Verification of Franchise and Licensing Agreements in Sponsor Due Diligence

The SFC’s thematic inspection findings on sponsor due diligence, published in its 2024 Sponsor Compliance Review report, identified franchise and licensing agreement verification as a recurring deficiency in IPO application packages. Of the 18 cases reviewed where the listing applicant operated a franchise or licensing model, 11 involved material gaps in the sponsor’s verification of the underlying contractual arrangements, including failure to confirm the legal enforceability of master franchise agreements and the absence of independent confirmations from licensors. This is not a niche concern. The SFC’s Report on the Thematic Inspection of Sponsors (March 2023) had already flagged that sponsors must “obtain direct confirmation from the licensor or franchisor” where the agreement is material to the applicant’s business model. With the HKEX’s Listing Decision LD143-2024 (December 2024) further clarifying the disclosure requirements for franchise-dependent revenue streams, the regulatory spotlight on this area has intensified. For sponsors holding a Type 6 (advising on corporate finance) or Type 6A (sponsor) licence, the margin for error in verifying these agreements has narrowed to zero. This article examines the specific verification protocols required, the common failure modes observed in enforcement actions, and the documentary standards that satisfy both the SFC’s Code of Conduct for Persons Licensed by or Registered with the SFC (the Code) and the HKEX’s Listing Rules.

The Regulatory Framework for Franchise and Licensing Verification

SFC Code of Conduct and Paragraph 17 Requirements

The SFC’s Code of Conduct (Chapter 17, paragraphs 17.1 to 17.6) sets the baseline standard for sponsor due diligence. Paragraph 17.2(b) specifically requires that the sponsor “take reasonable steps to satisfy itself that the information contained in the listing document is accurate and complete in all material respects.” For franchise and licensing arrangements, this translates into a requirement to verify the legal existence, validity, and material terms of each agreement. The SFC’s 2023 thematic inspection report explicitly stated that “sponsors should not rely solely on representations from the listing applicant” where the agreement is with a third-party licensor. The report cited a case where the sponsor accepted a copy of a franchise agreement provided by the applicant without independently contacting the franchisor. The SFC found this to be a breach of paragraph 17.2(b) because the sponsor had not taken “reasonable steps” to confirm the agreement was genuine and currently in force.

HKEX Listing Rules and Disclosure Obligations

Under the HKEX Main Board Listing Rules, Chapter 14 (Notifiable Transactions) and Chapter 14A (Connected Transactions) may apply where a franchise or licensing agreement involves a connected party or constitutes a material acquisition of assets. Rule 14.04(1) defines “assets” to include contractual rights, meaning a franchise agreement with a value exceeding the relevant percentage ratios must be treated as a notifiable transaction. The HKEX’s Listing Decision LD143-2024 addressed a scenario where a listing applicant derived 68% of its revenue from a single franchise agreement. The Exchange required the sponsor to obtain a legal opinion from a qualified PRC law firm on the enforceability of the agreement under PRC Contract Law (now the Civil Code of the People’s Republic of China, Book Three, Chapter 16) and to confirm that the franchisor held all necessary regulatory approvals. The decision made clear that the sponsor’s verification must extend beyond the four corners of the agreement to the regulatory environment governing the franchise.

Practical Verification Protocols

Direct Confirmation from the Licensor or Franchisor

The SFC’s 2023 report is unambiguous: “Direct confirmation from the licensor or franchisor is the primary means of verification.” This means the sponsor must send a confirmation letter directly to the licensor’s registered address or authorised representative, requesting confirmation of the agreement’s existence, current status, and key commercial terms. The confirmation should be returned directly to the sponsor, not through the listing applicant. In practice, the sponsor should maintain a log of all confirmation requests sent, the date of despatch, the method of delivery (e.g., registered mail, courier with signature), and the date of receipt of the response. Where the licensor is a government authority—common in PRC franchise models for natural resources or infrastructure projects—the sponsor must also verify the issuing authority’s statutory power to grant the licence. The SFC’s 2024 review noted that in one case, the sponsor accepted a confirmation from a provincial government bureau without verifying whether that bureau had the legal authority to issue the licence under PRC Administrative Licensing Law (2019 Amendment). The SFC considered this a material deficiency.

Verification of Royalty and Fee Structures

Franchise and licensing agreements typically involve royalty payments, upfront fees, or minimum purchase commitments. The sponsor must verify that the revenue recognition policies applied by the listing applicant are consistent with the contractual terms. Under HKFRS 15 (Revenue from Contracts with Customers), the applicant must recognise revenue when control of the promised goods or services is transferred to the customer. For a franchise model, this often means recognising the initial franchise fee over the term of the agreement, not upfront. The sponsor should obtain a breakdown of all fees paid and received under the agreement, reconcile these to the applicant’s bank statements and management accounts, and confirm that the royalty rate stated in the agreement matches the rate applied in the applicant’s revenue calculations. The SFC’s 2023 report cited a case where the sponsor failed to identify that the applicant was recognising 100% of the initial franchise fee in the first year, contrary to the agreement’s requirement for the fee to be amortised over five years. The SFC required the sponsor to restate the applicant’s financials and disclose the error in the prospectus.

Legal Enforceability and Regulatory Compliance

The sponsor must obtain a legal opinion from a qualified law firm in the jurisdiction governing the agreement. For PRC-based applicants, this means a PRC law firm holding a valid practising licence. The legal opinion should address: (i) whether the agreement is valid and enforceable under applicable law; (ii) whether the licensor holds all necessary approvals, permits, or registrations to grant the franchise or licence; (iii) whether the agreement contains any provisions that are void or unenforceable under local law; and (iv) whether the agreement has been properly stamped or registered with the relevant authorities. The HKEX’s Listing Decision LD143-2024 specifically required the sponsor to confirm that the PRC Regulations on Administration of Commercial Franchises (State Council Order No. 485, 2007) had been complied with, including the requirement for the franchisor to have two or more directly operated stores for a period of more than one year before granting a franchise. The SFC’s 2024 review found that in three cases, the sponsor had not obtained a legal opinion on these points, relying instead on the applicant’s internal legal department’s assessment. The SFC considered this a breach of paragraph 17.2(b).

Common Failure Modes and SFC Enforcement Actions

Failure to Verify the Licensor’s Identity and Authority

A recurring issue identified in the SFC’s 2024 review is the sponsor’s failure to verify that the person signing the franchise agreement on behalf of the licensor had the authority to do so. In one case, the agreement was signed by a director of the licensor who was later found to have been removed from the board six months before the signing date. The sponsor had not obtained a board resolution or power of attorney confirming the signatory’s authority. The SFC required the sponsor to conduct a retrospective verification, including obtaining a fresh board resolution from the licensor and a confirmation from the licensor’s company secretary. The SFC’s enforcement action in SFC v. Sponsor A (2022, unreported) resulted in a reprimand and a fine of HKD 12 million for similar failures. The SFC’s Guidelines on Sponsor Due Diligence (2023 update) now explicitly require that the sponsor “obtain evidence of the signatory’s authority, including board resolutions or powers of attorney, for all material agreements.”

Incomplete Verification of Sub-Franchise Arrangements

Where the listing applicant operates as a master franchisee and grants sub-franchises to third parties, the sponsor must verify the entire chain of agreements. The SFC’s 2023 report cited a case where the applicant held a master franchise from a US-based brand and had granted 42 sub-franchises in the PRC. The sponsor verified only the master franchise agreement but did not confirm that the master franchise agreement permitted sub-franchising. The SFC found that the master agreement expressly prohibited sub-franchising without the licensor’s prior written consent, which the applicant had not obtained. The sponsor was required to obtain retrospective consent from the US licensor and to disclose the breach in the prospectus. The SFC’s 2024 review further noted that sponsors must also verify the sub-franchisees’ compliance with local laws, including the PRC Regulations on Administration of Commercial Franchises, which require sub-franchisees to register their franchise agreements with the local commerce bureau.

Reliance on Management Representations Without Independent Verification

The SFC’s 2024 review identified a pattern where sponsors accepted management representations about the existence and terms of franchise agreements without independent verification. In one case, the applicant’s CFO provided a spreadsheet listing 15 franchise agreements, but the sponsor did not request copies of the agreements or contact any of the franchisors. The SFC found that three of the listed agreements did not exist, and two had expired before the track record period. The sponsor’s reliance on the CFO’s spreadsheet was deemed a failure to exercise reasonable skill and care under paragraph 17.2(b). The SFC’s enforcement action included a public reprimand and a requirement for the sponsor to appoint an independent reviewer to assess its due diligence procedures. The SFC’s Report on Sponsor Compliance (2024) states that “management representations are not a substitute for independent verification, particularly where the information relates to the existence or material terms of third-party agreements.”

Documentary Standards and Audit Trail Requirements

The Sponsor’s Due Diligence File

The SFC’s Code of Conduct (paragraph 17.6) requires the sponsor to maintain a due diligence file that “documents the steps taken and the conclusions reached.” For franchise and licensing agreements, this file must contain: (i) a copy of each agreement, signed and dated; (ii) the direct confirmation from the licensor or franchisor; (iii) the legal opinion on enforceability and regulatory compliance; (iv) a reconciliation of the agreement’s commercial terms to the applicant’s financial records; (v) evidence of the signatory’s authority; and (vi) a summary of any issues identified and how they were resolved. The file must be structured so that a reviewer can follow the sponsor’s reasoning without needing to refer to external sources. The SFC’s 2024 review noted that in four cases, the sponsor’s file contained only the agreement and a brief internal memo, with no evidence of direct confirmation or legal opinion. The SFC considered this insufficient and required the sponsor to supplement the file retrospectively.

Timing of Verification

The SFC’s 2023 report emphasised that verification should be completed before the listing application is submitted to the HKEX. Paragraph 17.2(b) requires the sponsor to take reasonable steps “at the time the listing document is prepared.” In practice, this means the sponsor should have completed verification of all material franchise and licensing agreements before the A1 filing. The SFC’s 2024 review found that in two cases, the sponsor had not verified the agreements until after the HKEX had raised questions during the vetting process. The SFC considered this a material delay and required the sponsor to explain the reasons for the late verification in the prospectus. The HKEX’s Guidance Letter GL57-13 (updated 2024) states that sponsors should “complete all material due diligence before the submission of the listing application” and that “late-stage verification raises questions about the sponsor’s ability to exercise reasonable skill and care.”

Handling of Red Flags and Discrepancies

Where the sponsor identifies a discrepancy between the agreement’s terms and the applicant’s operations or financial records, the sponsor must document the issue and take steps to resolve it. The SFC’s 2024 review cited a case where the franchise agreement required the applicant to pay a royalty of 5% of gross revenue, but the applicant’s financial statements showed no royalty payments. The sponsor noted the discrepancy in an internal memo but did not follow up with the applicant or the licensor. The SFC found that the sponsor had failed to exercise reasonable skill and care because it did not seek an explanation or adjust the applicant’s financials. The sponsor was required to restate the applicant’s revenue and disclose the underpayment of royalties in the prospectus. The SFC’s Guidelines on Sponsor Due Diligence (2023) state that “any material discrepancy must be investigated and resolved before the listing document is finalised.”

Actionable Takeaways

1. Send direct confirmation letters to every material licensor or franchisor, using registered mail or courier with signature, and retain the delivery receipts and responses in the sponsor’s due diligence file.
2. Obtain a legal opinion from a qualified law firm in the governing jurisdiction that addresses enforceability, regulatory compliance, and the signatory’s authority, and ensure the opinion is dated no earlier than six months before the listing application.
3. Reconcile every royalty payment and fee structure in the agreement to the applicant’s bank statements and management accounts, and document any discrepancies with a written explanation from the applicant and independent confirmation from the licensor.
4. Verify the entire sub-franchise chain where the applicant acts as a master franchisee, including obtaining the licensor’s written consent for sub-franchising and confirming that sub-franchisees comply with local registration requirements.
5. Complete all franchise and licensing verification before the A1 filing, and if any issues are identified late in the process, disclose them prominently in the prospectus and explain the steps taken to resolve them.