Like consummate jazz musicians pitting traditional structure against crafty improvisation, mainland financial entrepreneurs have played around Hong Kong’s listing rules.

Last week, South China Morning Post columnist Shirley Yam highlighted the

growing problem of planting listed shell companies on the Growth Enterprise Market and main board of HKEx for future harvesting and acquisition by mainland enterprises. According to her estimates an astounding 40 per cent or more of the 22 companies listed on the main board in the past three months could be shells in disguise.

The integrity of HKEx’s main board and GEM are being threatened by wholesale regulatory arbitrage. Securities and Future Commission chairman Carlson Tong is indignant at the flagrant, serial abuse, but he naively sounds like the actor Claude Rains expressing surprise that, “I am shocked, there is gambling in Casablanca.”

Financial entrepreneurs have found a way to monetise listings through regulatory arbitrage. Many mainland companies seek to inject assets into a prestigious HKEx listing. A back door purchase creates an attractive vehicle for raising debt and equity financing in Hong Kong. The current premium for acquiring a GEM- or main board-listed company is about HK$150 million and HK$200 million, respectively, which is added onto the share price.

Regulators fail to understand that an entire cottage industry has sprung up in Hong Kong and the mainland

“If mainlanders are willing to pay big money for shell companies like they do for luxury purses then why not sell it to them?” said one adviser, who described the “endless” demand from mainland China.

HKEx joined the spirit of “one country, two systems”, inviting mainland companies to list in Hong Kong. Actually, it embarked on a road where it eventually came upon ethical challenges that have taken it completely by surprise.

Regulators fail to understand that an entire cottage industry has sprung up in Hong Kong and the mainland. Institutions and advisers can manage the entire process and organise the financing to pay for the listing, legal, accounting, placement and public relation fees to qualify and maintain a listing. Major investment banks aren’t the culprits due to their strict compliance and conduct rules, but a horde of other financial mercenaries are only a call away.

When the right time arrives, a buyer, who has already reserved the back door listing candidate years ago emerges. After the transaction, the adviser splits the premium earned with the back door company’s shareholders after deducting the fees.

READ MORE: Hong Kong’s red-hot corporate shell game is cause for concern

Back door listings are not alien to Hong Kong. Large enterprises such as Richard Li Tzar-kai’s PCCW gained a listing through the back door in 2004 by injecting US$1.5 billion in property assets into Dong Fang Gas to create Pacific Century Premium Developments. But the sheer volume driving today’s underground avalanche of back door listings represents a threat to the regulators’ authority.

Tighter rules can never entirely stop back door listings. While tougher rules can make it more challenging to bring certain mainland assets to market through an initial public offering, they will only encourage more back door attempts.

After all, the purpose of a stock exchange is to freely buy and sell shares if not entire companies. Placing increasingly high burdens of proof over change of control acquisitions will not necessarily stop undesirable back doors. Rather they could make the market inefficient and cumbersome.

Cultivating listed shell companies for sale is unethical and illegal conduct. It perverts the purpose of an exchange. But, there is little the SFC and HKEx can do. At this stage any plans for a third board serving smaller companies ought to be shelved until regulators can understand these problems.

Lax supervision and a lack of investor protection plague HKEx. Hong Kong’s regulation requirements favour process and disclosure over enforcement. Related party transactions and back doors have long been a corporate governance problem. Insiders and family owners could easily channel assets in and out of their listed entities or even conjure up sales that never existed. However, as long as disclosures were made according the listing rules, regulators rarely objected.

Today, mainland buyers are treating the stock exchange like an incubator or assembly line. Hong Kong regulators seem out of touch with and slow to adapt to the listing challenges posed by mainland businesses. Their senior managers are unreachable – like Harry Potter’s Voldemort, usually referenced obliquely and never directly by name. They rarely engage the media, who may actually be the best source of information on the latest scams. “No comment” is the consistent refrain to any inquiries to HKEx or SFC. It only worsens their isolation.

Peter Guy is a financial writer and former international banker

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