Recently, Chinese companies that became publicly listed in the U.S. through reverse mergers have fallen on tough times: the SEC strengthened its scrutiny of them, the stock exchanges have suspended or even delisted them, investors are suing them in class actions, and short sellers have rushed to expose alleged accounting problems. These developments have drawn extensive attention from New York to Shanghai.
Focusing on China-based reverse merger companies, this article attempts to provide some insight into the source of the problems and potential solutions thereto.
I. Reverse Merger of Chinese Companies in the U.S. Market
A reverse merger, also referred to as a reverse takeover, is used by some private companies as an alternative method of going public. In a reverse merger, a private company merges with a “shell” company that is already publicly listed but has little or no operations, and the private company thereby becomes public without having to go through the usually lengthy and complex process of an initial public offering (“IPO”). 1See, Salmon P. Chase, The Truth About Reverse Mergers, The Ohio State University, Entrepreneurial Business Law Journal, 2 ENTREPREN. BUS. L.J. 743. Going public through a reverse merger allows a private company to get listed typically at a lesser cost and in a shorter time frame than through an IPO. 2Gariel Nahoum, Small Cap Companies and the Diamond in the Rough Theory: Dispelling the IPO Myth and Following the Regulation A and Reverse Merger Examples, 35 HOFSTRA L. REV. 1865 (Summer 2007).
In the past few years, reverse merger has become a popular method for China-based companies, particularly those with smaller market capitalization, to access the U.S. capital market. According to a research note by Public Company Accounting Oversight Board (“PCAOB”), a nonprofit corporation established by Congress to oversee the audits of public companies, more than 150 companies from the China region went public in the U.S. through reverse merger transactions from January 1, 2007 to March 31, 2010. 3The Public Company Accounting Oversight Board, Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region (January 1, 2007 through March 31, 2010), available at:http://pcaobus.org/Research/documents/Chinese_Reverse_Merger_Research_Note.pdf
II. Recent Problems Attracting Attention
Lately, reverse mergers by China-based companies have attracted skeptical looks from the market and been subject to regulatory sanctions. 4See, e.g., Bill Alpert & Leslie P. Norton, Beware This Chinese Export, Barron’s, Aug. 28, 2010, available at http://online.barrons.com/article/SB50001424052970204304404575449812943183940.html According to a recent Wall Street Journal article, from February, 2011 to early June, 2011, about 40 Chinese reverse merger companies either acknowledged accounting problems or saw the SEC or U.S. exchanges halt trading in their stocks because of accounting questions. 5Michael Rapoport, SEC Probes China Auditors, Wall Street Journal, Jun. 3, 2011 On June 9, 2011, the SEC issued an investor bulletin summarizing recent actions that it took against certain reverse merger companies and warning investors of the risks associated in purchasing securities issued by such companies. Besides the action taken by regulators, securities litigators have also filed class action securities law suits against a number of Chinese companies listed in the U.S. Moreover, short sellers have targeted Chinese reverse merger companies. A short seller would first research Chinese reverse merger companies for possible frauds and misdeeds. Upon the discovery of what the short seller believes to be frauds and misdeeds, the short seller would first enter into a short sale contract, essentially a bet that the company’s securities would fall in price, and then publish its research (which research would, of course, tend to cause a fall in the company’s securities). The short selling activities against Chinese reverse merger companies have been so successful recently that, at a conference devoted to reverse mergers, one short seller commented: “This is harvest time for our side. If you don’t see a bunch of really wealthy guys up here, you are not looking close. This has been making more money than you can imagine.” 6For Short Sellers on Chinese Stocks, It is Time to Reap, June 16, 2011, available at http://news.yahoo.com/s/nm/20110616/bs_nm/us_china_shortsellers; see also Bearish Bets on Chinese Reverse Mergers, Barron’s, March 7, 2011.
The types of frauds, misdeeds or mistakes which Chinese reverse merger companies have been accused of committing or proven to have committed are wide-ranging. Some reverse merger companies have been de-listed for simply failing to file required period reports. One Chinese reverse merger company was accused by the SEC for being involved in a “pump-and-dump” scheme by which original shareholders manipulated the market through trades to artificially inflate the price of stock before selling such stock to public investors for a profit. 7SEC v. China Energy Savings Technology, Inc., 2008 U.S. Dist LEXIS 110349 (S.D.N.Y. March 18, 2008). More commonly, reverse merger companies have committed (or have been accused of committing) significant accounting frauds. In some cases, auditors have refused to certify a company’s financials or have resigned. Chinese reversed merger companies have also been accused of reporting grossly inflated revenues or making up non-existent customer contracts and assets in their SEC filings. 8SEC Investor Bulletin: Reverse Merger, available at http://www.sec.gov/investor/alerts/reversemergers.pdf.
III. Viewing the Problems in a Larger Context
Given the amount of attention focused on problems with Chinese reverse merger companies listed in the U.S. in recent months, it must be noted that these issues are neither recent nor unique to Chinese companies going public in the U.S. by way of reverse merger. Instead, such problems are simply one of multiple ways in which accounting and corporate governance issues of Chinese companies have revealed themselves when these companies rush to seek capital by going public, and thus subjecting themselves to the duties of publicly traded companies.
To begin, using a reverse merger to enter the U.S. market is merely one of many ways in which Chinese companies have sought public investment. For example, a number of Chinese companies have used reverse mergers to become publicly traded in the Chinese stock market. In fact, when publicly traded companies in China become insolvent (which typically would cause such company to be designated as “ST” or “Special Treatment” companies) and seek relief under China’s Enterprise Bankruptcy Law, one of the assets that it would sell in bankruptcy is its publicly traded “shell.” 9Alan CW Tang, How the New PRC Bankruptcy Law has Fared—Reorganization of A-share Listed Companies and Cross-border Implications, September 2009 INSOL International, Technical Series Issue No. 9; A private company would purchase the publicly traded shell in order to go public in China by way of reverse merger. Moreover, Chinese companies can and have, of course, gone public in China, U.S., Hong Kong, Singapore and elsewhere by way of the traditional IPOs.
The accounting and corporate governance issues of Chinese companies have been significant concerns regardless of where their securities are traded and how such securities become publicly traded. For example, as early as 2004, investors were concerned with accounting scandals of Chinese companies which had gone public in the U.S. by way of IPOs. 10Cautionary Tale: China’s IPOs Boom Cools Off; Fortune May 31, 2004 In recent years, several so-called “S-Chip” companies, i.e. Chinese companies traded in the Singapore stock market, including FerroChina and China Gaoxian Fiber Fabric Holdings, have faced accounting scandals. On June 14, 2011, concerns over such scandals led Singapore’s Corporate Governance Council to propose requiring boards to comment on “whether they have received assurances from a company’s CEO and chief financial officer on the accuracy of the financial statements” in order to “[maintain] investor confidence, and to enhance Singapore’s reputation as a leading and trusted international financial centre.” 11Singapore Wants Top Executives to Vouch for Company Accounts; Reuters, June 14, 2011; available at http://www.reuters.com/article/2011/06/14/singapore- governance-idUSL3E7HE0JI20110614. The press release of the Corporate Governance Council can be viewed at: http://www.mas.gov.sg/news_room/press_releases/2011/Consultation_on_the_Proposed_Revisions_to_the_Code_of_CG.html.
Chinese stocks traded in Korea have faced similar suspicions from investors and regulators. For example, one Chinese deep sea fishing company traded in Korea, China Ocean Resources, saw its stock plunge after an allegation that the company inflated the size of its fishing fleet in its public disclosures. 12To some investors, China still not trustworthy; Korea Times, June 5, 2011; available at http://www.koreatimes.co.kr/www/news/biz/2011/06/123_ 88357.html The company quickly denied the allegation and showed that different vessels had different engine numbers during a presentation to journalists and analysts. Nevertheless, investors’ distrust of China’s accounting and auditing practice have caused Chinese companies to trade at a lower value than their financials may warrant, creating a “China discount” in the Korean stock market. 13Id.
In fact, the accounting and governance problems experienced by Chinese companies traded in one market can cast suspicions on those traded elsewhere. For example, it was reported that several Chinese companies traded in Korea saw their stock prices plummet upon the revelation of the accounting scandal of the Singapore-traded China Gaoxian Fiber Holdings, Inc.. 14Id.
IV. Potential Solutions
To prevent the problems described above from happening again and to better protect the investors, efforts from various parties are necessary, which are discussed in more details below:
The SEC and the Several U.S. Stock Exchanges
The SEC has brought a number of cases against China-based issuers for market manipulations as well as accounting and disclosure violations. 15Mary L. Schapiro, Letters to the Honorable Patrick T. McHenry, April 27, 2011. Available at: s.wsj.net/public/resources/documents/BARRONS-SEC-050411.pdf It has also suspended the trading in the stocks or revoked the securities registration of some reverse merger companies for reasons including questions regarding the accuracy and completeness of information contained in the companies’ public filings or failure to make required periodic filings. 16Id. In addition, the SEC has launched a proactive risk-based inquiry into U.S. audit firms that have a significant number of domestic issuer clients with primarily foreign operations, including in the China region. 17Id. As a result, more than twenty-four China-based companies have filed Forms 8-K disclosing auditor resignations, accounting problems, or both, from March to late April, 2011. 18Id.
Additionally, U.S, stock exchanges are tightening their oversight over reverse merger companies in order to prevent the problems from the start. On May 26, 2011, Nasdaq OMX Group Inc. (NDAQ), the second-largest operator of U.S. stock exchanges, proposed to adopt additional listing requirements for reverse merger companies. 19Federal Register Volume 76, Number 114 (Tuesday, June 14, 2011), available at: http://www.gpo.gov/fdsys/pkg/FR-2011-06-14/html/2011-14648.htm
Specifically, Nasdaq proposed to prohibit a company going public by combining with a public shell from applying to list until six months after the combined entity submits all required information about the transaction, including audited financial statements, to the SEC. Further, Nasdaq proposed to require that the company maintain a $4 bid price on at least 30 of the 60 trading days immediately prior to submitting the application. Finally, under the proposed rule, Nasdaq would not approve any reverse merger for listing unless the company has timely filed its two most recent financial reports with the SEC if it is a domestic issuer or comparable information if it is a foreign private issuer. 20Id. These additional requirements are designed to discourage inappropriate behavior on the part of companies, promoters and others. 21Id. For example, they will make short term manipulative trading scheme to boost the stock price more difficult.
In addition, according to a Bloomberg article, NYSE Euronext (NYX), the largest U.S. stock exchange operator, has been assessing enhancements to listing standards to address concerns about reverse mergers and already has the authority to use qualitative factors in assessing eligibility. 22Dune Lawrence, Nasdaq Tightens Oversight of Reverse Mergers Amid SEC Scrutiny, Bloomberg, May 2, 2011, available at: http://www.bloomberg.com/news/2011-05-02/nasdaq-tightens-oversight-of-reverse-mergers-amid-sec-scrutiny.html
The SEC is also looking at additional step to address growing concerns about accounting and auditing of foreign-based companies that list in the U.S. 23Sarah N. Lynch, SEC Weighs New Policies on Foreign Reverse Mergers, Reuters, June 21, 2011, available at: http://uk.reuters.com/article/2011/06/21/us-sec-china- idUKTRE75K51420110621
PCAOB and the Auditors
Since the discovered problems with the reverse merger companies are mostly related to their financial information, the companies’ independent auditors should be able to play a key role in stopping the filings of inaccurate and/or incomplete financial information.
In addition to SEC’s risk-based inquiry into U.S. audit firms mentioned above, PCAOB has also identified issues with the audits of reverse merger companies and, in response, has issued Staff Audit Practice Alert No. 6 on July 12, 2010 and Staff Research Note 2011-P1 on March 15, 2011, cautioning registered accounting firms to follow certain specified auditing practices. 24Federal Register Volume 76, Number 114 (Tuesday, June 14, 2011), available at: http://www.gpo.gov/fdsys//FR-2011-06-14/html/2011-14648.htm Specifically, PCAOB is concerned that U.S. accounting firms are not in full compliance with some PCAOB standards in the audits of companies with substantially all of their operations outside the U.S. 25The Public Company Accounting Oversight Board, Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region (January 1, 2007 through March 31, 2010). Available at: http://pcaobus.org/Research/documents/Chinese_Reverse_Merger_Research_Note.pdf In one instance, a U.S. registered accounting firm retained an accounting firm in the China region to conduct audit over the issuer, and the audit procedures performed by the firm in the China region constituted substantially all of the audit procedures on the issuer’s financial statements. The U.S. firm’s personnel did not travel to the China region during the audit, and substantially all of the audit documentation was maintained by the firm in the China region. 26Id.
In short, PCAOB found that some U.S. auditors who farm out work to local Chinese auditors aren’t verifying that the work complies with U.S. auditing standards. As a result, PCAOB barred certain U.S. accounting firms from auditing public companies, in part over this issue. 27Michael Rapoport, SEC ProbesChina Auditors, the Wall Street Journal, Jun. 3, 2011, available at: http://online.wsj.com/article/SB10001424052702304563104576361422372121248.html
To solve the above problem, reputable auditing firms with language skills, extensive insight in Chinese accounting policies, and in-depth understanding of the local business environment must be utilized to conduct the auditing over the Chinese reverse merger companies. Direct auditing, instead of reliance on another accounting firm to perform part or all of the auditing procedure, should be encouraged. Meanwhile, the SEC is working with Chinese regulators to try to help PCAOB to obtain approvals to do inspections abroad. 28Sarah N. Lynch, SEC Weighs New Policies on Foreign Reverse Mergers, available at: http://uk.reuters.com/article/2011/06/21/us-sec-china- idUKTRE75K51420110621
Other Relevant Parties
Other parties could also make their contributions to the solution. The Chinese regulators, such as the China Securities Regulatory Commission (“CSRC”), could work with foreign regulators more closely. 29Stephanie Tong & Vincent Jiang, China Regulator ‘Aware’ of Concerns on Chinese Firms’ Accounting, Bloomberg, Jun 17, 2011, available at: http://www.bloomberg.com/news/2011-06-17/china-regulator-aware-of-concerns-on-chinese-firms-accounting.html Investment bankers, private equity investors, and law firms, as the seasoned players in reverse merger transactions, should conduct due diligence more thoroughly. Short sellers, security class action lawyers and investors, while motivated by self-interest, provide additional scrutiny over questionable practices by the reverse merger companies. Most important, the reverse merger companies themselves could better their chances of avoiding regulatory actions, law suits and short seller attacks by understanding the disclosure requirements, accounting standards and other burdens related to being publicly traded in the market in which they intend to go public.
V. Conclusion
As set forth above, relevant parties have been taking actions in response to the accounting and corporate governance problems of Chinese companies, including those of Chinese reverse merger companies in the U.S. market. Unfortunately, none of the responses completely protects investors from these problems. Increased disclosure requirements, while welcome, will not eliminate blatant fraud cases in which companies report fictional earnings and non-existent customer contracts. Lawsuits and regulatory actions have only limited effectiveness, particularly because of difficulties in obtaining jurisdiction in the U.S. courts against persons and properties located in China. In the short run, it would appear that the perceived risk of fraud and accounting problems in China must simply be reflected in the “China discount” in the price of the Chinese stocks.
However, this should not be seen as the end of the reverse mergers by China-based companies. Reverse merger, as a financial transaction, has nothing inherently bad with it. And accounting fraud is not a uniquely Chinese phenomenon. As an investment banker puts it, “I don’t doubt that there are some funny numbers in China, just as I don’t doubt that there are funny numbers in the UK, America and anywhere else where there is an individual motive to cook the books.” 30Isabella Steger, EM Corporate Governance: China, Russia, Not That Bad? The Wall Street Journal, June 9, 2011, available at: http://blogs.wsj.com/exchange/2011/06/09/em- corporate-governance-china-russia-not-that-bad/ While the SEC focuses on protecting the public investors, it also wants foreign private issuers to list in the U.S. 31Sarah N. Lynch, SEC Weighs New Policies on Foreign Reverse Mergers, Reuters, June 21, 2011, available at: http://uk.reuters.com/article/2011/06/21/us-sec-china- idUKTRE75K51420110621 Therefore, the current campaign against China-based reverse merger companies, while discouraging to Chinese companies, might be beneficial to them in the long run as a way to weed out the fraudulent and weak players and rebuild Chinese companies’ reputation in the U.S. 32Larah Hong, a legal intern of Nixon Peabody LL.P., has assisted in conducting some of the research on relevant Chinese law. Hopefully, we will get there soon.
