Market participants in the US and China are awaiting the results of an SEC probe into the practice of Chinese companies listing via shell companies in the US, in what are known as reverse mergers or reverse takeovers. Launched earlier this year, the investigation comes as a result of an increasing number of incidents in which investors in these deals have lost money following the discovery of irregularities in the numbers at the listed firms.
In a typical example, a Chinese company will hire accounting and legal firms at home and in the US to help it create a shell company, which is then listed on an exchange – typically in the US the OTCBB (over-the-counter bulletin board). Shares in the shell company then trade at values relating to the performance of the underlying company in China – the shell itself has no business itself, hence the name.
The structure invites problems because the diligence and disclosure requirements are much less rigorous than would be the case for an exchange listing. In a typical example highlighted by online magazine TheStreet, in December 2010 the SEC reached an agreement with US audit firm Moore Stephens Wurth Frazer & Torbet in which the firm agreed to a $129,000 fine and a temporary ban on accepting new China audit clients. The case involved a Chinese company called China Energy Savings Technology that has been the target of multiple fraud complaints since 2006.
These cases are multiplying, a former SEC investigator now based in Hong Kong tells Euromoney, and with increasing numbers of US investors being defrauded they are demanding action from Congress. China, too, is concerned about these deals, which tarnish the image of Chinese companies abroad – and make investors more wary about the majority of legitimate Chinese companies.
What is of most concern about them is that a pattern of activity or template appears to have emerged in many cases, with recurring details of the involvement of little-known small audit firms, misstatement of sales or revenue figures, and often quite complex attempts to mask these deficiencies in the numbers.
Yet another complication is the intervention in the US-listed China companies market of research firms linked to short-selling operations. Muddy Waters Research, a typical example, sparked a controversy at the end of last year by initiating coverage with a strong sell recommendation on RINO, a Nasdaq-listed Chinese company that sells equipment to Chinese steel mills. RINO reported 2009 revenues of $193 million when the true figure was closer to $15 million, Muddy Waters claimed. Rubbish, say detractors of Muddy Waters’ founder Carson Block, who point out that he does not disclose positions in the companies he covers and is simply trying to drive stocks down to profit from them. Block makes no secret of the fact that he invests ahead of issuing his reports but says that does not detract from the credibility of his very thorough analysis.
The situation is ugly for all involved. The SEC needs to decide if there is merit in the reverse merger structure at all, and if so – to shut it down completely would be a bold move – how it can prevent companies from abusing it. At the very least this will require stricter regulation of which firms are able to provide audits of Chinese companies for US listings, presumably under the aegis of the Sarbanes-Oxley created Public Company Accounting Oversight Board.
Investors, for their part, need to recognize the risks associated with investing in firms using the shell company structure, and need to do more due diligence into the auditing firms involved rather than just the listing entity itself. Estimates suggest that US investors might have lost more than $34 billion in frauds relating to reverse mergers. The US and China, unlikely as this may be in practice, would do well to coordinate to try to prevent further such losses.
