CSRC launches the strictest shell-borrowing rule, cutting grey profit chain

Grey profit chains such as avoiding shell-borrowing through a variety of ways to list unqualified assets, pursuing large scale arbitrage rapidly through shell-borrowing and ancillary fundraising, making profits by entrapping ordinary investors through hyping “fake shell” and “junk shell”, have warped the original intention of regulations, disturbed the market valuation and damaged the investment environment . Since all these problems are widely criticized by the public, the China Securities Regulatory Commission (CSRC) will be introducing the strictest shell-borrowing rules in history, to curb such misconducts.

On June 17 night, the CSRC announced to solicit public opinions for the revision of AnchorAdministration Methods on Major Assets Restructuring of Listed Companies (hereinafter referred to as “methods”). The revision introduces more stringent regulatory requirements on the identification of actual controllers, standard of assets for trading, the lock-up period of shares and tracing mechanism for rights and liabilities. The CSRC has simultaneously issued two new “questions and answers” in respect of “raising supporting funds by listed companies while issuing shares to purchase assets” and “compensation commitment on results by listed companies”, as the supplements to the methods.

Ancillary fundraising in backdoor restructuring also provides huge room for arbitrage for tunneling in different forms. It has long been a focus of the public opinions. We published on April 7 in the front page an article named “A Game of Insiders: Restructuring, Winners Take All.” It pointed out that the trend that magnate and financial oligarch have played increasingly dominant roles in fundraising through restructuring has caught the attention of the regulators. The revision of the methods clearly prescribes that raising supporting fund in shell-borrowing transactions should be cancelled, to restrain relevant arbitrage behaviors.

Some experienced industry insiders indicated that to improve and refine the standards of shell borrowing and shell selling and strengthen the accountability of avoiding shell borrowing will greatly improve the threshold of backdoor listing and costs of selling shells, and contract the profit making space for hyping “fake shells” and “junk shells”. This will promote listed companies to enhance the quality of assets through normal merging and restricting. And at the same time, “unqualified assets” and “zombie enterprises” in the market will be cleaned up, and the quality of A shares thus can be further improved.

Impose strict standards on assets in five aspects

The methods proposed to be revised directly include four additional indicators in five aspects, including total assets, revenue, net profit, net assets and additional shares, replacing the single indicator of “total assets”, which can easily leave loopholes.

For a long time, backdoor listing, as an important method to change the actual controller and main business of listed companies simultaneously, has been equivalent to IPO in terms of assets listing standards. Parties intended to restructure are not willing to adopt backdoor listing. To list relevant assets, as well as to avoid the requirements of IPO, listed companies, restructuring parties and intermediates avoid backdoor listing by taking any alternative, so as not to evade any of the existing identification standards of “change of control of listed companies” or “the total assets purchased should be 100 percent or above the total assets of listed companies for the previous year”.

To deal with the above situations, the methods directly include four additional indicators in five aspects, including total assets, revenue, net profit, net assets and additional shares, replacing the single indicator of “total assets”, which can easily leave loopholes. If any of the indicators touched the red line of 100 percent, the transaction would be regarded as backdoor listing. The party borrowing shell then cannot avoid shell borrowing through intentionally covering the scale of assets purchased, or simply taking into account of the new actual controller’s assets corresponding to the its shareholding instead of the total assets of the acquisition subject when calculating the percentage of the acquisition subject in the listed company.

Taking a listed company that has revealed its draft for restructuring but has not yet answering the second hearing of the exchange for example, when it plans to acquire the entire shareholding of an Internet finance company, though the actual controller has changed, and the consideration of the subject assets is also more than the original total assets of listed company, the announcement insisted that the new actual controller does not control the subject company, and claim that the consideration of the transaction is only 16 percent equities of the subject company held by the new actual controller and its related parties. The percentage of the scale of assets is accurately set at 93.8 percent of the listed company’s total assets as at the end of last year.

If the new identification standard is adopted, even though the scheme is well designed to avoid the indicator of total assets, the revenue and net profits is beyond the red line of 100 percent, even calculated by the new actual controller and its related party’s shareholding percentage in the subject company.

A partner of a sunshine private fund is in the view that the clause “additional shares should be no more than 100 percent of the share capital of a listed company before the transaction”, which is different from other four financial indicators, is also restrictive. “Assets volume of such restructuring is not small, as 3 billion yuan is just the starting line. Similarly, for a shell company with market capitalization of 3 billion yuan, the additional issuance of share capital of more than 100 percent can easily be touched.”

In additional to the five aspects, regulators added another standard in order to further prevent any loophole, namely “if assets bought a listed company from the buyer and its related party doesn’t violate the requirements in the five aspects but may cause the main business of the listed company to change, the transaction should be deemed as backdoor listing.”

“In light of the prevailing cross-sector acquisition, once new industrial assets are injected, the main business would definitely change. Since the regulators have great discretion power, it has a final say to whether the main business of the listed company will change or not.

Revised identification method of actual controller

Except for the requirements on assets, another identification standard on shell borrowing—the identification on the change of actual controller, is also perfect in the revised methods. Self-identified “actual controller remaining unchanged” or “there being no actual controller” due to original actual controller’s participation in raising supporting fund or the shareholding is highly fragmented, is held invalid.

The methods prescribe the material identification of actual control: controlling right referred to in item (1) of this clause shall be identified according to provision 84 of Administration Methods on Acquisition by Listed Companies. When listed companies’ shareholding is highly fragmented, board of directors and senior management that can make major financial and operational decisions of a listed company should be deemed as taking the controlling rights of the company. For companies listed on the new third board, its assets acquisition from the buyer and its related party from the day when the controlling right changed shall not breach any requirements set out in item (1).

Taking San Bian Science & Technology Co., Ltd. (002112.SZ) for example, the company announced in January 2016 that it proposed to acquire the 100 percent equities of a metro internet scenario operator named Galaxy-Valley through share issuance and cash. The asset pre-valuation of Galaxy-Valley is 2.8 billion yuan. Up to the end of 2014, the assets of San Bian Science & Technology had totaled at 1.3 billion yuan. Before this transaction, the actual controller of the listed company was Sanmen County Government, which has altered to others after the transaction.

However, the listed company stressed in its announcement that the company’s equity proportion is scattered after the said transaction; the three largest shareholders and person acting in concert do not have concerted action relationship; they all cannot guarantee a majority seat in the board of directors, or control the board and management for decision making, or independently govern the company’s behaviors. Therefore, the company does not have the actual controller now.

This was immediately enquired by the Shenzhen Stock Exchange. The company revised the scheme on May 31, and stated that its actual controller altered as Lu Xuri after the restructuring.

Besides that, the CSRC issued Questions & Answers Related to Listed Companies’ Acquiring Assets through Share Issuance while Raising Supporting Funds (hereinafter as Questions & Answers) on June 17. The regulator also proposes new supervision requirements on the situation that controlling shareholder, actual controller and person acting in concert consolidate their controlling right through subscription when the listed company raises supporting funds, or through obtaining underlying assets. “When the regulators judge whether the situation meets the transaction requirement of the 13th rule in Major Assets Restructuring Method of Listed Companies, in terms of controlling shareholder, actual controller and person acting in concert of listed companies who proposing subscription when the listed company raises supporting funds, their corresponding shareholdings will not be accounted in the calculation to determine the controlling right. This calculation method will also be carried out, if they gained the equities of underlying assets six months before or during the trading suspension, and used the gained equities to subscribe the shares of the listed company. ”

Journalist found that such situation has existed in previous cases for many times. And the case was a typical one when Jiangsu Zongyi Co., Ltd. (600770.SH) acquired Hangzhou Zongxing Technology Co., Ltd.

At the end of March, Zongyi announced to acquire the 100 percent equities of Zhongxing Technology, and raise the fund no more than 5.1 billion yuan. However, just before the announcement, Beijing Shengda Asset Management Co., Ltd., controlled by the actual controller of Zongyi named Zan Shengda, suddenly acquired 33 percent equities of Zhongxing Technology, invested in the underlying asset before the restructuring. Zan also provided 500 million yuan for subscription when the listed company raised the supporting funds. After the acquisition, Zan is still the actual controller, which blocks this restructuring from backdoor listing. But in line with the CRSC’s Questions & Answers, Zan used the 33 percent equities of Zhongxing Technology to participate in the fundraising to acquire the newly-added shares of the listed company, which will not be accounted in when determining the actual controller of Zongyi.

Cancel supporting fundraising against arbitrage

In the Method to be revised, rules become stricter on definition of backdoor listing, and those on related arbitrages are also adjusted to cut off the profit chain that winner gets all benefits.

Since last year, as the core part in restructuring operation of listed companies, supporting financing has become a natural platform formed by various resources and capitals in a hidden or clear way, as such financing will bring in explosive benefits. Insiders involve in the said financing with low price, and share the benefits by gained equities when the assets securitize. “It is very hard to earn money in the secondary market or private placement. Only the said financing related to restructuring can easily bring in benefits without doing anything. However, good projects are usually pursued by each party with various measures. Besides insiders, outsiders must have money but also ‘enough social connections’ to follow up the project investment,” said a private funds insider frankly. It is a highly-looped game for “insiders”, and others are barely allowed in.

Based on this situation, the Method to be revised will further restrict the arbitrage space from backdoor listing, and acquirer and related parties are limited to gain massive benefits through financing when carrying out backdoor listing. Qualification threshold is raised for restructuring parties, and the Method to be revised will cancel the supporting fundraising related to backdoor listing.

At the meantime, the regulators also intend to tighten the restructuring quota not related to backdoor listing. The Questions & Answers mentions that, in line with Applicable Opinions for the 14th and 44th Rules of the Major Assets Restructuring Method of Listed Companies – No.12 Applicable Opinions on Securities and Futures Laws, “the raised supporting funds when the listed company issue new shares to acquire the assets shall not exceed the 100 percent of proposed transaction price, which will all be investigated and approved by merging, acquisition and restructuring commission”. Additionally, “the transaction price of the assets in proposed acquisition” means that of the assets to be acquired through share issuance, excluding the transaction price corresponding to part of the underlying assets invested by counterparty with cash increment six months before or during the trading suspension caused by this acquisition. It also means that suddenly invested underlying assets will directly reduce the quota for supporting fundraising. This rule will make related parties less willing to bring in important shareholders temporarily, blocking the operational path of speculators from suddenly investing the underlying assets and expanding the asset scale.

Based on the Questions & Answers, the raised supporting funds can only be used to: pay the cash consideration of this merging & acquisition transaction; pay fees for this merging, acquisition and integration, such as taxes and employee settlement; and invest in the under-constructed projects of the underlying assets. But such funds cannot be used to supplement the liquidity or repay the debts of the listed companies and underlying assets.

According to insiders at investment bank, liquidity supplement and debt repayment are the commonest purpose to raise supporting funds, which are now clearly banned.

The way to rely on loans as transitional capital for merging & acquisition will be no longer feasible, and the trading parties lacking of capital need to consider new fund flow modes.

It is worthy to notice that the AnchorMethod to be revised also proposes new requirements to avoid the walk away of previous actual controller after bringing in backdoor listing parties. It mentions that “when the situation meets the requirements specified in the 13th rule of this Method, previous controlling shareholder, actual controller and affiliated parties controlled by them shall publically promise that they will not transfer their held equities of this listed company within 36 months from the transaction completion; besides acquirer and related parties, other special parties shall publically commit that they will not transfer their held shares of this listed company gained through their asset subscription within 24 months since the share issuance”.

Introduction of discretion brings huge influence

The introduction of discretion makes it easy to determine the nature of some proposals which are widely applied but have not been finalized.

“After we have just concluded a proposal, the new regulation comes out; so we have to revise the proposal.” an investment banker told the journalist at weekend.

It is learnt that in terms of the method that listed companies make a fuss about control power and total investment amount so as to avoid backdoor listing, detailing identification standard of control power and adding “five dimensions” to the indicators judging asset scale have largely squeeze the arbitration potential of policy about backdoor listing. In addition, regulators introduce the right of discretion.

The to-be-revised methods point out that companies’ move will be regarded as backdoor listing even though the value of asset they purchase from buyers and their affiliated persons fail to meeting standards of the foresaid “five dimensions” but is likely to bring fundamental changes in principal business of listed companies. What’s more, there is an additional miscellaneous provision saying “other situations identified by China Securities Regulatory Commission”; therefore, the above two rules are widely believed to be “the most lethal clauses”. This means that these rules make it difficult for the common transaction avoiding standards on “change in control right” or “total asset amount” to escape from the new polices; also, the introduction of discretion makes it easy to determine the nature of some proposals which are widely applied but have not been finalized.

The acquisition model that introducing actual controller through raising funds by private placement but the third party provides assets is adopted by Nantong Metalforming Equipment Co., Ltd. (300280.SZ) and Shenke Slide Bearing Corporation (002633.SZ). This model is frequently used in the restructuring cases with PE involved in.

Taking the latest case for example, Xinjiang Zhundong Petroleum Technology Co., Ltd. (002207.SZ), which just announced restructuring proposal on June 15, plans to acquire 100 percent equity of Zhongke Fuchuang (Beijing) Technology Co., Ltd. held by Fu Zhengqiao, Zheng Shuoguo and Huiguo Investment Co., Ltd. by issuing shares and paying in cash, which totally values 2.4 billion yuan. It will also raise supporting funds from Yingjiu Tongda and other companies. After the deal is done, Yingjiu Tongda will become the controlling shareholder of the listed company and its actual controller will become the actual controller of the listed company. Although this case did not meet the condition about purchasing assets from “buyers and their affiliated persons” based on the existing standards identifying backdoor listing, the target firm specialized in intelligent comprehensive service of express logistics is rather different from Zhundong Petroleum Technology in terms of principal business. It is noteworthy that the target firm suffered losses of 6.7 million yuan and 29.12 million yuan in 2014 and 2015 respectively.

“Under the new identification standard, as long as there is change in control right, the company will draw attention from the market, which will make it easy to trigger conditions of backdoor listing.” An industry insider told the journalist.

The revised methods will solicit opinions for one month. When implemented, the methods will delimit a time range for the on-going backdoor listing. Namely, the backdoor listing, which has been approved by the general meeting of stockholders before the scheme is implemented, will be carried out in accordance with the previous methods; while those that fail to pass the shareholders’ meeting after the scheme is implemented will adhere to the new ones. Facing such restrict requirements, whether will the proposals which intend to avoid backdoor listing rush to pass the shareholders’ meeting or shrink back from difficulties? Obviously, last Friday (June 17) was bound to be a “sleepless night” for the companies which are under the “transition period”.

The power of “five dimensions” and “discretion” is evident. Therefore, it is foreseeable that revision of new rules on restructuring not only exerts significant influence on some companies which have put forward restructuring plans but also will impact the restructuring progress of those which are carrying out trading suspension now. At present, a great many of companies which are suspending trading and mulling over restructuring proposal on Shanghai and Shenzhen bourses may need to reconsider based on the new rules and their own conditions.

Latent rules for backdoor listing will fail to work

The new rules will help compress arbitrage room in backdoor listing, break existing profit model in backdoor listing and block path for earning quick morning via backdoor listing. As the well-operated profit chain by backdoor listing is soon to be interrupted, the old rules followed by the market will not work.

Except that the identification criteria include methods, the new regulations also intend to restrain arbitrage and conduct regulations in a stricter and comprehensive way. There is also a mix of supporting policies.

Backdoor listing is always connected with behaviors of violating rules and breaching promises of listed companies. In recent years, driven by all kinds of capitals, the market has hoarded shell companies which are really rare, and even became favor of “the worse shell, the better”. Once a company succeeds in backdoor listing, it may trigger speculations in the market. There are frequently companies with poor performance trying to push up their stock prices in the name of reorganization. Following them are illegal behaviors. In reality, however, even though these companies had record, a great of them will “whitewash” themselves by changing actual controller and injecting capital. Although there are punishments for companies violating rules and breaching promises, none can hit their pain points.

The revised rules on reorganization make stricter requirements on supporting financing and extension of lock-up period, especially for companies that have violated rules and breached promises.

The news rules point out that for companies that plan to go listing via reorganization, the listed company, its controlling shareholder and actual controller shall not be on file by judiciary authorities for suspected crime or under investigation by the CSRC for alleged illegal behaviors; or they have terminated behaviors of suspected crime or behaviors violating rules and breaching promises for 36 months, and have not been condemned publicly by the stock exchange within recent 12 months and have no other major dishonesty behaviors.

To prevent companies violating rules and breaching promises from selling as shell resources cannot only restrict speculations on shell resource and crack down speculations on shells with poor performance, but also greatly increase the impact of regulatory policies and lift costs for reorganization of poorly performed companies. Listed companies or their substantial shareholders will be punished for violating rules and breaching promises and will therefore be under stricter supervision for reorganization.

Another regulatory change is that regulators will step in at key points, such as when companies plan to reorganize or launch reorganization plan. To enhance accountability after event is another important aspect. The CSRC points out that the revised measures provide more details about requirements for accountability in evading review for reorganization listing. The measures specify that for companies that have not completed transactions, the CSRC can order the listed companies to complement relevant information disclosure, suspend trading and submit application documents; for companies have completed transaction, the CSRC can warn and punish the companies, and take measures to prohibit relevant responsibility persons to entering the market. For companies committed crimes, the CSRC can transfer them to the judicial organs in accordance with law.

“In a word, the current policy has a clear aim. That is to remove the so-called value of shell companies,” the senior industry insider told the journalist.

The new rules will help compress arbitrage room in backdoor listing, break existing profit model in backdoor listing and block path for earning quick morning via backdoor listing. As the well-operated profit chain by backdoor listing is soon to be interrupted, the old rules followed by the market will not work. The ecosphere of backdoor listing will be reconstructed, which will undoubtedly change the acquisition and reorganization pattern in the entire capital market.

(APD/XH FINANCE)