Some Chinese firms have seen the opportunity to take part in stock offerings on international exchanges as a chance to make quick profits through shortcuts and tricks used to fool investors. The latest trick is that a Chinese operating company merges with an existing U.S. shell company that has been legitimately set up and gone public for access to the investment community. This is called a reverse merger.
“The reverse merger process is a relatively quick way to get listed on a U.S. exchange. A private company is merged into a shell, which is a publicly traded company that is no longer functioning as an operating entity. A share exchange or merger agreement is executed, and within 60–90 days the new company begins trading,” explains a RedChip White Paper.
In layman’s terms, a shell company generally has no real assets or operations and is set up for different legitimate purposes or to commit fraud. On the lawful side, it could just be a well-known company selling its products under a generic name to a discount store, while maintaining the brand name under its known operations. On the more shady side, it could be used as a tax haven, to hide profits, to move illicit profits, for money laundering, and other fraudulent activities.
In investment terms, a Chinese company accesses the U.S. market through the backdoor, under a Chinese Reverse Merger (CRM). This allows the foreign company to be listed on the U.S. stock exchange in a relatively short time and gain access to a large investors’ pool without having to dip into its pockets.
The regular process of entering a stock market is through an initial public offering (IPO), that is, the first sale of stock by a private company, which is a rather time-consuming process.
“A private operating company may pursue a reverse merger in order to facilitate its access to the capital markets, including the liquidity that comes with having its stock quoted on a market or listed on an exchange,” explained the SEC Investor Bulletin on reverse mergers.
SEC Warns Investor Community
“As with any investment, investors should proceed with caution when considering whether to invest in reverse merger companies,” warns the SEC.Companies that gained access to the U.S. market through reverse mergers may have used a local U.S., international auditing firm, or one of the big four auditing firms (Deloitte Touche Tohmatsu (DTT), PricewaterhouseCoopers, Ernst & Young, or KPMG) to give its financial statements the appearance of legitimacy, transparency, and acceptability to investors.
Some of the smaller auditing firms lack the resources to complete a true accounting audit of a company, as all operations and assets are in a foreign country. Even some of the Big Four, despite having done due diligence, may be hoodwinked because of collusion between banks and the company in the foreign country.
In May 2011, Deloitte Touche Tohmatsu resigned as auditor of Chinese-owned Longtop Financial Technologies Limited, as it discovered after six years of clean audits, that the company’s financial statements were fraudulent. Seeking confirmation of cash balances, DTT for the first time called the Chinese bank’s headquarters, instead of the local bank. There were no cash balances and large amounts of bank borrowing were not reported on the books.
According to its May 22 letter of resignation to Longtop Financial Technologies Limited, filed with the SEC, DTT stated its reasons for resigning as: “1) the recently identified falsity of the Group’s financial records in relation to cash at bank and loan balances (and also now seemingly in the sales revenue); 2) the deliberate interference by the management in our audit process; and 3) the unlawful detention of our audit files.”
China MediaExpress Holdings Inc., a Chinese television advertising operator, announced mid-March that DTT resigned as its auditor on March 11, after having been the company’s auditor since December 2009.
PCAOB Reverse Merger Warnings
The “PCAOB [Public Company Accounting Oversight Board] is actively reaching out to investors and other users of financial statements to give them more information about the audit environment for companies from the China region that may access the U.S. markets through reverse merger transactions,” said James R. Doty, chairman of PCAOB, in a March press release.
A total of 603 reverse mergers were completed between Jan. 1, 2007, and March 31, 2010, with 159 (26.37 percent) originating from China. The CRMs were almost three times more than the 56 IPOs completed during the same period. The RedChip White Paper identified 206 CRMs that have gone public in the U.S. stock market since 1996.
The market value, called market capitalization in investment terms, of around 67 percent of every one of the CRMs was less than $75 million on March 31, 2010. The total market value of all companies was $12.8 billion. And more than half of the CRMs reported revenues and assets of below $50 million.
Close to two-thirds of CRMs were audited by U.S. registered accounting firms, while local Chinese auditing firms audited about one quarter of the companies.
The PCAOB determined that in some instances, the U.S. registered accounting firms outsourced the audit work of Chinese companies to companies not located in the United States, as the U.S. auditor did not have expertise in the market where the company operated or did not speak the language needed to perform the audit.
“The Board’s inspection staff concluded that the U.S. registered firm’s involvement in the audit work performed by the consultants was insufficient for the firm to assert that the audit provided a reasonable basis for the firm’s opinion on the financial statements,” concluded the PCAOB in its March Research Note.
It should be noted that the PCAOB, a not-for-profit organization, was established by Congress and created by the Sarbanes-Oxley Act of 2002. It provides independent oversight over audits of public companies.
SEC Suspends Trading of CRMs
“The SEC and U.S. exchanges recently suspended trading in a more than a dozen reverse merger companies, citing a lack of current, accurate information about these firms and their finances,” stated the SEC in a June 9 press release.In 2011, the SEC suspended trading in the following CRM companies for misstatements in public filings: Heli Electronics Corp., China Changjiang Mining & New Energy Co., RINO International Corp., Advanced Refractive Technologies Inc., HiEnergy Technologies Inc., and Digital Youth Network Corp.
The SEC accused Heli Electronics Corp., a Nevada-based shell company with operations in China, of misstating cash balances in accounts receivable in its public filings. The company also failed to disclose that its independent auditor resigned because of accounting irregularities.
“The Commission is of the opinion that the public interest and the protection of investors require a suspension of trading in the securities of the above-listed company [Heli Electronics Corp.],” said the SEC in its March 21 trading suspension order.
On May 3, Advanced Refractive Technologies and HiEnergy Technologies, both Delaware shell companies with operations in China, received trading suspension orders for not providing periodic reports. HiEnergy Technologies has filed for a Chapter 7 petition in the U.S. Bankruptcy Court for the Central District of California. Chapter 7 is a liquidation bankruptcy where all debts are wiped out, and the company is allowed to start fresh after all assets are converted to cash and the money distributed to the creditors. That means most of the time the investor is left out in the cold.
On May 12, the SEC served a trading suspension order to Digital Youth Network Corp., a shell company located in Vancouver, Canada, for not providing periodic filings since 2006.
“Importantly, once the SEC has revoked a company’s securities registration, no broker or dealer or national security exchange can execute a trade in the stock unless the company files to re-register its stock,” advised the SEC in its Investor Bulletin.
