Backdoor SEC Registrations

SEC Commission Luis Aguilar recently gave a speech about regulation and its effect on capital formation. He made a distinction between capital formation and capital raising, which is important for our current financial markets. Capital formation is at the heart of modern economic growth theories, from Hicks, Samuleson, Solow and others. Its aim is to deploy tangible capital, together with labor and other economic inputs, to productively increase output and growth. CEO's looking to grow and sustain their businesses have to look for capital investment projects that generate value in excess of the required rate of return.

Modern captains of industry seem to have forgotten about this aspect of their economic briefs as they continue to sit on large hordes of excess capital, especially in the form of cash and equivalents. We've written about this before, so we'll move on. Commissioner Aguilar then notes that capital markets have become fixated on capital raising. He rightly talks about the importance of transparency and utility in financial disclosures, which are aimed at helping investors make better estimates of the intrinsic value of a business. Disclosure ought to be meaningful, transparent and provide a level informational playing field for all investors. Better disclosure offers investors an elment of protection too.

When he turns to the current state of capital markets, he identifies the phenomenon of"backdoor registrations," particularly by Chinese companies using public shells in the U.S. to float their businesses to domestic investors. Ironically, this past week, I discussed the case of a NASDAQ-listed company, China Media Express Holdings, Inc. briefly with my MBA Investment class as an example of risk in emerging market investing. I got the idea of discussing this stock by reading John Hempton's blog. China Media Express was touted by bulletin boarders and even by some boutique research houses, but a cursory review of their SEC disclosures made their business model seem like a financial printing press. As Hempton identified, it was too good to be true. After their US auditor resigned and the exchange threw up its hands and delisted the company, the patient prognosis is not good. The cracks in our regulations that allow these reverse mergers into public shells have been crying out for a remedy for years.

Yet, we were so mesmerized by pursuing "comprehensive" reform of the financial sector, that we still can't incrementally move towards a better solution to a specific problem. When Arthur Levitt's SEC moved on Reg FD, it seemed simple, and a "one off" kind of solution, but it yielded real benefits to all investors through better disclosures and the elimination of side channels for information. We can do better for US investors looking to get involved in emerging market issues by acting on Commissioner Aguilar's ideas.