In this article, Arpit Shivhare discusses the concept of Backdoor listing.

INTRODUCTION

Backdoor listing is a process which gets commercial enterprises onto a stock exchange listing without an Initial Public Offering (IPO). Listing of a company on the stock exchange has its own benefits which may come in the various form of:

• Access to more capital

• Providing liquidity to the existing shareholders

• Spread in shareholder base, and

• Value addition to the stature of a company

A backdoor listing is a method of going public, used by those companies which fail to meet the criteria for listing on stock exchange. Listing on a stock exchange does not come for granted.

Some companies may prefer to get listed on stock exchange, while others may prefer to go from the back door and enter into listing sphere secretly withoutissuance of a prospectus and taking out of initial public offer (IPO) and following other listing requirements such as:

• Definite shareholder’s base

• Complying with disclosure requirements etc.

Backdoor listing is an alternative available to the conventional mode. It is in the form of reverse merger or reverse takeover which is sometimes referred to as backdoor listing; with which we are concerned in this paper.

Backdoor listing is a complex set of transactions in which a listed company takes over the unlisted company on papers by issuing its shares in consideration to the target company. The listed company can also give shares and cash both as consideration. Practically it is the shareholders of the target company who will have a controlling stake in the resulting company.

Once the transaction is completed, the identity of the listed company will survive but, in reality, the resulting company would carry on the business of an unlisted company with its managerial board taking control of the resulting company. The resulting company may subsequently change its name and objective clause in order to reflect the business of a pre-merger unlisted company.

This unconventional method of getting listed by using a listed company as a tool is aptly termed as ‘backdoor listing’.

Motivations for doing backdoor listing are not only in the inability of some companies to fulfil listing requirements. But, some intrinsic benefits of backdoor listing and mutual necessity of target and acquiring company may also induce decision of getting listed by using the backdoor. A listed company which has failed miserably in its operations may see the transaction as a tonic of new life, while an unlisted company may opt for backdoor listing because of it being cheaper and speedier mode in comparison to IPO. Non-requirement of raising initial capital in the backdoor listing may also be a factor for a company which does not want to liquidate equity initially.

However, the brighter side of backdoor listing may tend to hide its ugly side. Due to no mandatory requirement of a prospectus, there is always a risk of less amount of due diligence which may add to the potential risk for the investors. Also, chances of fraud, skewed share-swap ratio and class action suits can never be ruled out in the cases of backdoor listing.

The frequency of backdoor listing and regulations associated to it vary across the globe. The USA has Chinese companies using backdoor to get listed there, while Australia has number of listed mining companies providing shells to tech companies for getting listed. Some countries have explicit regulations to deal with backdoor listing while other may lack such legal framework which tackles the issue to the head. This paper intends to analyse and discuss the phenomenon of backdoor listing, its hyped advantages and risks associated to it, along with the reactions of the regulators around the world to this issue, with some special focus to the situation in India.

CHOOSING BACKDOOR LISTING AGAINST IPO

Doing the same thing in a better way?

There are several lucrative inducements for doing backdoor listing by the companies. It is always argued that backdoor listing is a speedier process than becoming listed by the conventional method of taking out an IPO, as that involves preparation, printing and distribution of prospectus, and involvement of underwriters etc.Typically, reverse mergers can be completed in three to four months, whereas IPOs can take nine to twelve months or more.[1]Time may be of special consideration for those companies which want to get listed as soon as possible because of strategic reasons.

Another factor which is of relevance for the companies is economic nature of backdoor listing. Backdoor listing is always considered as a cheaper method of getting listed than by taking out an IPO. Arguably, the backdoor listing may cost less than $1 million and sometimes even less than $200,000, whereas IPOs may cost millions.[2] Backdoor listing has even been referred to as ‘‘Poor man’s IPO’’[3].Further, a decision to take out an IPO may be influenced by market conditions. Favourable market conditions ensure the positive response to the IPO and good value for the shares, and, unsurprisingly, negative market conditions give the contrary result. Getting listed through the backdoor is independent of the market conditions as it does not involve taking out an IPO and hence, proves to be an important tool to get listed even in adverse market conditions.

Also, listing through an IPO requires the company to compulsorily raise capital by issuing shares at the time of getting listed. This requirement has a two-fold effect on the company. First, the company may not need additional capital at the time of getting listed and may want to raise capital afterwards, and secondly, it dilutes the shareholding of the existing shareholders and thus loosen their grip off the company. These things can be avoided by using the backdoor listing as a method of getting listed.

Lastly, the backdoor listing may prove to be an important tool for getting listed in a foreign jurisdiction. A company which may not be able to satisfy the listing requirement abroad may choose this more convenient method of getting listed by merging into already listed company. Listing of Chinese companies in the USA through the backdoor on a large scale[4] can be seen as an example of this assertion. Thus, we can conclude that listing through the backdoor has its own advantages.

VEILED PROBLEMS OF BACKDOOR LISTING

Seeing Beyond the Sunny Side

The apparent advantages of backdoor listing may seem to emphasize on the superiority of backdoor listing over the conventional method of getting listed through an IPO. However, this may not always be the case. Getting listed through the backdoor may not be as swift and unchecked as it may seem. There might be several evils associated with backdoor listing which may not be apparent on the face of it. To start with, the listed company which is used as a shell by the target company may have some hidden liabilities in the form of unpaid debts and ongoing contractual liabilities.[5] This makes the transaction a gamble for an unlisted company and requires an extra amount of caution. Further, there may be an apprehension of reputational loss for the resulting company due to the bad name which listed shell company may have acquired because of its failure in its business.

Further, no requirement of issuing prospectus increases the potential risk associated with backdoor listing transactions. There may be instances of fraud as can be seen in several backdoor listing cases[6]. This may be done by tilting the share-swap ratio in the favour of an unlisted company by overvaluing it for the purpose of giving its shareholders controlling stake in the resulting company. Further, due to no issue of the prospectus, there is always a risk for potential investors due to the lack of disclosure and less amount of due diligence observed.

Also, the backdoor listing is not an as simple method of getting listed as it is sometimes portrayed. It is a complex transaction which requires approval from the shareholders of both the companies. There might be minority shareholders in the listed company who may not want to be part of resulting company, and thus, may seek an exit option. The selling out of shares by these shareholders at the beginning of being listed may not only harm the reputation of the company but can also reduce the price of the shares. In addition to that, the chances of class action suit can never be ruled out.

Getting listed through the backdoor does not create wide publicity which is generally done by the issue of the prospectus. It mitigates the reputational gains to the company which might have created additional investment due to wide publicity.Lastly, the inexperience of new management and directors; which will now control the company, in the field of stock market obligations, legal and regulatory framework etc. cannot be ignored.[7]These are some of the intrinsic problems of schemes involving backdoor listing.

POSITION ACROSS THE WORLD: A Brief Overview

Backdoor listing is a phenomenon which has been experienced at different rates by all the major economies of the world. The difference in the number of cases involving backdoor listing lies in the incentives for the company to get listed in a particular country, coupled with the need to use the backdoor listing as a comparatively advantageous way of getting listed. In the USA, the backdoor listing has been used as a method of getting listed by many Chinese companies, which either could not get listed owing to their failure to meet listing requirements or which found it more cost and time effective. There has been a boom in the number of increasing backdoor listing cases in the USA.[8] As a result of which, the USA has to release investors guide for informing the various stakeholders about the potential risk of such kind of transactions. Further, in the year 1992, Securities and Exchange Commission (SEC) of USA brought an amendment in the Securities Act 1933, bringing in Rule 419.[9]This rule was aimed to put a check on ‘blank check companies’ by defining them, and also by making it mandatory to observe some specific conditions by such companies when doing a merger. These companies are more likely to be used as a shell for backdoor listing. However, despite the introduction of this Rule, the cases of backdoor listing did not get minimized in the USA.

In contrast to their developed counterpart economies across the Atlantic, the United Kingdom has until recently not expressed much concern in the form of increased or tighter listing requirements for companies pursuing backdoor listings.[10] However, it is not the case that the stakeholders are unaware of this issue in the United Kingdom. More or less, there are rules by the stock exchanges like London Stock Exchange, which are aimed to bring more transparency and disclosure in these kinds of schemes for protecting the interest of investors.

In Australia, there has been an upsurge in the number of backdoor listing cases where the Australian listed mining companies which failed in their businesses were behaving like a shell for Information Technology (IT) companies to get listed.[11]This upsurge was the effect of IT boom in the country. However, there have been a number of cases of fraudulent transactions in such kinds of schemes. Thus, recently the Australian Stock Exchange (ASX) has changed its policy towards backdoor listings. Now, trading in the securities of the listed company would be suspended from the time it announces the backdoor listing till the time when it re-complied with the ASX’s listing requirements.[12] These requirements clearly show that the intent of ASX is to put a guard on the backdoor who will not allow entry in the listing realm until certain requirements are not complied with.

In Sweden, flexibility is the main ingredient of the backdoor listing regulations.[13] The regulators warn the investors if there is a change in the identity, nature or business of the company. The suspension of securities is one of the methods used by the Swedish regulators in these kinds of cases. However, even when there has been need to take serious actions, the flexibility could be seen in the actions of the Swedish regulator. This approach of Swedish regulators is a result of seeing the backdoor listing as just another kind of business restructuring which has nothing illegal.

BACKDOOR LISTING IN INDIA: An Unrecognized Event!

When Companies Act, 2013 was drafted, a provision was made in respect of phenomenon which is opposite of the kind of backdoor listing we are concerned with, i.e. what would happen when transferor company would be a listed company and transferee company would be an unlisted company. In this case, it has been provided by the Companies Act, 2013, that the transferee company would remain an unlisted company until it becomes a listed company by observing all listing requirements.[14] However, nothing has been given in case of transferee company being listed company. There was no such legal framework provided by the new Companies Act which can tackle the issue of backdoor listing.

The Companies Act provides that in a general course of approving a scheme of arrangement by a High Court, a notice to the Indian securities market regulator ‘Securities and Exchange Board of India’ (SEBI) is likely to be issued by the Court along with the draft of the scheme of compromise or arrangement, and SEBI can forward its objection to the Court within the thirty days.[15] This was to enable the SEBI to put forth its point of view in case of schemes involving listed companies or otherwise. However, in the beginning of 2013, SEBI issued a circular[16] and tried to enlarge the scope of its interference with respect to the schemes involving listed companies. Now the listed companies have to provide detailed information to SEBI and SEBI would base its objections or comments on this information and would forward them to stock exchanges.

By using the powers assumed by the SEBI through this circular, it has objected to the scheme of arrangement involving merger of an unlisted company Emami Reality Limited with a listed company Zandu Reality Limited; which was a transaction in the nature of backdoor listing, on the ground that it was an attempt to get listing benefits without following the requirements given in the Securities Contracts (Regulations) Rules, 1957 and SEBI (Issue of Capital and Disclosure Requirements)Regulations, 2009.[17] On another occasion, SEBI objected to the same kind of scheme of arrangement involving ACE TC Rentals Private Limited and Action Construction Equipment Limited, on the same ground of getting listed through the backdoor without following the listing requirements.[18] However, such kinds of objections were advisory in nature and could not stop the companies from placing their scheme before the Court for approval. What SEBI could do at the most was to direct the companies to incorporate such objections in the draft proposal of their scheme before placing it to the Court.

However, recently in the beginning of the year 2017, SEBI has formulated some guidelines in their Press Release[19] for preventing the very large unlisted companies to get listed by merging with very small companies. This can be seen as a move to prevent unlisted companies from using shell companies to get listed. After this Press Release, now holding of pre-scheme public shareholders of the listed entity and the Qualified Institutional Buyers (QIBs) of the unlisted company, in the post scheme shareholding pattern of the “merged” company shall not be less than 25%. Further, it has made the approval of public shareholders mandatory when the schemes involves the merger with an unlisted company which results in reduction by more than 5% in the voting share percentage of pre-scheme public shareholders of total capital of merged entity, or where the whole undertaking of a listed company is transferred and the consideration is not in the form of listed equity shares.

Evidently, such kind of step has been taken by the SEBI to curb the schemes which involve skewed share swap ratios which is biased in favour of shareholders of the pre-merger unlisted company, or schemes which reduces the shareholding of public shareholders of a listed company, and would give control to the shareholders of an unlisted company. However, it is really doubtful that if such a step, which come in the form of Press Release and not in the form of guidelines or circular, is adequate to tackle the issue of backdoor listing. Now, when two giants of telecom sector in India- Idea Cellular Limited and Vodafone India have announced their merger,[20] it may be the biggest case of backdoor listing in India as Vodafone is an unlisted company which is likely to get listing benefits post its merger with listed company Idea Cellular Limited. It would be interesting to see the approach of SEBI in this proposed scheme of arrangement.

There have been instances where SEBI has objected to the schemes giving listing benefits to an unlisted company without following process of getting listed; there has been an attempt by SEBI through their recent Press Release to check such schemes by placing a condition of having fixed minimum percentage of shareholding by public shareholders in post-merger companies, which is intended to not allow public companies to be used as a shell; however, if such steps are enough by any means to tackle these kinds of schemes is really doubtful. Indian regulator has been slow in realizing the gravity of these transactions and has not taken any concrete step to check these schemes. We can just hope for some statutory guidelines or regulations in India for taking this issue head-on.

CONCLUSION

Backdoor listing is a phenomenon which is occurring in every mature economy, however, only some pay heed to this by recognizing this phenomenon and making specific rules for this. It is just another kind of commercial transaction, having its motivation in comparative advantages. However, if such kind of transactions drives their advantages on the vulnerability of others, then they need to be checked. If the backdoor listing is side-lining measures made for the investors’ protection, then it is a reason to worry about and should be a raison d’être for securities market regulators all around the world to recognize this and to make regulations for this.

It may be contended that there is nothing illegal in such schemes, however, the question is not always about legal or illegal but is about checks and balances. The chances of fraud due to comparatively less disclosure and following least amount of due diligence is a reason enough for checking these schemes by regulatory bodies like SEBI. There has to be a proper legal mechanism in place in the form of guidelines or regulations for dealing with these kinds of schemes. This is the only way to protect the interest of investors by compelling the company achieving listing benefit to follow disclosure requirements and observe due diligence, which is sine qua non for securities market where public money is involved. The freedom of commercial wisdom of companies must be balanced against the need of investors’ protection. With the recent trend in favour of making more and more regulations for the protection of public investors, we can look forward to tackling this opaque phenomenon of backdoor listing by making it more transparent and investors friendly.

References

[1]David N. Feldman, Comments on Seasoning of Reverse Merger Companies Before Uplisting to National Securities Exchanges, 2 Harv. Bus. L. Rev.140, 141 (2012); See also, David N. Feldman & Steven Dresner, Reverse Mergers: Taking a Company Public Without an IPO 24 (Bloomberg Press, 2d ed. 2009).

[2]Id. at 23.

[3]NaagueshAppadul, Anna Faelten and Mario Levis, Reverse Takeovers: The Other Side of the Poor Man’s IPO, Semantic Scholar, 1 (January 10, 2014), https://pdfs.semanticscholar.org/b337/2ee6726 07154254eb2f7c755ea821df563f3.pdf

[4]Id. at 8.

[5]Back door listings, McCullough Robertson, 2, http://www.mccullough.com.au/icms_docs/166243_Back_ door_listings.pdf (last updated April 15, 2017)

[6]Cécile Carpentier, Douglas Cumming & Jean-Marc Suret, The Value of Capital Market Regulation: IPOs versus Reverse Mergers, SSRN, 11 (November 25, 2010),http://ssrn.com/abstract=1356324. See also, NaagueshAppadul, Anna Faelten and Mario Levis, Reverse Takeovers: The Other Side of the Poor Man’s IPO, Semantic Scholar, 2, 8 (January 10, 2014), https://pdfs.semanticscholar.org/b337/2ee6726 07154254eb2f7c755ea821df563f3.pdf

[7]Colin Nicholson, Backdoor Listings, Building Wealth Through Shares, 3, http://www.bwts.com.au/download/educational-articles/Backdoor%20Listings.pdf (last updated April 16, 2017)

[8]Ioannis V. Floras, Two Essays on Alternative Mechanisms to Going Public, University of Pittsburgh: D-Scholarship, 6 (30 June 2008), http://d-scholarship.pitt.edu/7255/.

[9]William K. Sjostrom, Jr., The Truth About Reverse Mergers, 2 Entrepreneurial Bus. L. J. 757 (2008).

[10]Erik P.M. Vermeulen,Rules on Backdoor Listings: A Global Survey, Indonesia-OECD Corporate Governance PolicyDialogue, 24 (2014), http://www.oecd.org/daf/ca/OECDBackgroundReportBackdoorListingsIndonesia2014.pdf.

[11]Andrew Ferguson, Backdoor Listings in Australia, 1 JASSA: The Finsia Journal of Applied Finance 24. 26 (2015).

[12]ASX Media Release, Updating ASX’s Admission Requirements for Listed Entities: Final Listing Rule Amendments, 3 (November 2, 2016), http://www.asx.com.au/documents/asx-news/ASXs_New_Admission_Requirements_and_Response_to_Consultation.pdf.

[13]Erik P.M. Vermeulen, Rules on Backdoor Listings: A Global Survey, Indonesia-OECD Corporate Governance PolicyDialogue, 28 (2014), http://www.oecd.org/daf/ca/OECDBackgroundReportBackdoorListingsIndonesia2014.pdf.

[14]Section 232(3) (h) (A), Companies Act,2013.

[15]Section 230(5), Companies Act, 2013.

[16]SEBI Circular on Scheme of Arrangement under the Companies Act, 1956– Revised requirements for the Stock Exchanges and Listed Companies, CIR/CFD/DIL/5/2013 (February 4, 2013).

[17]Letter by SEBI to Bombay Stock Exchange, CFD/DIL/AKD/SGS/OW/12250/2014 (April 30 2014).

[18]Letter by NSE to Action Construction Equipment Limited, NSE/LIST/11814 (January 22, 2015).

[19]SEBI Press Release, SEBI PR No. 5/2017(January 14, 2017).

[20]Merger of Vodafone India and Idea: creating the largest telecoms operator in India, Idea Cellular (Mar. 20, 2017), http://www.ideacellular.com/media-centre/news/national-news/merger-of-vodafone-india-and-idea-creating-the-largest-telecoms-operator-in-india.