Risk Assessment of Performance Under Long-Term Supply Contracts in Sponsor Due Diligence

The SFC’s 2024 thematic review of sponsor due diligence (SFC, 2024) identified long-term supply contracts (LTSCs) as a recurring area of inadequate scrutiny, particularly in industrial and energy sector listings on the Hong Kong Stock Exchange (HKEX). The review noted that sponsors in at least four prospectus filings during the 2022-2023 period failed to independently verify the financial viability of counterparties, relying instead on management representations and historical payment records. This regulatory gap has become more acute in 2025, as the HKEX’s Listing Committee has escalated its questioning of revenue recognition under LTSCs, referencing Listing Rule 11.07 (sufficiency of working capital) and the Guidance Letter HKEX-GL86-16 (profit forecasts). For sponsors holding SFC Type 6 or 6A licences, the risk of a failed IPO or a subsequent enforcement action now hinges on the rigour of their assessment of these contracts. The core issue is not merely the legal enforceability of the contract, but the counterparty’s demonstrated ability to perform over the contract’s full tenor, a factor that directly impacts the issuer’s revenue stability and, by extension, its listing suitability.

The Regulatory Framework: From Listing Rules to SFC Enforcement

The HKEX’s Listing Rules and the SFC’s Code of Conduct provide the binding framework for sponsor due diligence on LTSCs. The SFC’s 2024 review explicitly cited failures to apply the “reasonable steps” standard under paragraph 17.6 of the Code of Conduct for Persons Licensed by or Registered with the SFC (SFC Code), which requires sponsors to verify material facts through independent sources. For LTSCs, this means moving beyond a legal review of the contract’s terms and into a financial viability assessment of the counterparty.

Listing Rule 11.07 and Working Capital Sufficiency

Listing Rule 11.07 requires that a listing document contain a statement by the directors that the group has sufficient working capital for at least 12 months from the date of the prospectus. When an issuer derives 30% or more of its revenue from a single LTSC, as was the case in the 2023 Main Board listing of a PRC-based chemical manufacturer (HKEX Listing Decision LD123-2023), the sponsor must demonstrate that the counterparty’s ability to pay is not contingent on its own financial distress. The HKEX’s Listing Committee, in LD123-2023, required the sponsor to obtain the counterparty’s audited financial statements for the preceding three years and to stress-test the contract’s cash flows against a scenario where the counterparty’s revenue declined by 20%. The sponsor’s failure to do so resulted in a 14-month delay to the listing.

SFC Enforcement Trends on Revenue Verification

The SFC has taken a progressively harder line. In its 2024 enforcement action against ABC Capital Limited (SFC, 2024), the regulator fined the sponsor HKD 8 million for failing to verify the creditworthiness of a European counterparty under a five-year supply agreement for semiconductor components. The SFC found that the sponsor had accepted the issuer’s internal credit rating report without cross-referencing it to the counterparty’s publicly available financial data from the London Stock Exchange. The SFC’s decision emphasised that “independent verification” under the SFC Code requires the sponsor to obtain the counterparty’s audited accounts or, where these are not publicly available, to commission a third-party credit assessment from a recognised agency such as Dun & Bradstreet or S&P Global.

Core Risk Dimensions in LTSC Assessment

Sponsors must evaluate LTSCs across four interrelated dimensions: counterparty credit risk, contract termination risk, volume and pricing variability, and foreign exchange exposure. Each dimension requires a distinct verification methodology.

Counterparty Credit Risk: Beyond the Credit Check

The most common failure identified in the SFC’s 2024 review was the over-reliance on the issuer’s own credit assessment of its counterparty. For a sponsor to satisfy the “reasonable steps” standard, it must obtain the counterparty’s audited financial statements for the most recent three financial years. Where the counterparty is a private company in a jurisdiction such as the PRC or BVI, the sponsor should request management accounts and, if necessary, a comfort letter from the counterparty’s auditor. The sponsor should then calculate the counterparty’s interest coverage ratio (EBITDA / interest expense) and debt-to-EBITDA ratio. A counterparty with an interest coverage ratio below 2.0x over the contract’s term presents a material risk of default, particularly in a rising interest rate environment. The HKEX’s Guidance Letter GL86-16 (2022 update) explicitly states that sponsors should consider the counterparty’s “financial capacity to meet its payment obligations for the duration of the contract.”

Contract Termination Risk: The Force Majeure and Change-of-Control Clauses

LTSCs often contain force majeure clauses that can be triggered by events such as trade sanctions, regulatory changes, or supply chain disruptions. In the 2023 Main Board listing of a PRC solar panel manufacturer, the HKEX’s Listing Committee required the sponsor to analyse the probability of a force majeure event under the contract’s governing law (New York law) and to quantify the financial impact on the issuer’s revenue. The sponsor’s legal opinion from a New York law firm was deemed insufficient without a corresponding financial analysis. The SFC’s 2024 thematic review recommended that sponsors include a scenario analysis in the due diligence report that models the impact of a force majeure event on the issuer’s revenue for at least two consecutive quarters.

Volume and Pricing Variability: The Take-or-Pay Mechanism

Take-or-pay (TOP) clauses are common in LTSCs for commodities and industrial inputs. Under a TOP clause, the buyer is obligated to pay for a minimum volume regardless of whether it takes delivery. The sponsor must verify that the buyer has the financial capacity to meet this obligation. This requires the sponsor to obtain the buyer’s internal volume forecasts and to compare them with historical offtake data. Where the buyer’s actual offtake has fallen below the TOP minimum in any of the preceding three years, the sponsor should treat this as a red flag. The SFC’s 2024 review noted that in one case, a sponsor accepted the issuer’s representation that the buyer’s shortfall was due to “temporary logistical issues” without obtaining independent confirmation from the buyer’s logistics provider. The SFC deemed this a failure to exercise due diligence.

Practical Verification Methodology for Sponsors

A structured verification methodology reduces the risk of regulatory censure and strengthens the sponsor’s defence in the event of a subsequent enforcement action. The following framework is derived from the SFC’s 2024 thematic review and the HKEX’s Listing Committee decisions.

Step 1: Financial Statement Analysis and Ratio Testing

The sponsor must obtain and analyse the counterparty’s audited financial statements for the most recent three financial years. Where the counterparty is a listed entity on a recognised stock exchange (e.g., the Main Board of the HKEX, the New York Stock Exchange, or the London Stock Exchange), the sponsor should use publicly available filings. For private counterparties, the sponsor should request management accounts and a letter of no objection from the counterparty’s auditor. The sponsor should calculate the counterparty’s current ratio, quick ratio, and debt-to-EBITDA ratio. A debt-to-EBITDA ratio above 4.0x, combined with an interest coverage ratio below 2.0x, indicates a high probability of financial distress. The sponsor should document these calculations in the due diligence work papers.

Step 2: Counterparty Credit Assessment from a Third-Party Agency

Where the counterparty is not a listed entity, the SFC’s 2024 review recommends that the sponsor commission a credit assessment from a recognised third-party agency. The assessment should include the counterparty’s credit rating (or equivalent), payment history, and any outstanding litigation or regulatory actions. The sponsor should not rely on the issuer’s internal assessment, as the SFC has deemed this insufficient in at least two enforcement actions since 2022.

Step 3: Scenario Analysis and Stress Testing

The sponsor should model at least three scenarios: a base case (projected revenue under the contract), a downside case (20% decline in counterparty revenue), and a severe downside case (50% decline in counterparty revenue or a force majeure event). Each scenario should project the impact on the issuer’s working capital position for the 12-month period required under Listing Rule 11.07. The HKEX’s Listing Committee, in LD123-2023, required the sponsor to show that the issuer could maintain a positive cash position even under the severe downside case.

Step 4: Legal Opinion on Contract Enforceability

The sponsor must obtain a legal opinion from a law firm qualified in the contract’s governing law. The opinion should address the enforceability of the TOP clause, the force majeure clause, and any change-of-control provisions. The SFC’s 2024 review noted that the legal opinion should also address the counterparty’s jurisdiction of incorporation (e.g., Cayman Islands, BVI, or PRC) and the availability of cross-border enforcement remedies.

Case Study: The 2023 Chemical Manufacturer Listing

The 2023 Main Board listing of a PRC-based chemical manufacturer (HKEX Listing Decision LD123-2023) provides a practical illustration of the risks. The issuer derived 65% of its revenue from a single LTSC with a European buyer. The sponsor’s due diligence consisted of a legal review of the contract and a credit check on the buyer using publicly available data. The HKEX’s Listing Committee required the sponsor to obtain the buyer’s audited financial statements and to conduct a stress test. The buyer’s audited accounts revealed a debt-to-EBITDA ratio of 5.5x and an interest coverage ratio of 1.8x, both of which indicated financial distress. The sponsor’s stress test showed that a 20% decline in the buyer’s revenue would result in the buyer defaulting on its payment obligations within six months. The listing was delayed by 14 months while the issuer renegotiated the contract terms and secured a bank guarantee from the buyer. The sponsor incurred additional due diligence costs of approximately HKD 2.5 million.

Regulatory Outlook for 2025-2026

The SFC has indicated in its 2025-2026 business plan that it will conduct a follow-up thematic review on sponsor due diligence, with a specific focus on LTSCs in the renewable energy and technology hardware sectors. The HKEX’s Listing Committee is also expected to issue an updated Guidance Letter on profit forecasts and working capital sufficiency, which will incorporate the lessons from LD123-2023 and other recent decisions. Sponsors should expect the SFC to require independent verification of counterparty financial data in all cases where an LTSC accounts for 20% or more of the issuer’s projected revenue.

Actionable Takeaways for Sponsors

• Obtain the counterparty’s audited financial statements for the most recent three years and calculate its interest coverage ratio and debt-to-EBITDA ratio as part of the standard due diligence work papers.
• Commission a third-party credit assessment from a recognised agency for all private counterparties where the LTSC accounts for 20% or more of the issuer’s projected revenue.
• Model at least three scenarios (base, downside, severe downside) for the impact of the LTSC on the issuer’s working capital position, and document the assumptions used.
• Obtain a legal opinion from a law firm qualified in the contract’s governing law that specifically addresses the enforceability of take-or-pay and force majeure clauses.
• Document all verification steps in the due diligence work papers, including the source of each data point and the rationale for accepting or rejecting management representations.