The Future of Chinese-Based Reverse Mergers in the U.S.

Brant Hadaway DroneLaw blog
The United States Securities and Exchange Commission (“SEC”) is increasing its scrutiny of China-based companies suspected of submitting questionable financial statements to participate in reverse merger deals. A typical scenario involves a Chinese company that wishes to merge with U.S.-based shell companies for the sole purpose of gaining access to a U.S. stock exchange. The reverse merger process allows the Chinese company to avoid the stringent scrutiny of a formal initial public offering (“IPO”) and is also less costly both in cash and time.
This article addresses key issues to be tackled before pursuing a reverse merger, not the least of which is appropriate due diligence and the appointment of independent public accountants who can conduct annual audits to comply with U.S. securities laws. Companies who skip these steps can face severe consequences including government enforcement action, private civil liability, de-listing from U.S. stock exchanges, and unfavorable media scrutiny.

Chinese companies that seek public trading status in the United States through the use of reverse mergers with listed shell companies have new cause to be wary. The United States Securities and Exchange Commission (“SEC”) is currently investigating numerous China-based companies suspected of submitting questionable financial statements in order to participate in reverse merger deals. One California-based auditing firm – Moore Stephens Wurth Frazer & Torbet LLP – has already been sanctioned for “signing off” on the false financial statements of China Energy Savings Technology Inc. And, while the audit firm has agreed to pay $129,500 to settle with the SEC, it has also been temporarily barred from accepting new auditing assignments from Chinese companies. According to SEC officials, the China Energy Savings Technology Inc. case represents just the tip of the iceberg, projecting that reverse merger cases involving Chinese companies and or overly puffed-up financial statements may number in the hundreds. As SEC investigations intensify, more problems are likely to surface.

Components of a reverse merger.

A typical reverse merger occurs when a foreign-based company approaches a listed U.S. shell company for the purpose of getting access to the U.S. Stock Exchange. Shell companies are companies that exist but do not actually do any business or have any assets—sometimes the result of a business gone badly. A “listed” shell company is one that has obtained a listing on the U.S. Stock Exchange. Given the time and money it takes to obtain a listing, a listed shell has significant value even if it does not have any assets. Listed shells are therefore often the targets of reverse takeovers.

Given the ease of formation, reverse mergers have been popular vehicles for Chinese companies to “go public” in the United States. Most attractive is that a reverse takeover of a listed shell company bypasses the stringent scrutiny of an initial public offering (“IPO”). After that, the process is less costly both in cash and time. While underwriting costs for an IPO are typically seven to twelve percent of the total price of the offered stock, prices for purchasing a listed shell typically range between $50,000 to $500,000 dollars. With the assistance of experienced professionals, a reverse merger can be completed within weeks.

To be sure, reverse mergers also involve risks, especially with respect to the debts and liabilities of the shell company, making due diligence a critical component for a successful reverse merger deal. But even counting the time and costs of due diligence, a reverse merger is still much cheaper and faster than an IPO. That is why reverse mergers remain a favored means to “go public” among Chinese companies, especially medium and smaller size companies.

How much will the pending SEC investigations impact the reverse merger market for Chinese companies?

For those Chinese companies that have already used, or plan to use, inaccurate financial statements in reverse merger deals, intensified SEC scrutiny will undoubtedly pose a problem. Indeed, for many Chinese companies operating under comparatively lax accounting and auditing standards in China, keeping financial records clean and accurate by the U.S. accounting standards is a challenge, but a must. Thus, the ongoing SEC investigations will have a chilling effect on the Chinese reverse merger market overall.

In addition, a side effect of the SEC investigations is its impacted on pricing. Chinese-controlled companies currently traded on U.S. stock markets are complaining that their stocks have been undervalued. Concerns with defective auditing practices and inaccurate financial data will likely further reduce share prices. For example, a Hong Kong-based financial analyst recently published a report accusing RINO International of overstating its revenues and claiming non-existent customers and contracts. As a result, investors started to dump RINO shares. RINO was eventually de-listed from NASDAQ GS exchange and moved to the “over the counter” market. Similar incidents may be repeated in the future as SEC investigations unfold.

The future is uncertain.

The future of the Chinese reverse merger market is uncertain at this point. As capital market analysts are watching, legal professionals are paying attention as well. In addition to fines and sanctions, there is hope that SEC investigative and enforcement measures will eventually weed out “bad apples” from the Chinese companies seeking to raise capital or become public in the United States. For those companies with true development potentials and solid financial resources, the U.S. remains an attractive market. Chinese stock may suffer in the short run, but a better-regulated capital market boosts investors’ confidence and ensures better returns for Chinese companies in the long run.