Asian Review of Financial Research Vol.27 No.3 pp.493-528
Analysis on Dysfunction of the Backdoor Listing in Korea
Key Words : Backdoor listing,Reverse Merger,IPO,Corporate Disclosure,Distress
In a backdoor listing, often called a “reverse merger,” an unlisted or “pearl” company obtains listed status by acquiring management control of a listed or “shell” company. Such backdoor listings provide unlisted companies with synergistic mergers and acquisitions (M&A) opportunities and the benefits of being listed. However, the reality is that the companies using this method are often involved in unfair trading scandals that harm investors, or become insolvent shortly after listing. For example, NeosemiTech was delisted in an accounting fraud scandal and issued an audit opinion of rejection on August 23, 2010, less than a year after its backdoor listing through its merger with Mono Solar, a KOSDAQ listed company. This backdoor listing practice raises many theoretical and regulatory issues because backdoor listings integrate aspects of both IPO and M&A. Adjei, Cyree, and Walker (2008) investigate the characteristics of companies using reverse mergers and Gleason, Rosenthal, and Wiggins III (2005) study the characteristics and performance of reverse mergers. In Korea, the research focuses on the factors affecting the choice between backdoor listing and IPO, the market reaction to backdoor listing, and the performance of the companies listed through reverse mergers (e.g., Kim and Lee, 2009; Choi and Lee, 2006; Park, Park, and Pae, 2009; Yun and Kang, 2009). While the literature documents the aforementioned typical features of backdoor listing, we focus on the deterioration of backdoor-listed companies—one of the most noted stylized facts in the literature that has barely been explored. In addition, our study is the first of its kind in the backdoor listing literature to investigate the corporate governance of shell companies as well as the financial characteristics of shell and pearl companies. In this study, we conducted an empirical analysis using 104 backdoor and 189 regular listing cases from July 2006 to June 2010 in the KOSDAQ market. Similar to the results of previous studies, backdoor listing was preferred over regular listing by companies that were smaller, had lower net profit margins, or were subject to information asymmetry. This held true regardless of whether the pearl companies met the quantitative listing requirements in the KOSDAQ market. Second, the shell companies were more likely to be businesses that could easily merged due to their smaller size, lower ownership of the largest shareholders, and poor performance. Third, an analysis of the public disclosures revealed that compared to firms that undertook regular listing, backdoor-listed firms reported the following cases more often: violation of regulations, changes in governance structure, and delisting. Backdoor-listed firms were also more likely to experience distress shortly after the listing, when the shell company's largest shareholders had a low ownership share and the shell company saw frequent changes in its corporate governance, or when the pearl company experienced higher profits just before the listing. Fourth, high positive excess return was observed around the date when the backdoor listing was disclosed and negative excess return occurred after the designated date. The cumulative excess return before and after backdoor listing was high for the shell companies that violated regulations before a reverse merger, implying that the investors positively evaluated the reverse merger's effect on the governance reorganization of the shell company. However, the cumulative abnormal return after the designated date was lower for the pearl companies that recorded higher profits right before backdoor listing, which shows that pearl companies sometimes window dress before backdoor listing. The findings in this study demonstrate that backdoor listing is likely to occur with a shell company that is small in size, has relatively lower ownership by the largest shareholders, exhibits poor performance, and whose business is irrelevant to that of the pearl company. Often, the motive for the backdoor listing is the acquisition of listed status rather than the creation of synergy, resulting in a high probability that pearl companies choose backdoor listing because they fail to meet the quantitative or qualitative requirements for a regular listing.. We found that backdoor listed companies that merged with shell companies under weak corporate governance experienced investor protection- related problems or delisting more frequently, emphasizing the importance of examining qualitative requirements during the backdoor listing process. Hence, our study ascertains that the qualitative inspection system for backdoor listing introduced in September 2010 is appropriate.