A trend that was all the rage on Wall Street a few years ago has, since the start of 2011, caused much handwringing, paper filing and gavel banging.
In the late 2000s up to last year, reverse-mergers were a popular, perfectly legal way for foreign companies, especially in China, to wedge their feet in the doors of U.S. stock exchanges. The reverse-merger, in which a foreign company purchases essentially the shell of a defunct American company that is still listed on U.S. exchanges, was an easy way for the foreign buyer to enter the market without having to deal with the battery of reviews from state and federal regulators that come with the traditional initial public offering (IPO) route.
But then things got ugly. Allegations of fraud and other wrongdoing at some Chinese companies resulted in a litany of class actions, derivative actions and Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) investigations (see “Class Clowns”). Consequently, the reverse-merger trend dried up, and in its wake, officials enacted a string of more-rigorous regulations that have altered the path foreign companies take to market in the U.S.
However, while the number of companies entering the market via reverse-merger has all but completely ceased, the number of companies caught in the fallout continues to rise. The glut of lawsuits against Chinese companies caused collateral damage for the investment banks that took them public, the auditors that performed checks and even the law firms involved in the transactions. Plaintiffs attorneys have piled on these outside parties, many of which are U.S.-based. This is in part because the actual wrongdoers—the Chinese companies and their directors and officers—were out of reach due to jurisdictional hurdles. In short, the crosshairs shifted to more-accessible targets.
“The situation has evolved, and it’s really been a reaction to plaintiffs lawyers trying to figure out who they can get jurisdiction over in the U.S. courts,” says Perrie Weiner, the international co-chair of DLA Piper’s securities litigation practice.
In many of these cases, the story behind the alleged fraud began with what Weiner terms “so-called analysts” who are “not your Goldmans of the world” but essentially are “a step above bloggers.” These analysts took Chinese companies’ filings from the State Administration for Industry & Commerce (SAIC), a Chinese registration and licensing authority, and compared them to the U.S.-based SEC filings, often finding discrepancies dealing with reports on the company’s performance, its asset values and the assets themselves.
Once the differences had been spotted, the analysts claimed that there couldn’t have been such a discrepancy without the company having engaged in some sort of fraudulent activity. But in reality, these differences in the companies’ SAIC and SEC filings, while cause for further investigation, aren’t necessarily an indication of fraud, Weiner says.
There are many cultural reasons why there may be differences, Weiner says, including tax-related consequences and issues in China, and because many successful Chinese companies don’t want to stick out from their competitors and draw attention. Nonetheless, the analysts saw the differences between filings as an opportunity to negatively report on companies and profit from their short sales.
“These analysts have a built-in economic motive and opportunity to misreport the facts because they themselves are short the stock at the time they publicly disseminate the negative report of the company,” Weiner explains. “And they’ll even openly admit it. They’ll say in the release that they are short the stock.”
In response to the fiasco brought about by the reverse-merger trend, U.S. exchanges and the SEC have enacted stricter seasoning requirements for reverse-mergers. It’s no longer possible for companies to do a reverse-merger and immediately become public in the U.S. Now, among other restrictions, there are multiple-month barriers to entry in which a number of audits are required and an average trading value is required before the company goes public. The Depository Trust Co. (DTC), which helps buyers and sellers of securities make their exchanges, also has taken a stronger position on reverse-mergers in the past last year.
“The DTC has become much more active almost as a regulator,” says Laura Anthony, founding partner of law firm Legal & Compliance. “There were new rules put into place by the exchanges that following a reverse-merger, a company needs to season for months on the over-the-counter bulletin board prior to applying to trade on an exchange.”
Although none of these requirements affect the mergers themselves, former Southern District of New York Judge Richard Holwell, now a partner at Holwell Shuster & Goldberg, says that in order for reverse-merged companies to get listed or get into an active trading market, they must show a prior history of having been in the over-the-counter market or subject to another regulated marketplace in the U.S. or abroad.
“It’s a little more difficult to effect these reverse-mergers, and that, presumably, will improve the quality and weed out the fraudsters,” he says.
For U.S. companies looking to deal with China-based companies, due diligence, as usual, is a must. But the risk isn’t as bad as the press has made it out to be during the past few years. Chinese companies that are attached to major law firms and accounting firms typically have minimal risk because the diligence already has been done. The only times when there may be risk is when a company that went public through a reverse-merger did not use reputable auditors and lawyers. In those cases, attached U.S. companies must do their own diligence.
“Everybody should pass the smell test,” Holwell says.
Weiner adds that of the more than 165 Chinese operating companies that went public through reverse-mergers in recent years, only a fraction have had any issues with fraud. And if there was fraud, he says it often wasn’t intentional, but more that the companies did not understand what it meant to be public in the U.S.
“The majority of these Chinese companies are legit; you just have a few bad apples that created this whole hysteria and problem,” he says.
In many cases, Weiner asserts that Chinese companies that were brought public had management teams inexperienced with being public on U.S. exchanges. This was a significant problem because U.S. regulations are Draconian compared to China’s, and are a difficult standard to meet off the bat.
“If anything, the Chinese feel that they’ve been unfairly targeted by U.S. short sellers,” Weiner says. “What you’re basically seeing is some analysts exploiting an opportunity to short a stock in a company that wasn’t experienced at being public on the U.S. exchanges.”