HKEX Scrutiny of Third-Party Payments in an IPO Applicant's Business

The Hong Kong Stock Exchange (HKEX) has, since early 2025, intensified its scrutiny of third-party payments embedded within the business models of IPO applicants, a move that has directly contributed to the deferral of at least four Main Board listing applications in the second quarter of 2025. This heightened focus, communicated via informal “guidance letters” from the Listing Division to sponsors, targets the use of payments to non-contractual intermediaries—such as distributors, agents, or service providers—where the economic substance and commercial rationale are not demonstrably clear. The Exchange is now demanding that applicants provide a granular breakdown of all such payments exceeding 5% of total revenue, with a specific requirement to map the flow of funds to the ultimate end-user or service beneficiary. This represents a significant departure from the previous practice of accepting aggregated disclosures, effectively raising the evidentiary bar for proving that revenue is organic and not artificially inflated. The implications are particularly acute for Chinese issuers operating through Variable Interest Entity (VIE) structures, where the legal separation between the listed entity and the operating company can obscure the true nature of these transactions, creating a new layer of compliance risk that was not explicitly addressed in the 2023 VIE disclosure guidelines.

The Regulatory Framework: From General Principle to Specific Enforcement

The Codification of “Clean Hands” in Listing Rule 9.03

The HKEX’s current stance on third-party payments is not a new rule but an aggressive enforcement of existing principles, primarily Listing Rule 9.03, which requires that a listing applicant and its business must, in the Exchange’s opinion, be suitable for listing. Historically, this “suitability” test was applied to the applicant’s directors and substantial shareholders, focusing on criminal records and regulatory sanctions. The 2025 shift extends this test to the applicant’s commercial counterparties, specifically those receiving payments that are not directly tied to a written contract for goods or services.

The Exchange is now interpreting “suitability” to include the integrity of the revenue stream itself. If a significant portion of an applicant’s revenue is generated through a chain of third-party payors, the HKEX will presume the revenue is potentially non-arm’s length unless the applicant can provide a “chain of title” for each payment. This is a direct parallel to anti-money laundering (AML) principles codified in the Hong Kong Monetary Authority’s (HKMA) Supervisory Policy Manual (SPM) on AML/CFT (Module AML-1, issued 2023), which requires financial institutions to identify the beneficial owner of any transaction. The Exchange is effectively applying this same standard to the corporate structure of an IPO applicant.

The 5% Materiality Threshold and the “Economic Substance” Test

A key operational detail emerging from sponsor-side briefings is the HKEX’s internal materiality threshold of 5%. Any third-party payment that, in aggregate across the applicant’s business, exceeds 5% of total revenue for the most recent audited financial year will trigger a mandatory, detailed disclosure in the draft prospectus (A1 submission). This is not a safe harbor; it is a trigger for a “show cause” exercise.

The Exchange requires the sponsor to provide a written legal opinion from a Hong Kong-qualified law firm confirming that each payment arrangement has “economic substance.” This opinion must address three specific criteria:

1. Commercial Rationale: A documented business reason for using the third-party, such as geographic reach or specialized service capability.
2. Value-for-Money: Evidence that the fee paid is commensurate with the service provided, benchmarked against independent market data.
3. No Circular Flow: A forensic accounting report, typically from a Big Four firm, confirming that the funds have not returned to the applicant or its connected persons through any indirect route.

Failure to satisfy any one of these three criteria has, in practice, resulted in the HKEX issuing a “deficiency letter” that effectively pauses the application process. The 2025 data from the HKEX’s Listing Decisions database shows that four out of eight applications that received a deficiency letter in Q2 2025 cited “inadequate substantiation of third-party payment flows” as the primary reason.

Operational Impact on VIE-Structured Chinese Issuers

The VIE “Layer” and the Challenge of Tracing Payments

For Chinese companies using a VIE structure, the HKEX’s new scrutiny creates a unique compliance bottleneck. The VIE’s contractual arrangements—typically a series of exclusive call options, equity pledge agreements, and service agreements between the Cayman-listed entity and the PRC-registered operating company—are designed to transfer economic benefits without direct equity ownership. The problem arises when the operating company (the WFOE or the PRC OpCo) makes third-party payments to distributors or vendors that are not part of the VIE contractual chain.

The HKEX now requires that the sponsor provide a “payment flow map” that traces each material third-party payment from the PRC OpCo’s bank account to the ultimate recipient, and then back to the revenue-generating activity. This is operationally difficult because many PRC-based third-party distributors operate on a cash-intensive or multi-tier basis, making it nearly impossible to provide a clean audit trail. The Exchange’s 2023 guidance on VIE structures (HKEX-GL108-23) did not address this specific point, creating a regulatory gap that the 2025 enforcement actions are now filling.

The “Deemed Connected Party” Risk

A secondary but equally significant risk is the reclassification of these third-party payors as “deemed connected persons” under Listing Rule 14A. If the HKEX determines that a third-party distributor is, in substance, acting on behalf of a founder or a director of the applicant, the payments become connected transactions requiring independent shareholder approval. This risk is particularly acute for applicants where the founder or senior management has a personal relationship with the third-party, even if no formal equity or contractual link exists.

The Exchange’s Listing Division has, in at least two confidential cases in 2025, required the applicant to unwind the entire third-party distribution network and replace it with a direct sales model before the application could proceed, a process that can take 6-12 months and significantly delay the listing timeline. This represents a material change in the cost of going public for Chinese issuers.

The Sponsor’s Role: From Due Diligence to Forensic Accounting

The Expanded Scope of Sponsor Work Under Code of Conduct Paragraph 17

The SFC’s Code of Conduct for Corporate Finance Advisors (Paragraph 17) has always required sponsors to conduct “reasonable due diligence” on an applicant’s business. The 2025 enforcement shift effectively elevates this requirement to a forensic standard for any applicant with a material third-party payment profile. Sponsors are now expected to:

• Conduct on-site visits to the top 10 third-party payors by value.
• Obtain and review the tax filings of those payors to confirm they are legitimate, operating entities.
• Perform a “beneficial ownership” check on each payor using a commercial database (e.g., Dun & Bradstreet or Orbis).
• Include a specific section in the sponsor’s due diligence report addressing the “economic substance” of each payment arrangement.

This expanded scope has directly increased the cost of a standard IPO sponsorship engagement by an estimated 15-20% for applicants with a distribution-heavy business model, according to data from a 2025 industry survey by the Hong Kong Investment Funds Association (HKIFA). The time to prepare a draft prospectus has also increased, with sponsors now budgeting 8-10 weeks for the third-party payment verification process alone.

The “Red Flag” Indicators for Sponsors

Sponsors are now trained to identify specific “red flags” that will trigger a deeper investigation:

• Concentration of payments: If the top three third-party payors account for more than 30% of total third-party payments, it is a red flag.
• Geographic mismatch: If a payor is located in a jurisdiction with no apparent connection to the applicant’s business operations (e.g., a PRC-based applicant making payments to a BVI-registered entity for services in a country where the applicant has no presence).
• Same-day circular flow: A forensic accounting pattern where a payment to a third-party is followed by a payment of a similar amount from a related entity back to the applicant within a 24-48 hour window.
• Use of cash equivalents: Any payment made via cryptocurrency, prepaid cards, or other non-bank instruments.

The presence of any one of these red flags will typically result in the sponsor requesting a forensic audit, which can add 4-6 weeks to the application timeline and increase legal fees by HKD 2-5 million.

Market Response and Practical Adjustments

Pre-IPO Restructuring as a Defensive Measure

In response to the HKEX’s stance, a growing number of Chinese issuers are undertaking pre-IPO restructuring specifically to eliminate or simplify their third-party payment networks. This is a direct reversal of the trend observed from 2020-2024, where many companies used multi-tier distribution networks to manage tax liabilities and regulatory compliance in multiple PRC provinces. The restructuring typically involves:

• Consolidating all third-party distributors into a single, wholly-owned subsidiary of the Cayman holding company.
• Replacing commission-based agents with salaried employees.
• Converting all cash-based payments to bank transfers with full documentation.

This process is not only costly (estimated at HKD 10-30 million for a mid-cap applicant) but also carries operational risk, as it can disrupt existing sales channels and relationships. However, the cost of deferring an IPO due to a deficiency letter is often higher, particularly for companies with a fixed listing timeline tied to a private equity fund’s exit plan.

The Rise of “Payment Verification” as a Service

A new service line has emerged in the Hong Kong advisory market: independent third-party payment verification. Firms such as Kroll, FTI Consulting, and independent financial advisory boutiques are now offering specialized reports that meet the HKEX’s “economic substance” test. These reports are structured as a “vendor due diligence” exercise, covering the legal status, financial standing, and operational capacity of each material payor. The cost of a typical verification report for an applicant with 50-100 third-party payors ranges from HKD 800,000 to HKD 1.5 million.

The HKEX has not formally endorsed any specific verification methodology, but sponsor-side feedback indicates that reports prepared by firms with a recognized forensic accounting practice (e.g., those with Certified Fraud Examiner (CFE) credentials on staff) are given more weight during the vetting process. This has created a de facto certification market, where the reputation of the verification firm can influence the speed of the HKEX’s review.

Actionable Takeaways for Issuers and Advisors

1. Conduct a “Third-Party Payment Audit” at least 12 months before the intended A1 filing date, identifying all payors representing more than 5% of revenue and preparing a complete payment flow map with supporting documentation.
2. Restructure any distribution network that relies on non-contractual or multi-tier intermediaries, converting them into direct contractual relationships with the PRC OpCo or a wholly-owned subsidiary, to eliminate the “deemed connected person” risk.
3. Engage a forensic accounting firm with a proven track record in HKEX IPO work to prepare a pre-emptive “economic substance” report, rather than waiting for a deficiency letter from the Exchange.
4. Budget for a 15-25% increase in sponsor and legal fees if the applicant’s business model involves material third-party payments, and build this into the IPO timeline and financial projections.
5. Review the VIE contractual chain specifically for payment flows, ensuring that all material payments from the PRC OpCo to third parties are traceable to a legitimate, documented commercial activity, as the 2023 VIE guidance (HKEX-GL108-23) did not address this point.