August 2, 2011

China Reverse Merger Boom Goes Bust Costing Investors Billions

More than $18 billion lost in collapse of Chinese stocks

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Chinese reverse mergers, in which Chinese companies were able to come to market on American exchanges, experienced a boom over the past decade, but that appears to be coming to an end, at least partly because of weak regulatory oversight. And the bust appears to have cost American investors at least $18 billion.

Of the selection from among 122 reverse mergers with Chinese companies that Reuters examined, it found that $18 billion of their market capitalization had disappeared between the time of the companies’ peak stock prices and July 10, 2011. Accounting irregularities and other problems have resulted in share prices plummeting, and since March some 25 Chinese companies have been delisted while auditors at 30 have resigned.

According to a Reuters report, reverse mergers work is this way: A private company that wants to be listed on a U.S. exchange buys a shell company, one that has no meaningful operations or assets, that is already listed on the exchange in question. Usually this is done through a shell broker, who has acquired the shell company and then seeks a buyer for it.

Shell companies are often based in corporation-friendly states like Delaware, Nevada or Utah. When the shell broker finds a buyer, it puts the deal together and the acquiring firm becomes a publicly traded company without having to go through the scrutiny it would endure if seeking listing on its own.

Since companies are incorporated under state laws, not federal, they are not subject to the oversight of the SEC, which doesn’t usually examine reverse mergers until after the process has been completed.

The distinguishing factor for most Chinese deals is that the company doing the acquiring of the shell company is generally a holding company based somewhere like Delaware, the British Virgin Islands, or some other tax haven. That holding company controls the operations of the mainland China business operations, and that extra layer makes it even tougher for regulators to wade through the company’s accounts.

And accounting is where the process breaks down. While reverse mergers are legitimate business processes, a company that wants to hide its balance sheets can find it easy to do so by using a shell corporation and then hiring an auditor who is unable to provide an accurate account of its books; or one who is willing not to.

An acquiring company must have an auditor registered with the watchdog Public Company Accounting Oversight Board (PCAOB). (In March the PCAOB put out a report about possible problems with audits of Chinese companies engaged in reverse mergers; the SEC has set up a working group on Chinese reverse merger companies, and the FBI has opened an investigation.)

Auditors for many of these Chinese reverse merger companies are small companies, usually with no ties to China and perhaps even without a familiarity with the language. They are responsible for reviewing and signing off on documents for a company on the other side of the globe, which creates a situation ripe for corruption and deception. Another factor is that the PCAOB only reviews small companies in the U.S. once every three years.

Large auditors are not immune to problems with such companies, either. ShengdaTech, a chemicals manufacturer, was audited by KPMG—until April, when the auditor resigned, citing "serious discrepancies" in its bank statements and representations of customers.

Problems have included misrepresentation of assets, clients, and funding; cash balances; management integrity; idle factories; nonexistent suppliers; and other irregularities. Lack of transparency means that extra caution should be taken when considering investments in such companies.

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