Gambling on Shell Companies' Stocks Resurfaces
(Beijing) — China's strictly controlled stock issuance system has produced one unlikely hot commodity — shell firms. And although Beijing cracked down on them recently, they're coming back in vogue.
Shell firms are companies that have little investment value in their own right. They are sought after because they can be used to help other companies get a "backdoor listing" — the right to trade on an exchange without first having an initial public offering (IPO).
Speculative traders gamble on which companies might turn into shell firms because the stock price of such companies will often skyrocket regardless of the firm's actual performance. The hype around such firms has been criticized by the China Securities Regulatory Commission (CSRC) as irrational and harmful to market order.
Shell firms play an important role in backdoor listings. In such moves, a private company will inject its own assets into a publicly listed shell firm and take control of it. The private company then becomes a public one without the regulatory hurdles of an IPO.
The CSRC has attempted this year to rein in speculative trading related to shell firms. It announced in June the draft of a policy on listed firms' asset restructuring, which included rules that would make backdoor listings more difficult. The rules were implemented in September.
The policy hurt the demand for shell firms and cooled related speculation — but only temporarily.
Since October, the market has seen out-of-the-ordinary price movements again in a number of stocks after the companies each announced a new controlling shareholder. The price gains indicate more speculating in those firms and reflects a rebound in demand for shell firms, according to securities analysts.
Shanghai-listed Sichuan Guodong Construction, a building panels maker, for example, saw its stock price more than double in just one month after it said on Oct. 9 that a real estate developer would become its new biggest shareholder after the developer completed the purchase of nearly a quarter of the company's shares. During the same period, the market's benchmark Shanghai Composite Index rose by less than 7%.
Guangfa Securities, a brokerage firm, chalked up Guodong's unusual price surge to the developer's paying a premium price for what could be used as a "shell" for its own assets. Retail investors were drawn to that prospect, pushing up the firm's stock price, the securities firm said in its research report. Guodong lost 57 million yuan ($8.3 million) in net profit last year and another 95.3 million yuan in the first three quarters, according to its financial statements.
Another construction material maker, Sichuan Shuangma Cement Co., saw its market value rise even faster. Its stock price increased from 7 yuan per share in late August to more than 40 yuan in early November, driven by expectations that its new controlling shareholder — a little-known technology firm backed by famous venture capital firm IDG, which itself has no business interest in cement — would somehow turn the company into a shell for itself or others.
Investors flocked to possible shell firms because the CSRC's tougher new rules on backdoor listing did not entirely kill the demand for them, said Lin Jin, chief analyst from Shenwan Hongyuan Securities.
The shell-company route can be a more efficient way for Chinese companies to list on a stock exchange because getting the CSRC's permission for an IPO often takes years. As long as that remains true, firms that can serve as a shell will continue to be chased by speculative capital, Lin said.
As of Nov. 11, 728 companies were in the pipeline waiting for regulatory approval to go public, according to the CSRC.
The long waiting list is the primary reason why companies would want a backdoor listing instead, an investment banker said.
"Using a shell firm is costly," he said, "but some companies go for it anyway because the current route for getting permission for an IPO is too long."
Another investment banker said: "Some companies simply cannot afford to wait so long because they are in a highly competitive industry."
The CSRC tightened regulations for backdoor listings not only to crack down on shell-firm speculating but also because it was concerned that some companies had evaded tougher IPO requirements by exploiting loopholes in backdoor-listing rules, according to a CSRC official who worked in the committee in charge of listed firms' asset restructuring.
The new regulations attempt to better distinguish between shell listings and other types of asset restructurings. They broaden the range of indicators used for judging whether a firm is attempting a backdoor listing, making it harder for them to pass it off as a not-so-important asset restructuring. In addition, firms will be considered attempting a backdoor listing if they inject their own assets into a listed company within five years of becoming its biggest shareholder.
The new rules also prohibit backdoor-listed firms from immediately issuing new shares, meaning that their plan of tapping the stock market for funds will have to be postponed.
Fifty listed firms aborted their plan of "asset restructuring," a common pretext for backdoor listing, in July after the policy's draft came out, and 19 of them said they made the decision due to "regulatory policy changes," according to Caixin's calculation based on corporate filings with the Shanghai or Shenzhen stock exchanges.
Another 30 firms gave up their restructuring plan in August, followed by 34 in September. The number of dropouts for April and May, by contrast, was only 24 and 25 respectively.
But the IPO backlog remains long. "There are so many companies that need to securitize their assets, but the path (to the stock market) is gated, so many will have to seek a shell firm," said the CSRC official who worked on reviewing IPO applications.
The only real solution lies in adopting a more-liberal stock issuance system, such as one that requires registration rather than the CSRC's prior approval. This will remove the strongest incentive for companies to seek a backdoor listing, the CSRC official said.
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