances who had, or may have had, some connection to the parties involved. The true issue to be determined here was not whether or not the payments were recorded, but what was the effect of this flow of finance.

It was the SFC’s finding that (i) there had been a failure to obtain and review the agreements themselves and the relevant bank records; (ii) there had been a failure to follow-up on unsatisfactory or incorrect responses provided by acquaintances; and (iii) there had been a failure to state in the draft prospectus that four of the acquaintances were either third-party payers or were connected with the top five customers of Imperial Sierra.

The SFAT was satisfied that there was a failure by the sponsor to exercise due diligence.

The SFAT’s findings

In respect of the above three areas of concern, the SFAT was satisfied that the sponsor failed to conduct reasonable due diligence.

The Issue of Sanctions

The Objection to the Name ‘Well Link’

The first matter raised by the sponsor was the SFC’s draft press release citing its past name of ‘Well Link International Capital’, as it was known from December 2017 until August 2018. The sponsor had objected to the citation of this name because this was the name by which it was known after the impugned sponsorship had been completed and was a name abandoned before the SFC proceedings.

In the SFAT’s opinion, the sponsor’s contention was misconceived. Sanctions under the SFO are defensive in nature and not penal, and their purpose is to defend the market’s integrity and to ensure that the particular harm is not repeated. A threat can only be effectively countered if its source is clearly identified. For an offender to be fully and accurately identified means the name or the names it has been known by must be made known to the market.

The Sufficiency of a Public Reprimand

The sponsor contended that a public reprimand was a sufficient sanction in the circumstances and that a fine was unwarranted. It submitted that the misconduct had not affected the market and that adequate steps were taken to address the failings, and that it had relied upon the expertise and experience of its transaction team led by a person with over 25 years of relevant experience.

The SFAT considered it inevitable that sponsors will set up an operational team to bring a listing application to fruition, and that this does not mean that a sponsor can wash its hands of responsibility. The SFAT accepted the position of the sponsor’s counsel that whether a public reprimand alone was sufficient turned on the SFAT’s view as to the sponsor’s culpability. In the SFAT’s opinion, that culpability must first be put into the context of the duties imposed on a sponsor in a listing application. As the SFAT stated in Sun Hung Kai International limited v SFC:“[i]t is clear to us that the regulatory framework insisting on the exercise of due diligence by each and every sponsor is critical to the orderly and transparent working of the market. That is why emphasis is placed on the dual obligation of a sponsor, an obligation not only to the client but, equally importantly, to the integrity of the market.”

The SFAT in Sun Hung Kai International limited v SFC went on to state that investors must be able to assess the risk in purchasing shares in an IPO by relying on accurate and relevant information in listing documents. If they are unable to do so, then trust in the market is undermined. If the regulators had not raised concerns about the issue of a circular flow of funds, that concern may have been reflected in the market and may have resulted in concerns as to the integrity not only of the listing but also of the listing process itself.

Accordingly, in the view of the SFAT, evidence of material culpability on the part of a sponsor in the listing process will almost inevitably demand more than a public reprimand.

The SFC recognised that Yi Shun Da Capital had not been found culpable of any prior breach of regulatory conduct, but had nonetheless proposed an original fine of HK$14.5 million. In the SFC’s final decision, the fine was lowered to HK$4.5 million, the reduction being made in light of the sponsor’s difficult financial circumstances. The sponsor submitted to the SFAT that this was manifestly excessive given that it had a clear record, had ceased its sponsor business, and was in dire financial circumstances at the time.

Yi Shun Da Capital also submitted that it would suffer a significant loss in respect of the work done, given the sponsor fees received and the size of the fine. The SFAT had difficulty accepting this submission. It could not be the case that a sponsor is entitled to make a profit for work carried out by it even though that work has been undermined by its own culpability.

Considering all the evidence, the SFAT concluded that Yi Shun Da Capital’s essential culpability lay in its failure to look at the broader picture; to recognise that the dominant practice of third-party payments was, at least on its face, so unusual as to raise concern, a concern that was compounded when Aric Yip’s very substantial advance of funds to acquaintances for purposes of loans and/or investments was integrated into the overall picture. If sponsors are to fulfil their dual obligation to represent the interests of a listing applicant and to protect the integrity of the market, they must have the ability to be completely objective and to step back and view matters as market participants would view them.

The SFAT accepted that the dominant practice of third-party payments should have been viewed as a major red flag by the sponsor’s transaction team and was puzzled why it was not. However, the other failings were not all to be measured at the same level of culpability. In the SFAT’s view, the sanction of a public reprimand was appropriate together with a fine of HK$3 million which it considered appropriate given Yi Shun Da Capital’s financial position.

SFAT’s Determination of the Application for Review

For the above reasons, the SFAT reduced the fine from HK$4.5 million to HK$3 million.

SFC October 2021 Statement

Following the SFAT’s decision to uphold the SFC’s original decision, on 19 October 2021, the SFC reprimanded and fined Yi Shun Da Capital HK$3 million for failing to discharge its sponsor obligations in the listing application of Imperial Sierra.

The SFC had found that Yi Shun Da Capital had failed to: (i) perform all reasonable due diligence on Imperial Sierra before submitting its listing application; and (ii) ensure that all material information obtained was included in the Application Proof and that the information was accurate and substantially complete.

Failure to perform all reasonable due diligence

The SFC’s investigation made the following findings in relation to the third-party payments:

  • the sponsor failed to verify Imperial Sierra’s customers’ relationships with 23 third-party payers and the reasons for the third-party payments;
  • no steps were taken to follow-up on four of the seven third-party payers who showed in interviews that they did not know the reasons for the payments;
  • the sponsor merely relied on Imperial Sierra’s representations as to the reasons the other third-party payers made the payments, without carrying out any independent enquiries; and
  • no appropriate follow-up enquiries were made to address red flags concerning the third-party payments.

In respect of the finance arrangements between Aric Yip and the acquaintances, the SFC’s investigation found that:

  • the sponsor failed to obtain and review the agreements and the bank transaction records relating to the finance arrangements prior to the listing application submission;
  • three out of the six acquaintances were unable to explain the reasons or purposes of the finance arrangements when asked by the sponsor, and the sponsor did not follow-up on the matter;
  • four of the acquaintances were third-party payers or entities connected with Imperial Sierra’s customers, but the Application Proof did not include disclosures about these relationships; and
  • there were potential connections between three of the acquaintances and Imperial Sierra’s customers, and the sponsor failed to take appropriate steps to verify the nature of the relationships.

The SFC’s investigation also revealed that there were suspicious transactions which should have raised a question as to whether Imperial Sierra and/or its chairman had provided financial support for certain customers’ payments. However, the sponsor carried out minimal or no due diligence on these suspicious transactions.

Incomplete disclosure in the Application Proof

The SFC’s investigation found that the sponsor did not ensure that all material information was disclosed in Imperial Sierra’s Application Proof. In particular, it failed to disclose:

  • details of the relationships between Imperial Sierra’s customers and their third-party payers, or the reasons for the third-party payments;
  • that a third-party payer was the spouse of Imperial Sierra’s deputy general manager;
  • that the significant increase in the “amount due from a shareholder” was principally attributable to withdrawals made by Imperial Sierra’s chairman to facilitate the finance arrangements between the chairman and his acquaintances, and certain acquaintances were third-party payers or entities connected with Imperial Sierra’s customers; or
  • an explanation for the suspicious transactions.

1 https://apps.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=21PR103

2 https://apps.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/enforcement-news/doc?refNo=21PR104

3 https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/code-of-conduct-for-persons-licensed-by-or-registered-with-the-securities-and-futures-commission/Code_of_conduct-Dec-2020_Eng.pdf

4 See SFC “ Hontex ordered to pay $1.03 billion buy-back offer over untrue IPO prospectus ” (20 June 2012)

5 These proposals were only consulted on in May 2012 when the SFC published its “Consultation Paper on the regulation of sponsors” containing the proposals for what is now Paragraph 17 of the SFC Code of Conduct

6 https://apps.sfc.hk/edistributionWeb/api/news/openAppendix?lang=EN&refNo=21PR103&appendix=0

7 https://apps.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=21PR103

8 https://apps.sfc.hk/edistributionWeb/api/news/openAppendix?lang=EN&refNo=21PR103&appendix=0

9 https://en-rules.hkex.com.hk/sites/default/files/net_file_store/gl3612.pdf

10 https://apps.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/enforcement-news/doc?refNo=21PR104

11 https://www.sfat.gov.hk/files/SFAT4%20-%202020%20-%20Determination%20(19.10.2021)(final).pdf

12 The company was known as Zhaobangji International Capital Limited from November 2015 until December 2017 and as Well Link International Capital Limited from December 2017 until August 2018. After that, it became known as Yi Shun Da Capital Limited.

13 See the SFAT’s Determination dated 19 October 2021 at paragraph 12

14 https://apps.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=20PR90

15 Application No. 3 of 2013 https://www.sfat.gov.hk/files/AN-3-2013-Determination.pdf

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Sfc disciplinary action, sfc ample capital, sfc yi shun da capital, reasonable due diligence hong kong, sfc code of conduct, section 194 sfo, securities and futures appeals tribunal, breach of sponsor duties, hkex application to list, hkex ipo prospectus, public reprimand, application proof disclosure, sponsor interview customer supplier, distributorship business model due diligence, hkex guidance letter 36-12, ipo prospectus verification hong kong, hkex practice note 21, companies (winding up and miscellaneous provisions) ordinance prospectus, hontex hkex, sfc statement of disciplinary action, hkex imperial sierra, paragraph 17 due diligence, sfc sponsor fine.

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Hkex plans to develop integrated fund platform for distribution of hong kong retail funds.

distributorship business model hkex

HKEX has announced plans to develop an integrated fund platform for the distribution of retail funds in Hong Kong. The platform aims to lower barriers to entry in the industry and enable market participants to better distribute fund products to their clients. This will provide investors with a wider range of products and enhance overall market efficiencies. The platform will initially operate as a business-to-business service model and will consist of a Communication Hub, a Business Platform, and an Information Portal. HKEX is currently evaluating the operating model and structure of the platform in collaboration with the Hong Kong Government, the SFC, and other stakeholders.

Resource: https://www.hkex.com.hk/News/News-Release/2023/231102news?sc_lang=en

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The HKD-RMB Dual Counter Model was launched on June 19, 2023 and this article explains how the Dual Counter Model works, promotes RMB internationalisation and strengthens Hong Kong’s role as an international financial centre.

Hong Kong was the first market in the world to offer offshore RMB investment products and, since 2010, HKEX’s offshore RMB product ecosystem has grown to include a wide range of RMB-denominated bonds, real estate investment trusts (REITs), equities and ETFs.

Timeline showing the growth of HKEX's offshore RMB product ecosystem between October 2010 and June 2023

To further support the development of RMB securities, HKEX has also introduced risk management tools, such as USD/CNH futures. 

That product, the world’s first deliverable RMB currency futures product to be quoted, margined, and settled in RMB, was introduced in September 2012 and average daily contract volume reached more than 14,000 contracts in 2022, according to HKEX data.

Apart from products, HKEX has worked with partners and stakeholders to create mutual market access programmes, such as Stock Connect and Bond Connect, that provide global investors with access to RMB-denominated products via a user-friendly interface and system. 

The HKD-RMB Dual Counter Model is the latest initiative that connects offshore investors with RMB-denominated investment opportunities and paves the way for onshore Mainland investors to trade RMB-denominated securities through Southbound Stock Connect at a later stage.  

Chart showing average daily contract volume for USD/CNH Futures at HKEX from 2012 to 2022

In short, this model is simply: “one share, two currencies.” 

The HKD-RMB Dual Counter Model offers investors a choice of trading the shares of a Hong Kong-listed company in either HKD or RMB.

From the launch of the Dual Counter Model on June 19, investors may trade 24 Dual Counter Securities: a selection that includes some of the largest, most widely traded companies on the Hong Kong cash equities market and their HKD counters account for approximately 40% of average daily turnover of cash equities, according to HKEX data.

In the HKD-RMB Dual Counter Model, securities under the two counters are of the same class and are fully interchangeable and investors in either counter have identical rights, such as dividend and voting rights. 

The Dual Counter Market Making Programme is a key part of the Dual Counter Model. 

Through it, market makers will offer buy and sell quotes on RMB-denominated securities, providing consistent liquidity in the RMB counter, linking up liquidity between HKD and the RMB counters and carrying out arbitrage trading, cross-counter, to minimise price discrepancies between the two counters.

Through the Dual Counter Model, investors will have a wider choice of trading currencies and investing opportunities and will be able to seamlessly and flexibly interchange securities listed in both HKD and RMB counters.

For issuers, the Dual Counter Model connects them to the RMB liquidity pool, in particular investors with offshore RMB. As the model develops, it is expected that investors in Mainland China will eventually have the opportunity to trade RMB-denominated, Hong Kong-listed stocks via Southbound Stock Connect.

Why launch the HKD-RMB Dual Counter Model now?

The RMB internationalisation process means the RMB is increasingly being used as a trading and investment currency and offshore RMB liquidity pools are growing.

For example, RMB 42.1 trillion (USD 6.1 trillion) of China’s cross-border payments and receipts were settled in RMB during 2022, up 15% compared with RMB 36.6 trillion in 2021, and up 48.2% compared with RMB 28.4 trillion in 2020, according to data from the People’s Bank of China.

Chart showing total cross-border RMB settlements in RMB trillions from 2018 to 2022

The RMB is now one of the five most actively traded currencies in the world. It rose to fifth place in over-the-counter (OTC) foreign exchange markets in April 2022, up from eighth in the same month in 2019, according to an October 2022 survey of central banks by the Bank for International Settlements (BIS).

By enriching the RMB product ecosystem with the addition of RMB-denominated securities in the Dual Counter Model, HKEX is channeling the growing vitality in the RMB space into financial markets and promoting RMB internationalisation. 

Hong Kong is the world’s leading offshore RMB centre – total RMB deposits in Hong Kong have increased from RMB 597 billion in April 2018 to RMB 832 billion in April 2023, and Hong Kong was the world's largest offshore RMB settlement center in 2020, handling approximately 75% of all global RMB payment transactions, according to the Society for Worldwide Interbank Financial Telecommunication (SWIFT).

Also, the number and value of RMB-denominated investment products in Hong Kong is expanding – rising from 260 in 2018 to 342 at the end of 2022, and with the total value growing from RMB 78 billion to RMB 217 billion over the same time horizon, according to the Securities and Futures Commission.

Chart showing the total number of RMB-denominated investment products registered in Hong Kong and their total AUM between 2018 and 2022

Over the years, HKEX has made continuous enhancements to Stock Connect and Bond Connect, and it will be the same for the Dual Counter Model. 

The number of Dual Counter Securities will increase, albeit in stages, and it is expected that Mainland investors will eventually be able to trade RMB-denominated securities through Southbound Stock Connect.

Under the current Southbound Stock Connect mechanism, Mainland investors trade HKEX securities in HKD and settle the trades in RMB, hence are exposed to foreign exchange risks, if exchange rates fluctuate. 

Quoting and trading Hong Kong-listed stocks in RMB can reduce exchange rate risks for Mainland China investors and increase the attractiveness of Hong Kong-listed securities to them.

The inclusion of RMB-denominated securities in Southbound Stock Connect will, however, take some time as it requires upgrading some infrastructure and close cooperation among various stakeholders in both Hong Kong and Mainland China.

While it will take time to build liquidity, the Dual Counter Model is an important step in growing Hong Kong’s RMB ecosystem, one that already includes access to A-shares via Stock Connect, RMB bonds through Bond Connect, as well as HKEX’s diverse selection of RMB-related products. 

This latest step also follows the recent inclusion of international companies with a primary Hong Kong listing in Southbound Stock Connect, providing them with accessibility to the sizeable mainland market. 

With the Dual Counter Model, mainland investors could eventually buy the stocks of these companies directly in RMB, raising the appeal and convenience of these transactions. 

As the RMB product ecosystem expands, the direction of travel is clear – more choice for investors, bigger capital pools for issuers, increased cross-border capital circulation, closer connectivity with China, and faster RMB internationalisation – and all this is happening in Hong Kong, strengthening the city’s role as East-West superconnector, offshore RMB hub and international finance centre. 

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1.  What is the HKD-RMB Dual Counter Model?  

The HKD-RMB Dual Counter Model refers to the overall trading, market making and settlement model of HKD-RMB Dual Counters.

2. When did the HKD-RMB Dual Counter Model launch?

The HKD-RMB Dual Counter Model was launched on June 19, 2023.

3. What are Dual Counter Securities?

Dual Counter Securities refer to securities with HKD and RMB counters (“HKD-RMB Dual Counters”) designated by the Exchange in accordance with the Rules of the Exchange and are eligible for Dual Counter Market Making programme. (See FAQ Q1, pg. 2)

4. How many Dual Counter Securities have been included in the HKD-RMB Dual Counter Model?

A total of 24 Dual Counter Securities were available at the launch of the HKD-RMB Dual Counter Model on June 19, 2023. For a full list of Dual Counter Securities, click here .  

5. What is the Dual Counter Market Making Programme?

The new Dual Counter Market Making Programme is a new market making programme to support inter-counter Dual Counter Securities trading, provide liquidity in the secondary counters (initially RMB counters) and minimise price discrepancies between the two counters. (See FAQ Q1, pg. 2)

Dual Counter Market Makers will offer buy and sell quotes for the RMB-denominated securities trading, providing liquidity in the RMB counter and minimising price discrepancies between the HKD and RMB counters.

(See press release )

6. What is the benefit to investors from the HKD-RMB Dual Counter Model?

A key advantage of a dual counter security for investors is that it offers the convenience of being able to trade in either one of the two currencies.

7. What is the benefit for an issuer to list both HKD and RMB counters and then be designated as a Dual Counter Security?

An issuer with a dual counter arrangement including a RMB counter under the Dual Counter Model can offer investors choices of trading currency and potentially tap into new RMB liquidity.

Further, a Dual Counter Security designated by HKEX may have market makers which would provide liquidity in the secondary counter (initially RMB counter) and narrow price discrepancies between its HKD-RMB Dual Counters.

8. Are holders of securities under the RMB counter and the HKD counter under the Dual Counter Model treated differently from a legal perspective?

The Rules of the Exchange require that a Dual Counter Security may be traded in two different currencies provided that the securities concerned are of the same class.

Holders of Dual Counter Securities shall be entitled to identical rights under the issuer’s constitutional documents. The HKD-RMB Dual Counter arrangement is for trading and settlement purposes only.

9. How do single-counter and inter-counter trading work?

Single-counter trading is equivalent to trading HKD-denominated securities or RMB-denominated securities and there are no additional requirements for brokers as compared to the current practice.

As usual, for trading under the RMB counter, brokers should ensure their own readiness for trading and settlement of securities in the RMB counter.

Inter-counter trading means buying in one counter and selling in another counter as two independent transactions, even though both transactions involve the same security. However, brokers and their clients should ensure that necessary actions are taken (e.g. interchanging securities from one counter to another) to prevent failed settlement.

10. Where can I find more information about the HKD-RMB Dual Counter Model?

You can find updated FAQs and briefing materials, lists of Dual Counter Securities, reference materials for the Dual Counter Market Making Programme, circulars and clients notices at the dedicated HKEX HKD-RMB Dual Counter Model information page here .

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2. Nikkei Asia

3. People’s Bank of China

6. Bank of International Settlements 

7. Hong Kong Monetary Authority 

8. SWIFT: RMB Tracker

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COMMENTS

  1. PDF HKEX GUIDANCE LETTER HKEX-GL36-12 (May 2012) (Updated in February 2020

    benefits and reasons of using the particular distributorship business model and whether it is an industry norm; the applicant's different distribution channels and their respective revenue contribution during the track record period;

  2. PDF 4.5 Distributorship

    Definitions In this chapter, Distributors refer to an applicant's direct counterparties who contractually resell, or are reasonably expected to resell the applicant's products, which include franchisees and consignees.

  3. PDF HKEx GUIDANCE LETTER HKEx-GL36-12 (May 2012) Subject Distributorship

    the benefits of using the particular distributorship model and whether it is an industry norm; whether the applicant's relationship with the distributors is seller/buyer or principal/agent; the turnover rate of distributors and movements in the number of distributors during the track record period and reasons for the major changes;

  4. Archive

    Guidance on due diligence to be conducted by the sponsor and disclosure in the listing document relating to a distributorship business model (GL36-12) (Streamlined and incorporated into the Guide for New Listing Applicants in January 2024 ... (Withdrawn; superseded by HKEX-GL105-19 issued in October 2019) Guidance Letter: Listed Issuers: 30/05 ...

  5. HKEx Updates and Streamlines Guidance Materials

    On 28 February 2020, HKEx updated its listing guidance including guidance for mineral company listing applicants and on the IPO sponsor due diligence work and listing document disclosure required for distributorship business models.

  6. Continuous Disclosure Obligations

    The Exchange has issued a guidance letter HKEx-GL36-12 ( Guidance Letter) which sets out the information that listing applicants should disclose in their listing documents in relation to any distributorship business model they have adopted.

  7. Understanding Distributorship Business Model of Listing Applicant to

    In Exchange Guidance Letter GL36-12 on Distributorship Business Model - Risks and Disclosure in Listing Documents, the Stock Exchange cited a case where the listing applicant encouraged its employees to become its independent distributors during the track record period, and when the Stock Exchange raised concerns on the independence of those ...

  8. e-Distribution

    The integrated fund platform, which will be developed and operated by the Hong Kong Exchanges and Clearing Limited (HKEX), will provide a business-to-business service model initially and will cover the front-to-back distribution life cycle and value chain for distribution of SFC-authorised funds in Hong Kong (Note 2).

  9. PDF Carltons

    Distributorship Business Models 1. HKEx Guidance Letter 89-16: Situation when there is no Controlling Shareholder HKEx Guidance Letter GL89-16 has been updated to include guidance that in relation to the ownership continuity and control requirement that is a condition for meeting the financial

  10. PDF HKEX INVESTOR PRESENTATION

    7 HKEX -Strong Core Business with Unparalleled Growth Opportunities 1 | Sole exchange group in Asia's leading financial centre with robust and resilient business model underpinned by Internationally trusted financial markets Diverse investor mix and comprehensive offerings across the value chain 2 | Strong structural growth in equities sustained by

  11. PDF HKEX Investor Presentation

    1. HKEX signed a licence agreement with MSCI to introduce futures contracts on the MSCI China A Index, subject to regulatory approval and market conditions. 2. HKEX signed a licence agreement with MSCI to introduce 39 futures and options contracts in Hong Kong based on a suite of indexes in Asia and Emerging Markets, subject to regulatory

  12. PDF 3.7 Business

    3.7 BUSINESS 1. The "Business" section in a listing document should explain the material components of an applicant's business operations. Guidance on Disclosure 2. The table below provides some general guidance:

  13. SFC Fines Sponsors for Due Diligence Failures

    In both cases, the sponsor was found to have failed to conduct adequate due diligence of third-party payments which the SFC alleged raised red flags - in the Ample case of channel stuffing in the context of a distributorship business model, and in the case of Yi Shun Da Capital, of a circular flow of funds potentially indicative of an attempt to...

  14. Hong Kong's New Listing Rules for Specialist Technology Companies

    Eligibility Requirement Commercial Company Pre-Commercial Company; Specialist Technology Company: Company must be primarily engaged in a Specialist Technology Industry. 3. Where a company has multiple business segments some of which do not qualify as Specialist Technology Industries, HKEX will look at the following factors to determine whether the company meets the "primarily engaged ...

  15. Distributorship Business Model

    HKEx GUIDANCE LETTER HKExGL3612 (May 2012) SubjectDistributorship business model risks and disclosure in listing documentsListing RulesMain Board Rules 2.13(2) and 11.07 GEM Rules 14.08(7) and 17.56(2)Related. ... Find the Distributorship Business Model - Risks And Disclosure In Listing you need. Open it up using the online editor and begin ...

  16. PDF Major changes to the Guidance Materials on 28 February 2020

    HKEX-GL36-12: Guidance on due diligence to be conducted by the sponsor and disclosure in the listing document relating to a distributorship business model Revised to provide more specific guidance on sponsors due diligence work and prospectus disclosure requirements in relation to a distributorship model to assist investors to properly assess th...

  17. Our Strategy

    Learn more about HKEX Corporate Strategy. HKEX Strategy is to build The Marketplace of the Future by facilitating the vital two-way capital flow between East and West, and using our size, scale and reputation as a platform to support our stakeholders and capture the opportunities presented by the megatrends that are shaping our markets and our societies.

  18. HKEX Plans to Develop Integrated Fund Platform for Distribution of Hong

    The platform will initially operate as a business-to-business service model and will consist of a Communication Hub, a Business Platform, and an Information Portal. HKEX is currently evaluating the operating model and structure of the platform in collaboration with the Hong Kong Government, the SFC, and other stakeholders.

  19. HKEX Plans to Develop Integrated Fund Platform for Distribution of Hong

    Hong Kong Exchanges and Clearing Limited (HKEX) is pleased to announce today (Thursday) that it is developing an integrated fund platform for the distribution of retail funds, supporting Hong Kong's continued role as a regional and global wealth management centre.

  20. Effective Distribution Models for Business Success

    Choosing the right distribution model and effectively managing distribution channels is crucial for the success of a business, ... Distribution business model involves logistics, transportation, warehousing, and channel management, with strategies depending on product type, market served, and geographic scope, including intensive distribution ...

  21. PDF HKEX-GL110-21 (March 2021) (Last updated in August 2022)

    This letter (i) elaborates on why Distributors are encouraged to submit a Pre-vetting Application for the Exchange's review; and (ii) provides guidance to Distributors on information required for pre-vetting in anticipation of potential placing of securities to connected clients, regardless of whether they are ultimately placed with any securiti...

  22. HKD-RMB Dual Counter Model, Explained

    The HKD-RMB Dual Counter Model is the latest addition to HKEX's ecosystem of offshore RMB products and offers investors the choice of trading the security of a Hong Kong-listed company in either HKD or RMB. At launch on June 19, the Dual Counter Model includes 24 Dual Counter Securities. Those securities' HKD counters account for ...