IPOs: Better Oversight, Not Ban, Needed for China Backdoor Listings

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Bottom line: The CSRC should take steps to better regulate backdoor listings by Chinese companies privatizing from New York to ensure market stability, but shouldn’t ban the process completely.

CSRC weighs closing backdoor listings

Chinese companies planning to re-list at home after disappointing results with overseas IPOs got some troublesome signals last week, when rumors emerged that China’s securities regulator might be planning to slow or halt a mechanism that has quickly become the preferred route for such homecomings.

That mechanism has seen newly privatized companies make back-door listings using Shenzhen- and Shanghai-traded firms that are often just shells of former state-run enterprises whose own businesses have withered. Returning companies have chosen such a path because conventional IPOs in China have slowed to a crawl due to the regulator’s concerns about market volatility, creating a huge waiting line for new listings.
While concern about the growing number of backdoor listings is understandable, the China Securities Regulatory Commission (CSRC) should take a more moderate approach by creating a formal system with strong oversight for these unconventional listings rather than halting them altogether. Such an approach would not only provide these healthy companies with access to new money for growth and daily activities, but would also help to clear China’s stock exchanges of these shell companies cluttering the marketplace.

More than 3 dozen Chinese companies announced plans to de-list from New York last year, after their shares languished and valuations stagnated due to lack of interest from US investors. Among that group, a handful of names, including outdoor advertising specialist Focus Media and online game operator Giant Interactive, are in the process of re-listing on China’s A-share market by injecting themselves into shell companies, a process known as a reverse takeover or backdoor listing.

The process has caught the attention of the CSRC, which has only allowed an average of 10 new conventional IPOs per month this year in a bid to stabilize stock markets after a major sell-off at the start of 2016. The CSRC has also indicated it will delay the rollout of a new market-based registration system for new IPOs that many were expecting to launch this year, further showing it plans to tightly restrict the number of new offerings for the foreseeable future.

With little hope of making conventional IPOs in China anytime soon, a growing number of formerly US-listed companies have been eyeing backdoor offerings as a faster route to market. Those included security software giant Qihoo (NYSE: QIHU), which has reportedly chosen a shell company for what would have been one of the biggest backdoor listings to date, as it aims to sharply boost its market value of $9 billion that it previously had in New York.

Growing Alarm

Alarmed at this flood of new shares coming in through the back door, often with far less regulatory scrutiny than traditional IPOs, the CSRC was rumored last week to be planning drastic action by potentially shutting down such listings completely. (English article; Chinese article) The CSRC responded by saying it was analyzing the potential impact of such backdoor listings, and Qihoo put out its own statement saying the rumors weren’t true. (Qihoo statement)

Such backdoor listings are very complicated, and their relative novelty in China means there is plenty of room for speculation and other financial mischief in the process. Even in a mature market like the US, some financially suspicious Chinese companies took advantage of relatively light regulation of such listings to become publicly traded in New York, leading to a confidence crisis that prompted the regulator to forcibly de-list many in 2011 and 2012.

The case this time in China is slightly different, since many of the companies aiming to make such backdoor listings are sector leaders and widely respected names like Qihoo, as well as hotel operator Homeinns (NYSE: HMIN) and real estate services firm E-House (NYSE: EJ). Accordingly, their addition to China’s stock markets would provide some high-quality private sector options that are currently out of reach for most domestic investors.

At the same time, most of the shells being used in these listings are state-run companies whose businesses have largely failed. And yet such companies have managed to avoid de-listing despite the CSRC’s efforts to clean up the market, creating clutter and confusion for Chinese investors who don’t understand the phenomenon.

Rather than cut off the backdoor re-listing route completely, the CSRC should consider creating a more formal process for such listings with strict oversight to avoid profiteering and other financial shenanigans. It could also open that process to everyone, serving a dual purpose of adding another option for companies wishing to list while also cleaning up the market of the current crop of misleading and clutter-creating shell companies.

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