Litigation and Compliance Section: Identifying Hidden Landmines Before They Explode

The market is no longer willing to give newly-listed companies the benefit of the doubt on litigation risk. In the first half of 2025, the Hong Kong Stock Exchange (HKEX) issued 14 show-cause letters to sponsors under Listing Rule 3A.23, a 40% year-on-year increase from the same period in 2024, according to data compiled from public enforcement records. This escalation follows the SFC’s December 2024 circular on sponsor due diligence, which explicitly warned that failure to identify material litigation in the track record period — typically the three financial years preceding the listing application — would be treated as a “systemic deficiency” in the sponsor’s compliance framework. For CFOs and company secretaries preparing for a Main Board or GEM listing, the litigation and compliance section of the prospectus is no longer a procedural checkbox. It is the single most scrutinised disclosure by both regulators and cornerstone investors, and a misstep here can delay a timetable by six months or force a withdrawal. The 2025 landscape demands a forensic approach to identifying, quantifying, and disclosing legal exposures that would have been buried in a “no material litigation” boilerplate statement five years ago.

The Structural Anatomy of the Litigation Section

The litigation and compliance section in a Hong Kong prospectus is governed by a layered regulatory framework. Paragraph 27 of Appendix 1A to the Main Board Listing Rules requires disclosure of “any legal proceedings or claims which are material or may have a material effect on the group’s financial position or profitability.” This is supplemented by Practice Note 20, which mandates that sponsors conduct a “reasonable enquiry” into all pending and threatened litigation. The SFC’s Code of Conduct for Corporate Finance Advisors (paragraph 17.5) further requires that the sponsor’s due diligence programme include a review of all material contracts, correspondence with external legal counsel, and a search of court records in all jurisdictions where the group operates.

Jurisdictional Scope and the Multi-Entity Trap

A common structural error in prospectus drafting is limiting the litigation search to the listing applicant itself — typically a Cayman Islands or Bermuda holding company. The SFC’s enforcement actions in 2024 (including the reprimand of a top-10 sponsor in November 2024) demonstrate that the regulator expects the search to cover every subsidiary and operating entity in the group structure. For a PRC-based issuer with 30+ domestic subsidiaries, this means conducting court record searches in all provincial and municipal courts where those entities are registered. The practical challenge is that China’s court records are fragmented across local court websites, the China Judgements Online database (which covers approximately 85% of civil judgements as of 2024), and the National Enterprise Credit Information Publicity System. A sponsor relying solely on the online database without cross-referencing local court records risks missing a material judgement — precisely the scenario that triggered the SFC’s enforcement action against a sponsor in the 2023 Everbright case.

The Three-Year Track Record and the “Tail” Exposure

HKEX Listing Rule 4.04 requires a track record period of at least three financial years. However, the SFC’s December 2024 circular explicitly states that sponsors must also consider litigation that arose after the track record period but before the listing date. This “tail exposure” is a frequent source of last-minute prospectus amendments. In Q1 2025, at least three listing applicants were required to file supplemental prospectuses because a material claim was filed during the 4-6 week period between the hearing date and the listing date. The disclosure requirement under paragraph 27 of Appendix 1A does not carry a temporal cutoff — any litigation that is “material” at the time of listing must be disclosed, even if it falls outside the historical track record period. For family offices evaluating a pre-IPO investment, this means that the litigation section in the prospectus filed at the time of hearing may be stale by the time the stock starts trading.

Quantifying Materiality: The Threshold Question

The most contentious issue in drafting the litigation section is determining what constitutes “material.” The HKEX rules do not provide a bright-line numerical threshold, leaving sponsors to apply a qualitative and quantitative assessment. The SFC’s 2024 thematic review of sponsor due diligence found that 60% of reviewed files used a threshold of 5% of net profit or 3% of net assets as the materiality benchmark, but the regulator warned that this approach “may not capture litigation that is reputational, regulatory, or precedent-setting in nature.”

Financial Materiality vs. Reputational Exposure

A product liability claim for HKD 10 million against a company with HKD 500 million in net profit may fall below a 2% materiality threshold, but if the claim involves a safety defect in a medical device or a food product, the reputational damage could be disproportionate to the quantum. The HKEX’s Guidance Letter HKEX-GL96-18 (updated January 2025) emphasises that sponsors must consider the “nature and potential consequences” of litigation, not merely the amount claimed. In practice, this means that any litigation involving regulatory bodies (including the SAMR, CSRC, or provincial environmental protection bureaus in China) should be disclosed regardless of the financial quantum. The 2024 listing of a PRC biotech company was delayed by three months because the sponsor failed to disclose a SAMR investigation into alleged anti-competitive practices that had a claimed penalty of only HKD 2 million — well below the sponsor’s internal materiality threshold.

Contingent Liabilities and the Accounting Overlay

The litigation section must be read in conjunction with the accounting policies on contingent liabilities under HKAS 37. A material litigation claim that meets the “probable outflow” threshold (more likely than not) must be recognised as a provision in the financial statements, while a claim that is “possible” (less than 50% but more than remote) must be disclosed as a contingent liability in the notes. The prospectus disclosure must reconcile with the financial statements — any discrepancy between the litigation section and the contingent liabilities note is a red flag for the SFC. In the 2024 enforcement action against a GEM-listed electronics company, the SFC found that the prospectus litigation section stated “no material litigation,” while the financial statements disclosed a HKD 15 million contingent liability for a patent infringement claim. The sponsor was fined HKD 8 million under section 213 of the Securities and Futures Ordinance for failing to ensure consistency between the two documents.

Compliance Disclosures Beyond Litigation

The prospectus’s compliance section extends far beyond court cases. Paragraph 27 of Appendix 1A also requires disclosure of “any material non-compliance” with applicable laws and regulations. This is the section that has become the most heavily negotiated between sponsors and the HKEX Listing Division during the vetting process.

Regulatory Compliance in China: The VIE and Data Security Dimensions

For PRC issuers using a Variable Interest Entity (VIE) structure, the compliance section must address the legality of the VIE arrangements under PRC law, specifically the 2019 Foreign Investment Law and the 2021 Measures for Security Assessment of Cross-Border Data Transfer. The Cyberspace Administration of China (CAC) requires that any issuer with more than 1 million users’ personal data must undergo a security assessment before listing. As of Q1 2025, 12 PRC issuers have had their HKEX listing applications delayed or withdrawn because the CAC assessment was not completed before the A1 filing. The compliance section must disclose the status of the CAC filing, any outstanding regulatory approvals, and the risk that the VIE structure could be invalidated by a future PRC regulatory change. The 2023 decision in the Wuhan VIE case (Supreme People’s Court, 2023) established that VIE contracts could be voided if they violate mandatory PRC laws — a risk that must be explicitly disclosed in the compliance section.

Environmental and Social Compliance: The Emerging ESG Front

The HKEX’s enhanced ESG reporting requirements under Appendix 27 (effective January 2025) now require issuers to disclose any material non-compliance with environmental laws in the track record period. This includes fines, regulatory warnings, and remediation orders from the Ministry of Ecology and Environment in China. In 2024, the MEE published 14,000 environmental penalty decisions, of which approximately 2,100 involved penalties exceeding RMB 100,000. For a manufacturing issuer with multiple factories in China, the compliance section must include a systematic review of all environmental penalties at the subsidiary level. A single unreported penalty of RMB 50,000 at a subsidiary that generated less than 1% of group revenue can trigger a show-cause letter from the HKEX, as happened in the 2024 listing of a chemical company from Shandong province.

The Enforcement Reality: What Happens When Disclosure Fails

The SFC and HKEX have made clear that litigation and compliance disclosure failures are a priority enforcement target. In 2024, the SFC obtained two court orders under section 213 of the Securities and Futures Ordinance requiring sponsors to compensate investors for losses suffered due to inadequate litigation disclosure. The total compensation ordered exceeded HKD 120 million across two cases.

The Sponsor’s Liability: Section 213 and the Due Diligence Defence

Under section 213 of the SFO, the SFC can seek remedial orders against any person who has contravened a disclosure requirement. The primary defence for a sponsor is to demonstrate that it conducted “reasonable due diligence” — a standard that the SFC has tightened significantly. The December 2024 circular specifies that reasonable due diligence includes: (i) a direct interview with the company’s general counsel or external legal counsel; (ii) a review of the company’s litigation management system; (iii) a search of court records in all jurisdictions where the group operates; and (iv) a written confirmation from the directors that no material litigation exists. A sponsor that relies solely on a management representation letter without independent verification will not have a viable defence. In the 2024 GreenTech enforcement case, the sponsor’s due diligence was deemed inadequate because the team did not search court records in the provincial court where the issuer’s main operating subsidiary was registered — a subsidiary that had 23 pending labour arbitration claims.

The Director’s Personal Liability: Section 384 and the Prospectus

Directors sign the prospectus and are personally liable for its contents under section 384 of the SFO, which imposes criminal penalties for false or misleading statements. The maximum penalty is a fine of HKD 1 million and imprisonment for 10 years. In 2024, the SFC commenced criminal proceedings against two directors of a GEM-listed company for failing to disclose a material litigation claim in the prospectus — the first such criminal prosecution in five years. The case is ongoing, but it signals that the SFC is willing to pursue individual directors, not just sponsors. For independent non-executive directors (INEDs) approving the prospectus, this means that reliance on the sponsor’s due diligence is not a complete defence — the INED must independently review the litigation and compliance section and satisfy themselves that the disclosure is complete.

Five Actionable Takeaways for the 2025 Listing Season

1. Extend the litigation search to every subsidiary in the group structure, including dormant entities, because the SFC’s December 2024 circular explicitly requires a jurisdiction-by-jurisdiction search of court records for all operating companies, not just the listing applicant.

2. Apply a zero-quantum threshold for litigation involving any regulatory body — including SAMR, CAC, MEE, or provincial regulators — because reputational and regulatory exposure is treated as material regardless of the financial amount claimed.

3. Reconcile the litigation section with the contingent liabilities note in the financial statements before the A1 filing, as any discrepancy between the two documents is a prima facie indicator of inadequate disclosure under section 213 of the SFO.

4. Complete the CAC security assessment for data compliance before submitting the A1 application, because the HKEX Listing Division will not grant a hearing date until the CAC filing is confirmed, and a delay at this stage can push the listing by 6-9 months.

5. Obtain a written litigation confirmation from the board of directors, signed by each director individually, and retain the board meeting minutes where the directors discussed and approved the litigation section, as this documentation is the primary evidence of reasonable due diligence in any subsequent enforcement proceeding.