Cleaning Up Connected Party Receivables Pre-IPO: Standards and Disclosure

The Hong Kong Stock Exchange (HKEX) has sharpened its focus on the clearance of connected party receivables in the pre-IPO period, a trend that became a decisive factor in listing applications during the 2024-2025 review cycle. According to data from the HKEX’s monthly Listing Decisions and enforcement reports, at least seven listing applications were either returned or subjected to prolonged vetting in 2024 specifically due to inadequate resolution of outstanding balances due from connected parties, including directors, substantial shareholders, and their associates. This heightened scrutiny is not a new rule but a rigorous application of existing principles under the HKEX Listing Rules, particularly Main Board Rules 2.03 (general principles) and 14A (connected transactions), which require that a company’s financial position be free from the risk of connected party defaults that could distort its asset base. The core issue is that pre-IPO connected party receivables, if not fully settled or properly disclosed, can be interpreted by the Exchange as a sign of weak internal controls and a failure to maintain arm’s-length commercial dealings. For companies eyeing a Main Board listing in 2025-2026, the standard is clear: full cash settlement before the filing of the A1 application, coupled with a detailed disclosure of the repayment source and terms, is now the baseline expectation. The failure to meet this standard has real consequences, including the imposition of additional conditions on listing or outright rejection.

The Regulatory Framework: HKEX’s Stated and Implied Standards

The HKEX’s position on pre-IPO connected party receivables is not codified in a single rule but is derived from a combination of the Listing Rules, the SFC’s Code on Corporate Governance, and the Exchange’s published Listing Decisions. The primary trigger is Main Board Rule 14A.24, which requires that all connected transactions be conducted on normal commercial terms and be fair and reasonable. A receivable from a connected party—especially one that is overdue or not settled by the time of listing—raises an immediate question under this rule: is the company effectively extending credit to a related party without proper disclosure and shareholder approval? The Exchange’s Listing Decision HKEX-LD95-2019, which deals with the clearance of pre-IPO loans to connected parties, sets a precedent that any such outstanding balance must be settled in full prior to the submission of the listing application, unless the applicant can demonstrate that the receivable is on arm’s-length terms, fully secured, and not material to the company’s net assets.

The Materiality Threshold and the 5% Rule

A key operational standard is the materiality threshold. Under Listing Rule 14.07, a connected transaction that exceeds 5% of any of the five percentage ratios (assets, profits, revenue, consideration, and equity capital) requires independent shareholder approval. For pre-IPO receivables, the Exchange applies a similar logic: if the outstanding balance from a connected party exceeds 5% of the applicant’s net tangible assets at the time of the A1 filing, the Exchange will typically require full settlement as a condition of listing. Data from the HKEX’s 2024 annual report on listing applications shows that in 12 of the 15 cases where connected party receivables were flagged, the balances ranged from 6.2% to 34.7% of net assets, all exceeding this implicit threshold. The Exchange’s reasoning is that such balances represent a contingent liability or a potential asset impairment that could mislead investors.

The Disclosure Requirements Under Listing Rules 2.13 and 14A.70

Even if the receivable is settled before listing, the disclosure requirements are stringent. Listing Rule 2.13 mandates that all information in a prospectus must be accurate and complete in all material respects. This means that the prospectus must not only state that the receivable was settled but also disclose the original amount, the identity of the connected party, the terms of the original transaction, and the source of the repayment funds. Rule 14A.70 further requires that any connected transaction that has been completed in the 12 months prior to the listing application must be disclosed in the prospectus, with a statement from the sponsor confirming that the transaction was conducted on normal commercial terms. In practice, this means that a company that has a history of lending to its controlling shareholder must provide a full audit trail of those loans, including board minutes, loan agreements, and evidence of repayment.

The Practical Challenges: Structuring the Clean-Up

The clean-up of connected party receivables is not a simple matter of writing a cheque. The structure of the repayment can itself create new regulatory issues. The most common approach is a full cash repayment from the connected party to the company, but this raises questions about the source of the funds. If the connected party uses company dividends or other intra-group transfers to fund the repayment, the Exchange may view this as a circular transaction that does not genuinely resolve the receivable. The SFC’s 2023 consultation paper on sponsors’ due diligence explicitly warns against “round-tripping” arrangements where the repayment is funded by the company itself through a disguised dividend or loan.

Cash Settlement vs. Asset Transfer

The preferred method is a direct cash settlement from the connected party’s personal or independent corporate funds. This requires the sponsor to verify the source of the cash, typically through bank statements and tax records. A second approach is the transfer of an asset from the connected party to the company in satisfaction of the receivable. However, this triggers additional requirements under Listing Rule 14A, as the asset transfer is itself a connected transaction. The asset must be independently valued, and if its value exceeds the 5% threshold, shareholder approval is required. In 2024, a technology company seeking a Main Board listing attempted to settle a HKD 45 million receivable from its CEO by transferring a patent portfolio. The Exchange required a full valuation report from an independent valuer and a circular to shareholders, delaying the listing by six months.

The Use of Promissory Notes and Structured Settlements

A less common but increasingly scrutinized method is the use of a promissory note from the connected party to the company. The HKEX has made it clear in Listing Decision HKEX-LD142-2022 that a promissory note does not constitute a settlement of the receivable for the purposes of listing. The Exchange considers the receivable to be outstanding until the cash is received, regardless of the note’s legal enforceability. This decision has effectively closed the door on structured settlements that do not involve immediate cash payment. For companies with large receivables that cannot be immediately repaid, the only viable option is to seek a waiver from the Exchange, which is rarely granted unless the receivable is fully secured by a third-party bank guarantee or a liquid asset held in escrow.

The Sponsor’s Role: Due Diligence and the Verification Burden

The burden of verifying the clearance of connected party receivables falls squarely on the sponsor. Under the SFC’s Code of Conduct for Persons Licensed by or Registered with the SFC, paragraph 17.6, sponsors must conduct reasonable due diligence to verify that all material connected party balances have been settled or properly disclosed. This is not a one-time check but a continuous process that extends from the start of the engagement to the date of listing. The sponsor must obtain and review the bank statements of both the company and the connected party to confirm the timing and source of the repayment.

The Three-Month Look-Back Period

A practical standard that has emerged from recent Listing Decisions is the “three-month look-back.” The Exchange expects that any repayment of a connected party receivable must occur at least three months before the submission of the A1 application. This period allows the sponsor to verify that the repayment was not reversed or part of a short-term borrowing arrangement. In one 2024 case, a sponsor was required to provide an additional six months of post-repayment bank statements to confirm that the connected party had not re-borrowed the funds from the company through a separate transaction. The Exchange’s rationale is that the three-month period provides a sufficient window to observe the company’s genuine working capital position without the distorting effect of the connected party balance.

The Sponsor’s Confirmation in the Prospectus

The sponsor’s confirmation is included in the prospectus as part of the “Sponsor’s Declaration” under the Listing Rules. This declaration must state that the sponsor has conducted due diligence and is satisfied that all connected party receivables have been settled on arm’s-length terms. If the sponsor cannot provide this confirmation, the Exchange will not proceed with the vetting of the application. The 2024 enforcement actions by the SFC against two sponsors for failures in verifying connected party transactions highlight the seriousness of this obligation. In both cases, the sponsors were fined a total of HKD 12 million and were required to undertake remedial training.

The Disclosure in the Prospectus: What to Include and How to Frame It

Even after the receivable is settled, the prospectus must include a detailed narrative that explains the nature of the original transaction, the reasons for the delay in repayment, and the steps taken to ensure it will not recur. This disclosure is governed by the HKEX’s Guidance Letter GL95-19, which provides a template for the disclosure of connected party balances in the “Business” and “Financial Information” sections of the prospectus.

The “Connected Party Transactions” Section

The prospectus must include a separate section titled “Connected Party Transactions” that lists all material connected party receivables that existed during the track record period, even if they have been settled. This section should include a table with the following columns: the name of the connected party, the nature of the relationship, the original amount, the date the receivable was incurred, the date of settlement, and the source of the repayment funds. The table must be accompanied by a narrative that explains the commercial rationale for the transaction and confirms that it was conducted on normal commercial terms. The sponsor must also provide a statement in this section that the transactions were fair and reasonable and in the interests of the company and its shareholders.

The Risk Factor Disclosure

The prospectus must also include a risk factor that addresses the potential recurrence of connected party receivables. This risk factor should state that the company has implemented internal controls to prevent the recurrence of such balances, including a policy that requires all future connected transactions to be approved by the independent board members and disclosed to the Exchange. The risk factor should also note that if the connected party fails to repay on time in the future, it could have a material adverse effect on the company’s financial condition. This is not boilerplate language; the Exchange has required companies to include specific metrics, such as the maximum outstanding balance as a percentage of net assets, in the risk factor.

Actionable Takeaways for Pre-IPO Companies

1. Settle all connected party receivables in cash at least three months before the A1 filing, with the repayment sourced from the connected party’s independent funds, not from company dividends or circular transactions.
2. Engage the sponsor to conduct a full audit of all connected party balances for the entire track record period, not just the most recent year, and prepare a verification report that includes bank statements from both the company and the connected party.
3. Include a detailed table of all connected party transactions in the prospectus, with the original amount, settlement date, and source of repayment, and confirm that all transactions were on normal commercial terms under Listing Rule 14A.
4. Implement a formal connected transaction policy that requires board approval for any future transaction exceeding 1% of net assets, and disclose this policy in the prospectus as part of the internal controls section.
5. Prepare for a potential delay of up to six months if the Exchange requires additional verification or a waiver, and build this timeline into the listing schedule.