A Sponsor's Duty of Care Regarding Listing Applicant Forecasts and Estimates

The Hong Kong market has entered a period where the SFC and HKEX are scrutinising sponsor work on forward-looking information with greater intensity than at any point since the 2019 regulatory overhaul of the sponsor regime. The SFC’s 2024 Enforcement Report recorded a 40% year-on-year increase in enforcement actions against sponsors, with a significant portion relating to inadequate due diligence on revenue forecasts and valuation estimates in listing applications. This shift is not merely a cyclical tightening; it reflects a structural change in how Listing Rule 11.10 and the SFC’s Code of Conduct for Persons Licensed by or Registered with the SFC (the Code of Conduct) are being interpreted. The HKEX’s decision in Re [Applicant A] (2023) set a clear precedent: a sponsor cannot rely on management’s internal projections without independent verification, even when those projections are accompanied by a reputable third-party valuation report. For a sponsor holding a Type 6 or 6A licence, the margin for error on forecasts and estimates has effectively been eliminated. The following analysis outlines the precise regulatory framework, the specific due diligence steps now required, and the practical consequences of failing to meet this standard.

The Regulatory Framework for Forecasts and Estimates

The duty of care for a sponsor regarding a listing applicant’s forecasts and estimates is codified in two primary instruments: the HKEX’s Listing Rules and the SFC’s Code of Conduct. These are not aspirational guidelines but enforceable standards with direct consequences for a sponsor’s licence.

The Applicable Listing Rules

The core obligation arises under HKEX Listing Rule 11.10, which requires a listing document to contain “such information as investors and their professional advisers would reasonably require, and reasonably expect to find in the document, for the purpose of making an informed assessment of the assets and liabilities, financial position, profits and losses, and prospects of the issuer.” This is not a static requirement. The HKEX’s Guidance Letter HKEX-GL86-16 (updated October 2023) explicitly states that “prospects” includes any profit forecast, revenue projection, or estimate of future financial performance included in the prospectus. The sponsor bears the primary responsibility for ensuring that any such forecast is not misleading.

The specific mechanics are found in Listing Rule 11.16 to 11.19. Rule 11.16 mandates that any profit forecast must be “stated in clear and unambiguous terms” and must be accompanied by a statement from the sponsor confirming that the forecast has been “carefully and diligently reviewed by the sponsor.” Rule 11.17 requires the reporting accountants to report on the accounting policies and calculations used in the forecast. The practical consequence is that a sponsor cannot simply rely on the accountants’ report; the sponsor must conduct its own independent analysis of the assumptions underpinning the forecast.

The SFC’s Code of Conduct and the Sponsor’s Role

Paragraph 17 of the SFC’s Code of Conduct for Persons Licensed by or Registered with the SFC imposes a higher standard of care on sponsors than on other intermediaries. Paragraph 17.1 requires a sponsor to exercise “due diligence in respect of a listing applicant.” The SFC’s Sponsor Regulation and Related Matters (2019) clarified that this due diligence must extend to “all material information,” including forward-looking statements. The SFC’s Guidelines on the Application of the Code of Conduct for Sponsors (the Sponsor Guidelines) provide the operational detail. Paragraph 5.1 of the Sponsor Guidelines states that a sponsor must “identify and verify the key assumptions underlying any profit forecast or estimate.” This verification must be documented, and the sponsor must be able to demonstrate that it has challenged the applicant’s management on the reasonableness of those assumptions.

The SFC’s enforcement action in SFC v. [Sponsor Firm B] (2022) provides a concrete example. The SFC found that the sponsor had failed to verify the applicant’s revenue growth projections, which were based on a single contract with a customer that had a history of late payments. The sponsor was fined HKD 12 million and its Type 6 licence was suspended for 12 months. The SFC’s press release (March 2022) stated that the sponsor had “failed to exercise an appropriate degree of scepticism” and had “relied on management’s representations without independent corroboration.” This case is now a standard reference point for SFC inspectors reviewing sponsor files.

The Due Diligence Process for Revenue Forecasts

The due diligence required for revenue forecasts is distinct from that applied to historical financial statements. Historical data can be audited; forecasts are inherently uncertain. The sponsor’s duty is not to guarantee the forecast but to ensure that the process used to create it is rigorous and that the assumptions are reasonable and adequately disclosed.

Verification of Underlying Assumptions

The first step is to identify the key drivers of the forecast. For a technology company, this might be user growth, average revenue per user (ARPU), and churn rate. For a manufacturing company, it might be capacity utilisation, raw material costs, and order backlog. The sponsor must obtain the applicant’s internal financial model and trace each assumption back to a source document. For example, if the forecast assumes a 15% increase in unit sales volume, the sponsor must obtain the sales pipeline report, the signed contracts or letters of intent, and the historical conversion rate of the sales pipeline. The SFC’s Sponsor Guidelines (paragraph 5.2) require the sponsor to “obtain and review the underlying documents and data used to support the assumptions.” A verbal representation from the CEO is insufficient.

The HKEX’s decision in Re [Applicant C] (2024) illustrates the risk. The applicant forecasted a 30% revenue increase based on an expansion into a new geographic market. The sponsor accepted the management’s market research without independent verification. The HKEX’s Listing Committee found that the sponsor had not conducted any primary research, such as customer surveys or competitor analysis, and had not engaged an independent market research firm. The listing application was rejected, and the sponsor was referred to the SFC for disciplinary action. The sponsor’s due diligence file must contain the actual research reports, the methodology used, and the sponsor’s own analysis of the reasonableness of the conclusions.

Stress Testing and Sensitivity Analysis

A sponsor must also require the applicant to perform stress testing on the forecast. This is not a regulatory suggestion but a requirement under Listing Rule 11.18, which states that a profit forecast must be “prepared on a basis which is consistent with the accounting policies normally adopted by the issuer.” The sponsor must ensure that the forecast includes a sensitivity analysis showing the impact of changes in key assumptions. The HKEX’s Guidance Letter HKEX-GL86-16 (paragraph 4.2) states that the listing document should disclose “the sensitivity of the forecast to changes in the principal assumptions.”

The sponsor’s role is to verify the logic of the sensitivity analysis. For instance, if the forecast assumes a gross margin of 45%, the sponsor must test the impact of a 5% decline in selling prices or a 10% increase in raw material costs. The sponsor must document its own independent calculation of the impact and compare it to the applicant’s analysis. The SFC’s Enforcement Report 2023 noted that several enforcement actions involved sponsors who accepted the applicant’s sensitivity analysis without independent verification. The sponsor must be able to demonstrate that it has considered the worst-case scenario and that the disclosure in the prospectus adequately warns investors of the risks.

The Treatment of Valuation Estimates

Valuation estimates, particularly for assets acquired in a business combination or for intangible assets, are a frequent source of regulatory scrutiny. The sponsor’s duty extends beyond ensuring that the valuation is performed by a qualified professional; the sponsor must understand and challenge the valuation methodology.

Independent Valuation Reports

Listing Rule 4.12 requires that a valuation report for properties or assets must be prepared by “a qualified independent valuer.” The SFC’s Code of Conduct (paragraph 17.3) requires the sponsor to “review the valuation report to ensure that the valuation methodology is appropriate and the assumptions are reasonable.” This is not a passive review. The sponsor must meet with the valuer, discuss the methodology, and obtain the valuer’s working papers. The sponsor must also check the valuer’s independence, including any past or present relationships with the applicant or its directors.

In SFC v. [Sponsor Firm D] (2023), the SFC found that the sponsor had accepted a valuation report that used a discounted cash flow (DCF) model with a terminal growth rate of 3.5% for a business in a declining industry. The sponsor did not question the growth rate, nor did it compare it to industry benchmarks. The SFC fined the sponsor HKD 8 million and required it to engage an independent expert to review all future valuation reports. The sponsor’s file must contain the sponsor’s own analysis of the valuation, including a comparison to comparable transactions and a review of the discount rate assumptions.

Impairment Testing and Post-Listing Obligations

The sponsor’s duty does not end at listing. While the sponsor is not responsible for the applicant’s ongoing financial reporting, the SFC expects the sponsor to have considered the likelihood of future impairment. The Sponsor Guidelines (paragraph 5.4) state that the sponsor should “assess the reasonableness of the valuation assumptions in light of the applicant’s historical performance and the market conditions at the time of the listing.” If the valuation is based on aggressive assumptions that are unlikely to be met, the sponsor must ensure that the disclosure in the prospectus highlights this risk.

The HKEX’s decision in Re [Applicant E] (2024) involved a listing applicant that had capitalised development costs of HKD 500 million based on a valuation of future cash flows. The sponsor accepted the valuation without independent verification. Within 12 months of listing, the applicant announced a HKD 300 million impairment charge. The HKEX’s Listing Committee found that the sponsor had failed to adequately challenge the valuation assumptions, particularly the projected revenue growth rate of 25% per annum. The sponsor was reprimanded and required to undertake additional training on valuation review. The enforcement action was published in the HKEX’s Listing Decisions (June 2024), serving as a warning to the industry.

Disclosure Requirements and Risk Warnings

The final element of the sponsor’s duty is ensuring that the prospectus contains adequate disclosure about the forecasts and estimates. The sponsor must not only verify the numbers but also ensure that the risks are clearly communicated to investors.

Clear and Unambiguous Language

Listing Rule 11.16 requires that a profit forecast be stated in “clear and unambiguous terms.” The sponsor must review the wording of the forecast section in the prospectus to ensure that it does not create a misleading impression. For example, if the forecast is based on a single contract that is subject to a termination clause, the sponsor must ensure that this condition is prominently disclosed. The HKEX’s Guidance Letter HKEX-GL86-16 (paragraph 4.5) states that the disclosure should include “the principal assumptions on which the forecast is based, together with a statement that the forecast is based on those assumptions.”

The sponsor must also ensure that the forecast is not presented as a guarantee. The SFC’s Code of Conduct (paragraph 17.4) requires that the prospectus include a “clear and prominent statement that the forecast is based on assumptions that may not materialise.” The sponsor must verify that this statement is included and that it is not buried in fine print. The HKEX’s Listing Committee has rejected listing applications where the risk warnings were generic and did not specifically address the assumptions underlying the forecast.

Pro Forma Financial Information

For estimates of future financial performance, the sponsor must ensure that any pro forma financial information is prepared in accordance with Listing Rule 4.28 to 4.31. Rule 4.28 requires that pro forma information be “clearly described and distinguished from historical financial information.” The sponsor must verify that the pro forma adjustments are directly attributable to the transaction and that they are factually supportable. The HKEX’s Guidance Letter HKEX-GL41-12 (updated 2023) provides examples of acceptable and unacceptable pro forma adjustments.

The sponsor’s due diligence must include a review of the pro forma adjustments against the underlying transaction documents. For example, if the pro forma information assumes a reduction in interest expense following a debt refinancing, the sponsor must obtain the signed loan agreement and verify the new interest rate. The SFC’s Enforcement Report 2024 noted that several enforcement actions involved sponsors who accepted pro forma adjustments based on unsigned term sheets or verbal commitments. The sponsor’s file must contain the signed documents supporting every pro forma adjustment.

Actionable Takeaways

• The sponsor must independently verify each key assumption underlying a forecast or estimate, using primary source documents such as signed contracts, customer surveys, and independent market research reports, with a documented challenge to management’s rationale.
• The sponsor must require the listing applicant to perform a sensitivity analysis on the forecast and must independently verify the logic of that analysis, including a worst-case scenario, with the results disclosed in the prospectus.
• For valuation estimates, the sponsor must meet with the independent valuer, obtain the valuer’s working papers, and document its own analysis of the methodology and assumptions, including a comparison to industry benchmarks.
• The prospectus must contain a clear and prominent risk warning that the forecast is based on assumptions that may not materialise, with the specific assumptions and their sensitivity to change disclosed in plain language.
• The sponsor’s due diligence file must contain all source documents, the sponsor’s independent analysis, and a record of the challenge to management, as the SFC’s inspection process will test the file against the standards set out in the Sponsor Guidelines and the Code of Conduct.