Loosely regulated backdoor listings are promoting speculative behaviour and hobbling reform efforts on China’s stock markets.
Yin Zhongyu 18 May 2009
(Caijing Magazine) Backdoor listings, the apple of many an investor eye, have been commonly used on Chinese capital markets for many years. They’ve also jeopardized normal stock market operations and prevented key market reforms. One man’s apple can be another’s poison.
China’s main board has currently suspended initial public offerings (IPO), prompting many speculators to eye shell companies for backdoor listings as the date nears for the launch of the Growth Enterprise Market (GEM), China’s version of NASDAQ. But orderliness on the stock market will deteriorate unless regulators step in with new policies as soon as possible.
China’s industry watchdog has not only restricted backdoor listing operations but also issued interim regulatory measures for GEM that would enhance delisting mechanisms. That means regulators recognize the danger of backdoor listings. However, their first step should be to fix the main board, which is the true source of the peril.
Backdoor Dangers
In the past dozen years, many listed but valueless companies have been rescued. Nirvana seems quite common on China’s stock market.
In 1999, scandal-plagued Qiongmingyuan became the renowned Beijing Centergate Technologies (Holding) Co. Ltd., also known as Zhongguancun (SZSE: 000931). In 2007, debt-ridden ST Changyun (A delisting warning for investors: Companies with the ST prefix have reported losses for two consecutive years.) was acquired by Southwest Securities (SSE: 600369) as a shell corporation for Southwest Securities’ backdoor listing. The same year saw a chicken-farm company notorious for fraudulent financial statements converted into a mining company called Inner Mongolia Ping Zhuang Energy Resources Co. Ltd. (SZSE: 000780) by a local government. In fact, these types of nirvana operations have been favorites among speculators.
Data from market analyst Wind Info shows only 12 of the more than 1,000 companies listed on the Shanghai and Shenzhen exchanges since 2007 have been delisted. Six were acquired by parent companies, while others were acquired by Pacific Securities through backdoor listings. Only five were actually delisted.
Currently, there are still 157 ST-listed companies. However, since share prices for ST companies are low, they are ideal targets for backdoor listings. Prospects for a shell acquisition bolstered ST share prices, which is why small and medium-sized investors have been enthusiastic about ST stock. Nevertheless, this wave of backdoor listings is undermining the capital market.
Share prices on the secondary market usually soar when information surfaces that a company is being acquired as a shell. These soaring prices lure investors into insider trading.
Before and after the release of restructuring information, shares in Shandong Jintai Group Co. Ltd., or ST Jintai (SSE: 600385) rose 10 percent daily for 42 consecutive trading days, while ST Jizhi (SZSE: 000718) increased by a factor of 74 in total.
Astronomical gains can be irresistible temptations. Dong Zhengqing, former president of GF Securities, was sentenced to four years in prison for insider trading. Huang Guangyu, once the richest man in China, was investigated for alleged involvement in trading Zhongguancun and ST Jintai stock.
Market reforms to convert all stock into tradable shares led to the manipulative use of shell acquisitions as a tool for cashing non-tradable stock. (Under China’s stock market reform, some large shareholders’ shares were barred from sales for certain periods of time.) Some large shareholders of valueless companies, who should have gained nothing, made a fortune via shell-selling. Some even made up stories about shell acquisitions to raise stock prices. By the time common investors discovered the fraud, the big shareholders had already fled with bags of cash.
Jilin Pharmaceutical Ltd. Co. (SZSE: 000545) is a typical case. The second largest shareholder of Jilin Pharmaceutical often fabricated stories about a possible restructuring. By the end of 2008, the story-telling had earned 150 million yuan through the sales of only 10 percent of stock. If the company’s first and second largest shareholders succeeded in selling shares at current prices, they could grab up to 600 million yuan.
This author estimates that at least 200 listed companies in China are completely valueless. If other large shareholders follow the lead of Jilin Pharmaceutical’s stakeholder, investors may lose 120 billion yuan over the next three years.
What’s worse is that backdoor listings have upset the stock market’s basic function, which is to optimize the distribution of resources. The financial crisis has had a great impact on the real economy, encouraging industrial restructuring and consolidation. However, unreasonably high stock prices supported by great expectations for future backdoor listings have suppressed the normal merger and acquisition process in affected industries.
For example, a listed construction materials company in southwestern China -- with legally questionable operations -- should have been acquired by a stronger industry leader, based on the fact that its price should be quite low. But the company’s market capitalization of more than 2 billion yuan is a major obstacle for an acquisition. The transfer of all equities by Anhui Guofeng Group has been delayed because this listed company, owned by the group, has been overvalued at a price much higher than strategic investors expect.
Meanwhile, to some extent, mergers and acquisitions have become distorted. This business, considered a crown jewel of the securities industry, should play an important role in optimizing society’s distribution of resources. However, most domestic M&As business pivots on buying and selling shell companies due to low thresholds and their popularity in the market.
The prevailing use of backdoor listings stems from an issuance system that makes IPOs precious opportunities for companies. On one hand, the industry watchdog sets extremely strict rules and standards for companies that want to launch IPOs. On the other hand, it lacks regulations for backdoor listings.
To get listed, a private company can transfer assets or pump funds into a shell. This allows the private company to reach its goal to list, while the listed shell is spared from delisting or bankruptcy. At the same time, all investors are delighted as stock prices soar. This seemingly mutually beneficial model is recognized by regulators. Actually, a backdoor listing is similar to an IPO. But its attractiveness is based on its unlimited operational freedom.
The China Securities Regulatory Commission (CSRC) published a regulation in March 2008 stipulating that a significant restructuring should be treated as an IPO. But standards for a significant restructuring are much lower than those for IPOs, even though significant restructurings also must be approved by a branch of the committee.
For example, many securities firms that cannot meet three-year profit requirements can get backdoor listings. Companies in real estate and other industries with government restrictions on going public can bypass regulations through backdoor listings. New firms that have not operated for three consecutive years cannot be included as part of a listed company for an IPO application, but the rule does not apply for significant restructurings. In other words, since a restructuring committee only cares about asset quality, anyone who can afford an admission ticket can play.
The disparity is apparently an insult to legal authority, and overrides the principles of fairness and transparency. Meanwhile, rampant backdoor listings confuse investors and deprive them of risk awareness, while distorting pricing mechanisms for newly issued stock.
When investors are wild about the prospects of a backdoor listing, the market rewards many ST companies. When companies on the edge of bankruptcy still enjoy a relatively high per-share prices of eight to 10 yuan, why can’t the P/E ratios of more successful companies reach 50 or even 100? Sometimes the opening share prices of small- and medium-sized listed companies are 300 percent higher than the IPO price, which is understandable if institutional investors manipulate the opening prices out of certainty that speculators will follow.
Under such circumstances, marketization reforms are doomed to fail. CSRC let the market decide the issuing price in 2001 when it had skyrocketed to 15 times the P/E ratio. The issuing price of Fujian Mindong Electric Power Ltd. Co. (SZSE: 000993) even reached 88 times its P/E ratio, which forced the watchdog to take back the power to decide issuance price.
The financing process for listed companies is similarly dramatic. Whatever a company’s profitability, the market will dare to increase its share price as long as there are opportunities for speculation. Listed companies that price their newly issued stock at extremely high levels are attacked as “malicious money collectors.”
The industry watchdog has to function as a goalkeeper, examining every finance deal that goes through the stock market. However, the examination and approval process helps boost the value of shells, creating a vicious circle.
Such a large-scale and pervasive appetite for backdoor listings can only be found in China. The European and American capital markets use a registration mechanism, which means companies can go public as long as they disclose relevant information. Therefore, there is almost no demand for backdoor listings.
Backdoor listings were once popular on the Hong Kong stock market when mainland enterprises were eager to play international markets. In 2004, the Hong Kong Exchange revised its IPO regulations, stipulating that a deal should be regarded as an IPO if an acquirer pumps in assets worth more than the original value of the shell within 24 months of the acquisition. Such a deal has to go through the same approval procedures as IPOs.
Experience in mature markets demonstrates that backdoor listings should be stopped immediately in China to restore a fair environment for the capital market. In light of domestic investors’ low tolerance for risk, the main board can be redressed gradually.
First of all, standards for IPOs and backdoor listings should be unified. Second, approval procedures should be leveled over an appropriate period to block listing shortcuts. In this way, enterprises will opt to follow standard IPO procedures, and backdoor listings will lose their glamour. As shell acquisitions decline, investors will be more aware of risks. Speculators will be less likely to prey on the stock of companies with relatively low market capitalization, stocks of underperforming listed companies, or newly issued shares. Only in this way can reasonable investors dominate China’s capital market again.
Yin Zhongyu works for a merger and acquisitions agent in Shanghai. Staff reporters Fan Junli and Song Yanhua contributed to this article.
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Backdoor Listings: Sweet Market Poison
Loosely regulated backdoor listings are promoting speculative behaviour and hobbling reform efforts on China’s stock markets.
Yin Zhongyu
18 May 2009
(Caijing Magazine) Backdoor listings, the apple of many an investor eye, have been commonly used on Chinese capital markets for many years. They’ve also jeopardized normal stock market operations and prevented key market reforms. One man’s apple can be another’s poison.
China’s main board has currently suspended initial public offerings (IPO), prompting many speculators to eye shell companies for backdoor listings as the date nears for the launch of the Growth Enterprise Market (GEM), China’s version of NASDAQ. But orderliness on the stock market will deteriorate unless regulators step in with new policies as soon as possible.
China’s industry watchdog has not only restricted backdoor listing operations but also issued interim regulatory measures for GEM that would enhance delisting mechanisms. That means regulators recognize the danger of backdoor listings. However, their first step should be to fix the main board, which is the true source of the peril.
Backdoor Dangers
In the past dozen years, many listed but valueless companies have been rescued. Nirvana seems quite common on China’s stock market.
In 1999, scandal-plagued Qiongmingyuan became the renowned Beijing Centergate Technologies (Holding) Co. Ltd., also known as Zhongguancun (SZSE: 000931). In 2007, debt-ridden ST Changyun (A delisting warning for investors: Companies with the ST prefix have reported losses for two consecutive years.) was acquired by Southwest Securities (SSE: 600369) as a shell corporation for Southwest Securities’ backdoor listing. The same year saw a chicken-farm company notorious for fraudulent financial statements converted into a mining company called Inner Mongolia Ping Zhuang Energy Resources Co. Ltd. (SZSE: 000780) by a local government. In fact, these types of nirvana operations have been favorites among speculators.
Data from market analyst Wind Info shows only 12 of the more than 1,000 companies listed on the Shanghai and Shenzhen exchanges since 2007 have been delisted. Six were acquired by parent companies, while others were acquired by Pacific Securities through backdoor listings. Only five were actually delisted.
Currently, there are still 157 ST-listed companies. However, since share prices for ST companies are low, they are ideal targets for backdoor listings. Prospects for a shell acquisition bolstered ST share prices, which is why small and medium-sized investors have been enthusiastic about ST stock. Nevertheless, this wave of backdoor listings is undermining the capital market.
Share prices on the secondary market usually soar when information surfaces that a company is being acquired as a shell. These soaring prices lure investors into insider trading.
Before and after the release of restructuring information, shares in Shandong Jintai Group Co. Ltd., or ST Jintai (SSE: 600385) rose 10 percent daily for 42 consecutive trading days, while ST Jizhi (SZSE: 000718) increased by a factor of 74 in total.
Astronomical gains can be irresistible temptations. Dong Zhengqing, former president of GF Securities, was sentenced to four years in prison for insider trading. Huang Guangyu, once the richest man in China, was investigated for alleged involvement in trading Zhongguancun and ST Jintai stock.
Market reforms to convert all stock into tradable shares led to the manipulative use of shell acquisitions as a tool for cashing non-tradable stock. (Under China’s stock market reform, some large shareholders’ shares were barred from sales for certain periods of time.) Some large shareholders of valueless companies, who should have gained nothing, made a fortune via shell-selling. Some even made up stories about shell acquisitions to raise stock prices. By the time common investors discovered the fraud, the big shareholders had already fled with bags of cash.
Jilin Pharmaceutical Ltd. Co. (SZSE: 000545) is a typical case. The second largest shareholder of Jilin Pharmaceutical often fabricated stories about a possible restructuring. By the end of 2008, the story-telling had earned 150 million yuan through the sales of only 10 percent of stock. If the company’s first and second largest shareholders succeeded in selling shares at current prices, they could grab up to 600 million yuan.
This author estimates that at least 200 listed companies in China are completely valueless. If other large shareholders follow the lead of Jilin Pharmaceutical’s stakeholder, investors may lose 120 billion yuan over the next three years.
What’s worse is that backdoor listings have upset the stock market’s basic function, which is to optimize the distribution of resources. The financial crisis has had a great impact on the real economy, encouraging industrial restructuring and consolidation. However, unreasonably high stock prices supported by great expectations for future backdoor listings have suppressed the normal merger and acquisition process in affected industries.
For example, a listed construction materials company in southwestern China -- with legally questionable operations -- should have been acquired by a stronger industry leader, based on the fact that its price should be quite low. But the company’s market capitalization of more than 2 billion yuan is a major obstacle for an acquisition. The transfer of all equities by Anhui Guofeng Group has been delayed because this listed company, owned by the group, has been overvalued at a price much higher than strategic investors expect.
Meanwhile, to some extent, mergers and acquisitions have become distorted. This business, considered a crown jewel of the securities industry, should play an important role in optimizing society’s distribution of resources. However, most domestic M&As business pivots on buying and selling shell companies due to low thresholds and their popularity in the market.
Root of the Problem
The prevailing use of backdoor listings stems from an issuance system that makes IPOs precious opportunities for companies. On one hand, the industry watchdog sets extremely strict rules and standards for companies that want to launch IPOs. On the other hand, it lacks regulations for backdoor listings.
To get listed, a private company can transfer assets or pump funds into a shell. This allows the private company to reach its goal to list, while the listed shell is spared from delisting or bankruptcy. At the same time, all investors are delighted as stock prices soar. This seemingly mutually beneficial model is recognized by regulators. Actually, a backdoor listing is similar to an IPO. But its attractiveness is based on its unlimited operational freedom.
The China Securities Regulatory Commission (CSRC) published a regulation in March 2008 stipulating that a significant restructuring should be treated as an IPO. But standards for a significant restructuring are much lower than those for IPOs, even though significant restructurings also must be approved by a branch of the committee.
For example, many securities firms that cannot meet three-year profit requirements can get backdoor listings. Companies in real estate and other industries with government restrictions on going public can bypass regulations through backdoor listings. New firms that have not operated for three consecutive years cannot be included as part of a listed company for an IPO application, but the rule does not apply for significant restructurings. In other words, since a restructuring committee only cares about asset quality, anyone who can afford an admission ticket can play.
The disparity is apparently an insult to legal authority, and overrides the principles of fairness and transparency. Meanwhile, rampant backdoor listings confuse investors and deprive them of risk awareness, while distorting pricing mechanisms for newly issued stock.
When investors are wild about the prospects of a backdoor listing, the market rewards many ST companies. When companies on the edge of bankruptcy still enjoy a relatively high per-share prices of eight to 10 yuan, why can’t the P/E ratios of more successful companies reach 50 or even 100? Sometimes the opening share prices of small- and medium-sized listed companies are 300 percent higher than the IPO price, which is understandable if institutional investors manipulate the opening prices out of certainty that speculators will follow.
Under such circumstances, marketization reforms are doomed to fail. CSRC let the market decide the issuing price in 2001 when it had skyrocketed to 15 times the P/E ratio. The issuing price of Fujian Mindong Electric Power Ltd. Co. (SZSE: 000993) even reached 88 times its P/E ratio, which forced the watchdog to take back the power to decide issuance price.
The financing process for listed companies is similarly dramatic. Whatever a company’s profitability, the market will dare to increase its share price as long as there are opportunities for speculation. Listed companies that price their newly issued stock at extremely high levels are attacked as “malicious money collectors.”
The industry watchdog has to function as a goalkeeper, examining every finance deal that goes through the stock market. However, the examination and approval process helps boost the value of shells, creating a vicious circle.
Fix the Main Board
Such a large-scale and pervasive appetite for backdoor listings can only be found in China. The European and American capital markets use a registration mechanism, which means companies can go public as long as they disclose relevant information. Therefore, there is almost no demand for backdoor listings.
Backdoor listings were once popular on the Hong Kong stock market when mainland enterprises were eager to play international markets. In 2004, the Hong Kong Exchange revised its IPO regulations, stipulating that a deal should be regarded as an IPO if an acquirer pumps in assets worth more than the original value of the shell within 24 months of the acquisition. Such a deal has to go through the same approval procedures as IPOs.
Experience in mature markets demonstrates that backdoor listings should be stopped immediately in China to restore a fair environment for the capital market. In light of domestic investors’ low tolerance for risk, the main board can be redressed gradually.
First of all, standards for IPOs and backdoor listings should be unified. Second, approval procedures should be leveled over an appropriate period to block listing shortcuts. In this way, enterprises will opt to follow standard IPO procedures, and backdoor listings will lose their glamour. As shell acquisitions decline, investors will be more aware of risks. Speculators will be less likely to prey on the stock of companies with relatively low market capitalization, stocks of underperforming listed companies, or newly issued shares. Only in this way can reasonable investors dominate China’s capital market again.
Yin Zhongyu works for a merger and acquisitions agent in Shanghai. Staff reporters Fan Junli and Song Yanhua contributed to this article.
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