Domino effect as a result of cross-shareholding

In June 2017, we saw an episode likened to the fleet of war vessels catching fire through interlinked iron chains and hooks in the classical book of Romance of the Three Kingdoms unfold in the Hong Kong stock market. There was a consecutive huge tumble in the market involving many small-cap stocks with complex cross-shareholdings relationships.

Typically, cross-shareholding can take place between two companies or among several companies. Some companies use this as a strategy to prevent hostile takeovers and to strengthen business ties with other companies.

It is not easy to say whether cross-shareholding is good or bad. Retail shareholders should ask themselves the following questions.

• What is the purpose of that cross-shareholding? Generally speaking, if a listed company is not an investment company, the management should invest in its main business, and not the shares of other listed companies.

• To look into the earnings of a company, you should start with quality and the source. If a company records profits in particular unrealised profits from stock investment, it may not be stable and sustainable. If a company invests in another company that its shares are highly concentrated or thinly traded, then its share price may not be able to reflect its fair value, and volatility in share price will affect the valuation of the companies holding its shares.

Investors can image that mutual holding of shares between two companies or among several companies is not out of coincidence, but is out of common interest. However, such shareholding tie does not necessarily benefit the shareholders. In case the cross-shareholding is planned and manipulated by market manipulators, it can harm shareholders' interests.

Cross-shareholding can bring domino effect. When one company is in trouble, those companies that have shareholding link with that company will certainly be affected. Moreover, as companies form a "coalition" via mutual holding of share, then for any resolution of the company that requires the shareholders' approval, these companies can join together and make use of their voting rights to approve the resolution. This can undermine the interests of retail shareholders. Cross-shareholding makes the shareholding structures complex and opaque, so that the retail investors are hard to identify the majority shareholders, and the market manipulators can conceal their shareholdings and manipulate the market.