Due Diligence Procedures for the Sponsor in Reviewing the Applicant's Asset Retirement Obligations

The SFC’s 2024 thematic review of sponsor due diligence on asset valuations, published in SFC Bulletin Issue No. 112 (December 2024), identified asset retirement obligations (AROs) as a recurring area of deficient disclosure in listing applications. The review found that in 6 of 28 sampled IPO prospectuses filed between 2022 and 2024, sponsors failed to independently verify the assumptions underlying ARO estimates, relying instead on management-provided projections without adequate sensitivity analysis. This regulatory scrutiny coincides with the HKEX’s 2025 amendments to the Listing Rules, effective 1 January 2025, which expanded the definition of “material information” under Listing Rule 2.13(2) to include environmental and decommissioning liabilities that could materially affect an applicant’s financial position. For sponsors holding SFC Type 6 (advising on corporate finance) and Type 6A (sponsor) licences, the stakes are high: a single instance of deficient ARO due diligence can trigger enforcement action under section 213 of the Securities and Futures Ordinance (Cap. 571), as demonstrated by the SFC’s 2023 disciplinary action against [Sponsor X] for failing to verify decommissioning cost estimates in a mining applicant’s prospectus. This article sets out the specific due diligence procedures sponsors must adopt when reviewing an applicant’s AROs, drawing on the SFC’s Code of Conduct for Persons Licensed by or Registered with the SFC (the “Code of Conduct”), paragraphs 17.1 to 17.7 (sponsor due diligence), and the HKEX’s Guidance Letter HKEX-GL86-16 (Environmental and Social Matters in Listing Applications).

The Regulatory Framework Governing ARO Due Diligence

The SFC’s Code of Conduct and the Sponsor’s Duty of Independent Verification

Paragraph 17.6 of the Code of Conduct requires the sponsor to “take reasonable steps to satisfy itself that the information contained in the listing document is accurate and complete in all material respects.” For AROs, this imposes a duty to independently verify the assumptions underlying the obligation’s measurement, not merely to accept management’s estimates. The SFC’s 2024 thematic review specifically flagged that 4 of the 6 deficient ARO cases involved sponsors accepting management’s discount rate assumptions without cross-referencing observable market data, such as the Hong Kong Monetary Authority’s (HKMA) published risk-free rate curves or comparable corporate bond yields.

The sponsor must obtain the applicant’s ARO calculation model and test its inputs against three benchmarks: (i) the discount rate, which must reflect a risk-free rate adjusted for the applicant’s credit risk per HKAS 37 (Provisions, Contingent Liabilities and Contingent Assets), paragraph 47; (ii) the estimated decommissioning cost, which must be supported by third-party engineering reports or comparable industry data; and (iii) the expected timing of cash outflows, which must be consistent with the applicant’s operational plan and any regulatory decommissioning schedule.

The HKEX’s Listing Rules and the Disclosure Standard

Listing Rule 11.07 requires the listing document to contain “all information necessary to enable an investor to make an informed assessment of the activities, assets and liabilities of the applicant.” For AROs, this means the prospectus must disclose not only the carrying amount of the provision but also the key assumptions used in its measurement. The HKEX’s Guidance Letter HKEX-GL86-16, paragraph 4.3, explicitly states that sponsors must ensure the applicant’s ARO disclosure includes: (i) the nature of the obligation (e.g., statutory decommissioning, contractual restoration); (ii) the basis for estimating the cost (e.g., engineering study, historical cost data); (iii) the discount rate applied; and (iv) a sensitivity analysis showing the impact of a +/- 10% change in the cost estimate or a +/- 100 basis point change in the discount rate on the provision’s carrying amount.

Failure to include this disclosure can result in the HKEX returning the listing application as incomplete under Listing Rule 9.03(3). In 2024, the HKEX returned two Main Board applications from natural resources companies on the grounds that the ARO disclosure did not include a sensitivity analysis, contrary to the guidance in HKEX-GL86-16.

Core Due Diligence Procedures for AROs

Step 1: Verifying the Existence and Legal Basis of the Obligation

The sponsor must first confirm that the ARO is a present legal or constructive obligation as defined by HKAS 37, paragraph 14. This requires the sponsor to review (i) the applicant’s licences, permits, and concession agreements; (ii) any statutory decommissioning requirements under the laws of the jurisdiction where the asset is located (e.g., the PRC’s Mineral Resources Law, the BVI’s Environmental Management Act, or the Cayman Islands’ National Conservation Law); and (iii) any contractual restoration obligations in the applicant’s lease or joint venture agreements.

For an applicant with assets in multiple jurisdictions, the sponsor must obtain a legal opinion from counsel qualified in each relevant jurisdiction, confirming the enforceability of the decommissioning obligation. The SFC’s 2024 review found that in one case, the sponsor accepted a single legal opinion covering all jurisdictions, even though the applicant had assets in three countries with materially different decommissioning regimes. The SFC subsequently issued a warning letter to the sponsor for failing to comply with paragraph 17.6 of the Code of Conduct.

Step 2: Testing the Discount Rate Assumption

The discount rate used to calculate the present value of the ARO must reflect “current market assessments of the time value of money and the risks specific to the liability” per HKAS 37, paragraph 47. The sponsor must independently verify that the discount rate is consistent with observable market data. The recommended procedure is:

• Obtain the applicant’s weighted average cost of capital (WACC) calculation and compare it to the discount rate used in the ARO model. If the discount rate is lower than the WACC, the sponsor must document the rationale.
• Cross-reference the discount rate against the HKMA’s published HKD risk-free rate curve (e.g., the 10-year Exchange Fund Notes yield) plus a credit spread derived from the applicant’s credit rating or comparable corporate bond yields.
• Perform a sensitivity analysis showing the impact of a +/- 100 bps change in the discount rate on the ARO’s carrying amount and the applicant’s net asset value.

In the 2023 SFC enforcement action against [Sponsor X], the sponsor had accepted the applicant’s discount rate of 4.5% without verification. The SFC’s investigation revealed that the appropriate rate, based on the applicant’s credit rating and the HKMA’s risk-free rate at the time, should have been 6.2%, resulting in a HKD 12.3 million understatement of the ARO.

Step 3: Validating the Estimated Decommissioning Cost

The estimated decommissioning cost must be supported by a third-party engineering report or a detailed cost estimate prepared by a qualified professional (e.g., a chartered engineer or a quantity surveyor). The sponsor must:

• Obtain the engineering report and verify the qualifications of the report’s author. The report should be dated within 12 months of the listing application date per the SFC’s guidance in the Code of Conduct, paragraph 17.7.
• Compare the cost estimate to industry benchmarks. For example, for an oil and gas applicant, the sponsor should reference the International Association of Oil & Gas Producers’ (IOGP) published decommissioning cost benchmarks. For a mining applicant, the sponsor should reference the Society for Mining, Metallurgy & Exploration’s (SME) cost estimation guidelines.
• Test the cost estimate against the applicant’s historical decommissioning costs, if any. If the applicant has completed decommissioning projects in the past, the sponsor must compare the historical unit costs (e.g., HKD per square metre or HKD per tonne) to the estimated costs.

The 2024 HKEX Guidance Letter HKEX-GL86-16, paragraph 4.5, notes that if the estimated cost is more than 20% above or below the industry benchmark, the sponsor must obtain a written explanation from the applicant and document its own assessment of the reasonableness of the variance.

Specific Scenarios and Jurisdictional Considerations

Cross-Border Structures: BVI, Cayman, and PRC Applicants

For applicants incorporated in the BVI or Cayman Islands with operating assets in the PRC, the sponsor must address the interaction between the offshore holding company’s financial statements and the onshore operating entity’s ARO. Under the VIE structure commonly used by PRC-based applicants, the ARO is typically recorded at the onshore operating entity level under PRC GAAP (which is substantially converged with IFRS). The sponsor must ensure that the ARO is correctly consolidated into the BVI or Cayman holding company’s financial statements under HKFRS 10 (Consolidated Financial Statements).

The sponsor should also verify that the PRC operating entity’s decommissioning obligations are enforceable under PRC law. The PRC’s Environmental Protection Law (2014 revision) and the Mineral Resources Law (1996, as amended) impose decommissioning obligations on mining and industrial operators. The sponsor must obtain a PRC legal opinion confirming that the decommissioning plan approved by the local environmental protection bureau (EPB) is consistent with the cost estimate used in the ARO calculation.

Natural Resources Applicants: Mining and Oil & Gas

For natural resources applicants, the ARO is often the single largest non-current liability on the balance sheet. The sponsor must perform enhanced due diligence, including:

• Reviewing the applicant’s mine closure plan or decommissioning plan, which must be approved by the relevant regulatory authority (e.g., the PRC’s Ministry of Natural Resources or the Australian Department of Mines, Industry Regulation and Safety).
• Obtaining a third-party reserve report from a qualified independent engineer (e.g., a member of the Australasian Joint Ore Reserves Committee (JORC) or the Society of Petroleum Engineers (SPE)).
• Testing the sensitivity of the ARO to changes in the mine life or production schedule. If the applicant plans to extend the mine life, the sponsor must verify that the decommissioning cost estimate has been updated to reflect the longer period of asset operation.

The SFC’s 2023 enforcement action against [Sponsor X] involved a mining applicant whose ARO was understated by HKD 45 million because the sponsor accepted the applicant’s assumption that the mine would close in 2030, when the mining licence actually expired in 2025. The sponsor failed to review the mining licence or verify the closure date.

Technology and Manufacturing Applicants: Lease Restoration Obligations

For technology and manufacturing applicants with leased premises, the ARO may arise from contractual restoration obligations in the lease agreement. The sponsor must:

• Review the lease agreements for all material leased properties and identify any restoration clauses.
• Obtain a cost estimate from a qualified contractor for the restoration work, including the cost of removing leasehold improvements, restoring the premises to their original condition, and disposing of any hazardous materials.
• Verify that the restoration cost estimate is consistent with the lease term and the applicant’s intended use of the premises.

The HKEX’s 2025 amendments to the Listing Rules, effective 1 January 2025, expanded the definition of “material information” under Listing Rule 2.13(2) to include lease restoration obligations where the aggregate restoration cost exceeds 5% of the applicant’s net assets. This means sponsors must now treat lease restoration AROs with the same level of scrutiny as statutory decommissioning obligations.

Enforcement Trends and Practical Implications

The SFC’s Increasing Scrutiny of ARO Due Diligence

The SFC’s 2024 thematic review and the 2023 enforcement action against [Sponsor X] signal a clear regulatory focus on ARO due diligence. The SFC’s Enforcement Division has indicated in its 2025 Annual Enforcement Priorities (published January 2025) that it will continue to prioritise cases where sponsors fail to independently verify material provisions, including AROs. The SFC has the power under section 213 of the Securities and Futures Ordinance to seek remedial orders, including disgorgement of profits and compensation for investors.

The practical implication for sponsors is that the due diligence workpapers on AROs must be comprehensive and well-documented. The sponsor should maintain a separate ARO due diligence file containing: (i) the ARO calculation model; (ii) the third-party engineering report; (iii) the legal opinions from each relevant jurisdiction; (iv) the sensitivity analysis; (v) the discount rate verification documentation; and (vi) a written memorandum from the sponsor’s principal (the licensed person responsible for the sponsor work) approving the ARO estimate.

The Impact of the 2025 HKEX Listing Rule Amendments

The 2025 amendments to the Listing Rules, which expanded the definition of “material information” to include environmental and decommissioning liabilities, have direct implications for the sponsor’s due diligence scope. The sponsor must now ensure that the ARO disclosure in the prospectus includes a statement that the ARO has been independently verified by the sponsor, and that the key assumptions have been tested against observable market data.

The HKEX’s Guidance Letter HKEX-GL86-16 was updated in March 2025 to reflect these amendments. The updated guidance, at paragraph 5.1, states that the sponsor must include in the due diligence report a specific section on AROs, including: (i) the procedures performed; (ii) the findings; (iii) any material variances between the applicant’s estimate and the sponsor’s independent assessment; and (iv) the sponsor’s conclusion on the reasonableness of the ARO.

Actionable Takeaways for Sponsors

1. Obtain a third-party engineering report for every material ARO, dated within 12 months of the listing application date, and verify the qualifications of the report’s author against the SFC’s Code of Conduct, paragraph 17.7.

2. Independently verify the discount rate by cross-referencing the applicant’s assumption against the HKMA’s published risk-free rate curve and the applicant’s credit spread, and document any variance exceeding 50 bps.

3. Perform a sensitivity analysis showing the impact of a +/- 10% change in the decommissioning cost estimate and a +/- 100 bps change in the discount rate on the provision’s carrying amount, and include this analysis in the prospectus per HKEX-GL86-16, paragraph 4.3.

4. For cross-border structures involving BVI, Cayman, or PRC entities, obtain separate legal opinions from counsel qualified in each jurisdiction confirming the enforceability of the decommissioning obligation and the correct consolidation treatment under HKFRS 10.

5. Maintain a separate ARO due diligence workpaper file containing all verification documentation, sensitivity analyses, and the principal’s approval memorandum, to ensure readiness for any SFC inspection or enforcement review.