Hong Kong Exchanges & Clearing are proposing to broaden the definition of reverse takeover, or backdoor listing, in a bid to reduce the number of empty listed vehicles known as “shell” companies.

The Exchange issued a guideline after a three-month consultation that ended on August 31, saying that for a company to be deemed to have substantial business requires annual revenue or total assets exceeding HK$1 billion (US$127.7 million). Any less makes the company appear to be a shell.

As of August 17, there were 716 listed companies with both annual revenue and total assets below HK$1 billion. They account for one-third of all listed companies in Hong Kong.

Under the proposed rules, many of these 700+ companies will be denied opportunities to acquire new businesses larger than themselves or to dispose of old ones. Even the raising of funds will be severely limited.

One thing to consider is that the relatively small size of these companies is often caused by industrial downcycles. In fact, many are manufacturing companies that moved across the border into China in the 1990s in search of lower production costs. As South China’s economy grows and costs increase, they are forced to scale down.

Another factor is that markets are ever-changing, all the more so in the Internet era. Companies either keep reinventing themselves or they die.

Take a few classic examples: IBM changed from manufacturing to service; Berkshire Hathaway started as a textile company; American Express was in logistics. Apple is now better known for its iPhone than its Macintosh. Netflix prospers with video streaming while its old video-rental rival Blockbuster failed. Even banks are transforming into data companies.

Previous success cases

Alleged backdoor listings in Hong Kong, which turned into success stories, include China Everbright, Citic Ltd, Galaxy Entertainment, Geely Automobile and China Gas.

Under the new proposal, more than 700 companies will be denied access to any meaningful acquisitions, disposals or fundraising.

They would be left stranded and without the chance of a second lease on life. The Exchange will penalize them for the sin of being too small, without realizing that their smallness is of the Exchange’s own making.

Investors will start to sell small caps and buy large caps, sending borderline small-med caps into a downward spiral.

De-listing will also wipe out shareholders’ share value in the small caps. The Exchange will be blamed, as happened during the “penny stock fiasco” in 2002. Today’s political climate seems not much better than that of 2002, if not worse.

Privatization without a general offer

There is a black sheep in every flock. Most listed companies and market practitioners comply with the laws and rules. Are these 700+ small caps Lao Qian Gu (literally: “cheater’s stocks” in Cantonese)?

This proposal will inevitably have unintended consequences. Unable to sell their shells and cash in, controlling shareholders will try to extract value from the companies and abuse the rights of minority shareholders.

Alternatively, they could simply take the company private by letting the Exchange de-list it. In that way, they would be able take-over the entire interest without the general offer normally required for a privatization.

Public investors are prone to suffer from the fall of small-cap shares and the deterioration of corporate governance. Will the proposal really achieve its stated goal of protecting their interests?

The Exchange has been a cornerstone of Hong Kong’s economy. Going forward, the stake is higher and the challenges bigger.

Competing with Singapore and Australia

Last month, the Exchange prepared its three-year plan for the Greater Bay Area (GBA) which refers to an inter-city economic integration scheme between Hong Kong, Macau and a number of mainland cities located near the Pearl River Delta.

Hong Kong will take over the role as an international finance center serving GBA enterprises, with emphasis on creativity and technology. To integrate into the GBA, the Exchange must provide an efficient fundraising venue for these enterprises, most being high-growth young companies which often have an appetite for acquisitions.

Essentially, the Exchange must maintain openness and agility in the affirmation of international standards and practices. Unfortunately, the proposal is a step backward.

Hong Kong’s listing will lose out to Singapore and Australia, both of which strictly adhere to a rule-based approach. If Hong Kong’s market becomes more authoritarian like mainland China’s, enterprises would rather choose Shenzhen as the listing venue for its liquidity and proximity. Shenzhen Stock Exchange would take over the throne of the GBA’s major marketplace.

We already have well-established rules and laws in place to punish wrongdoings and protect investors’ interests. Market manipulation and insider dealings are criminal offenses.

The Securities and Futures Commission should strengthen enforcement and investors’ education. Regulatory measures should be well-targeted and avoid intervening in normal businesses. The proposal will have an impact on the market too large to bear.