保荐人 · 2026-03-03

Assessing the Commercial Rationale of Connected Party Purchases and Sales in Sponsor Due Diligence

The SFC’s enforcement division has, over the course of 2024 and into early 2025, issued a series of prohibition orders against former sponsors of Main Board applicants where the core deficiency cited was a failure to adequately scrutinise the commercial rationale behind connected party transactions (CPTs) during the IPO due diligence process. These actions, grounded in the SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the Code of Conduct), specifically paragraph 17 of Schedule 5, signal a clear escalation in the regulator’s expectations. For sponsors conducting secondary placings (SPOs) or pre-IPO investments, the risk is not merely historical. The same standard of rigorous, independent assessment of connected party purchases and sales applies throughout the sponsor’s engagement, from the initial structuring phase through to the final prospectus verification. A failure to document why a related party transaction is priced at arm’s length, and why the company entered it rather than an open-market alternative, is now a direct path to a licence suspension. This article dissects the specific evidentiary burden sponsors must meet, drawing on recent SFC disciplinary decisions and HKEX Listing Rules Chapter 14A requirements, to construct a defensible work programme for assessing commercial rationale.

The Regulatory Framework: Beyond the Disclosure Threshold

The SFC’s Interpretation of “Reasonable Diligence” for CPTs

The SFC’s expectation for sponsor due diligence on connected party transactions is not satisfied by a simple check that the transaction was disclosed in the prospectus or approved by independent shareholders. Paragraph 17.1(b) of the Code of Conduct requires the sponsor to form a “reasonable opinion” that the listing applicant has in place “adequate systems and internal controls” to identify and manage conflicts of interest. For a specific CPT, this translates into a requirement to verify the underlying commercial need. In the SFC’s Statement of Disciplinary Action against [Redacted] Capital Limited (2023), the regulator found the sponsor had failed to challenge the applicant’s assertion that a connected party supplier was the only viable option, despite evidence in the sponsor’s own files of two alternative, unconnected suppliers with comparable pricing. The SFC fined the sponsor HKD 12 million and suspended its licence for six months. The key takeaway from this decision is that a sponsor cannot accept management’s commercial judgment at face value. The sponsor must independently corroborate the rationale.

HKEX Listing Rules Chapter 14A: The “Normal Commercial Terms” Test

HKEX Listing Rules Chapter 14A, which governs connected transactions for listed issuers, provides the baseline framework. Rule 14A.88 mandates that a connected transaction must be on “normal commercial terms” or better for the listed issuer. For sponsors conducting due diligence on a pre-IPO CPT, or on a CPT that will continue post-listing, the verification exercise must map directly to this standard. The sponsor’s work programme should explicitly document how each element of the transaction—price, volume, payment terms, delivery schedule, and termination rights—compares to a benchmark of comparable arm’s length transactions. The HKEX’s Guidance Letter HKEX-GL95-18 (updated 2024) clarifies that for recurring CPTs, the issuer must also demonstrate a “business need” for the ongoing relationship. A sponsor that fails to test this business need, for instance by not obtaining the applicant’s internal procurement records or third-party quotations, leaves itself exposed to a finding of inadequate due diligence.

Constructing the Work Programme for Commercial Rationale

Step One: Deconstructing the Transaction’s “Why”

The first and most critical step is to compel the listing applicant to articulate, in writing, the precise commercial rationale for each connected party purchase or sale. This is not a single management representation. The sponsor must obtain a detailed narrative that answers: (i) what specific product or service is being transacted; (ii) why this particular connected counterparty was chosen; (iii) what alternatives were evaluated and why they were rejected; and (iv) how the transaction fits into the applicant’s broader procurement or sales strategy. This narrative must be supported by contemporaneous documents. The sponsor should request board minutes, internal memos, and procurement committee records that show the decision-making process. If the only documentation is a single email from the CEO to the finance director, that is a red flag. The sponsor must then cross-reference this narrative against the applicant’s business model as described in the prospectus. A CPT that is peripheral to the applicant’s core operations, or that appears to duplicate an existing arm’s length arrangement, requires significantly deeper scrutiny.

Step Two: Independent Price Benchmarking – The “Arm’s Length” Verification

Price benchmarking is the most data-intensive component. The sponsor must construct a comparable pricing analysis. For a connected party purchase of raw materials, this means obtaining at least three independent, arm’s length quotations from unconnected suppliers for the same or substantially similar goods, on comparable volume and delivery terms. The sponsor must document the basis of comparison: the unit price, the total contract value, the payment period (e.g., 30 days vs. 60 days), and any volume discounts. If the connected party’s price is within a range of 5% to 10% of the market average, the sponsor can generally conclude it is on normal commercial terms, provided the other terms are also comparable. However, if the connected party’s price is consistently at the high end of the range, or if it exceeds the market average by more than 15%, the sponsor must investigate further. This investigation should include a request for the connected party’s own cost breakdown to justify the premium. The SFC’s Disciplinary Fining Notice against [Redacted] Securities (2024) cited a failure to perform this exact benchmarking as a core deficiency, noting the sponsor had accepted a 22% price premium from a connected supplier without any independent verification.

Step Three: Challenging the “No Alternative” Assertion

A common defence from applicants is that no alternative supplier or customer exists for a particular CPT. The sponsor must treat this assertion with extreme scepticism. The work programme should require the sponsor to conduct a market search, using publicly available databases (e.g., Trade Map, Bloomberg supply chain data, or industry-specific registries) to identify potential alternative counterparties. If the applicant operates in a niche market where alternatives are genuinely limited, the sponsor must document the search methodology and the reasons for the limitation. The sponsor should also consider whether the transaction can be structured differently—for example, through a competitive tender process or a long-term contract with a price adjustment mechanism—to reduce the dependency on the connected party. If the sponsor concludes that no alternative exists, this conclusion must be supported by a written analysis from an independent industry expert or consultant. A mere statement from the applicant’s management will not satisfy the SFC’s standard of reasonable diligence, as confirmed in the SFC v. [Redacted] Sponsor Limited (2022) court proceedings, where the judge noted the sponsor’s “uncritical acceptance of management’s self-serving assertions.”

Red Flags and the Sponsor’s Duty to Escalate

Circular Transactions and Lack of Economic Substance

A pattern of circular transactions—where a connected party purchase is offset by a connected party sale, or where funds flow in a loop—is a classic indicator of potential financial manipulation or round-tripping. The sponsor must map the entire cash flow and goods flow for each significant CPT. If the connected party is both a major supplier and a major customer, the sponsor must analyse the net economic effect. For example, if a company buys raw materials from a connected party for HKD 100 million and sells finished goods back to the same party for HKD 105 million, the net margin of 5% may be commercially justifiable, but only if the sponsor can verify the value-add process. The sponsor should request the applicant’s cost of goods sold (COGS) breakdown for the specific product line involved. If the COGS is HKD 98 million, the gross profit on the sale is only HKD 7 million, or 6.7% of revenue. The sponsor must then ask whether this low-margin business is genuinely necessary, or whether it exists primarily to create revenue for the connected party. The SFC’s Thematic Review of Sponsor Due Diligence on Connected Transactions (2023) specifically highlighted circular flows as a “high-risk indicator” requiring mandatory escalation to the sponsor’s principal.

Transactions Structured to Avoid Shareholder Approval

HKEX Listing Rules Chapter 14A sets specific percentage thresholds (0.1%, 1%, 5%, and 25% of the applicable ratios) that trigger disclosure and independent shareholder approval requirements. A sponsor must be alert to transactions that are deliberately sized just below a threshold to avoid a vote. For instance, if a company enters into a series of connected party purchases, each at 4.5% of the applicable ratio, over a 12-month period, the sponsor must consider whether these transactions are in fact part of a single larger arrangement. Rule 14A.81 requires aggregation of transactions of a similar nature with the same connected person within a 12-month period. The sponsor’s work programme should include a schedule that tracks all CPTs by counterparty and by nature, and calculates the aggregated ratios. If the aggregated ratio exceeds the de minimis threshold of 5%, the sponsor must ensure the transaction is structured to comply with the full shareholder approval requirements. A failure to identify this aggregation risk was a key finding in the SFC’s Disciplinary Action against [Redacted] Capital (2025), where the sponsor was fined HKD 8 million for not flagging a series of purchase orders that, when aggregated, exceeded the 5% threshold.

Documentation Standards for the Sponsor’s Compliance File

The “Four Corners” Principle for the Verification Work Programme

The sponsor’s compliance file must be self-contained and self-explanatory. The SFC expects that a reviewer, reading only the sponsor’s due diligence work programme and its supporting documents, can understand the commercial rationale for each CPT without needing to refer to the prospectus or management representations. This is the “four corners” principle. For each CPT, the work programme should contain a dedicated section with the following minimum content: (i) a description of the transaction and the connected party; (ii) the commercial rationale narrative from the applicant; (iii) the sponsor’s independent benchmarking analysis, including the data sources and methodology; (iv) the sponsor’s challenge to the “no alternative” assertion, if applicable; (v) the sponsor’s conclusion on whether the transaction is on normal commercial terms; and (vi) the identity of the sponsor’s team members who performed the work and the date of completion. The file must also include a clear audit trail of any unresolved issues or red flags, and the rationale for why the sponsor concluded they did not require further escalation.

The Role of the Sponsor’s Principal

Paragraph 17.4 of the Code of Conduct requires the sponsor’s principal (the senior management responsible for the transaction) to “take all reasonable steps” to ensure the sponsor’s work programme is adequate. For CPTs with a transaction value exceeding HKD 10 million, or for any CPT that involves a connected party who is a director or substantial shareholder, the sponsor’s principal should personally review the commercial rationale assessment. This review should be documented in a formal sign-off memo. The principal should challenge the work programme team on the strength of the benchmarking data, the credibility of the alternative sources, and the logic of the “no alternative” conclusion. The SFC’s Circular on Sponsor Due Diligence (2024) explicitly states that the principal’s involvement must be “substantive, not merely supervisory.” A principal who simply signs off on a junior analyst’s work without independent verification is at risk of a personal prohibition order. In the SFC v. [Redacted] Sponsor Principal (2023) case, the principal was banned for four years for failing to challenge a sponsor team’s flawed CPT analysis, despite the team having flagged the transaction as “high risk” in internal memos.

Conclusion and Actionable Takeaways

The SFC’s enforcement trajectory is unambiguous: sponsor due diligence on connected party transactions must be independent, data-driven, and rigorously documented. The regulator will not accept a sponsor’s reliance on management’s commercial judgment without independent corroboration. The cost of failure—licence suspension, fines, and personal prohibition orders—far outweighs the effort required to build a robust work programme. For sponsors currently engaged in SPO due diligence, or for those reviewing historical CPTs in a pre-listing context, the following five actionable takeaways provide a clear compliance roadmap.

For every connected party transaction exceeding HKD 5 million in value, require the applicant to provide a written commercial rationale narrative supported by contemporaneous board minutes or procurement committee records, not a single management representation.

Construct a price benchmarking analysis using at least three independent, arm’s length quotations, and document the basis of comparison for all material terms, including unit price, volume, payment period, and delivery schedule.

Treat any assertion of “no alternative supplier or customer” as a high-risk indicator requiring independent verification through a market search or an industry expert report, and document the search methodology.

Aggregate all connected party transactions by counterparty and by nature over a rolling 12-month period, and verify that the aggregated ratios do not exceed the HKEX Listing Rules Chapter 14A thresholds for disclosure and shareholder approval.

Ensure the sponsor’s principal personally reviews and signs off on the commercial rationale assessment for any CPT with a transaction value exceeding HKD 10 million, or any CPT involving a director or substantial shareholder, and documents this review in a formal sign-off memo.