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Regulation and Compliance > Federal Regulation > SEC

Warning: U.S. ‘Under Attack’ by Chinese Reverse Mergers

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“We are under attack,” writes Wall Street Journal blogger Josh Brown, an advisor with Fusion Analytics and proprietor of The Reformed Broker website.

While it might sound like the paranoid plot update of the campy Patrick Swayze vehicle "Red Dawn," Brown says a slew of reverse mergers involving Chinese companies listed on American stock exchanges now has the attention of the SEC.

Chinese flagHere’s how it works. A publicly traded American-based company, once a going-concern but now a shell of its former self and trading for pennies, issues a large number of shares to purchase a Chinese company. The Chinese company then becomes the majority shareholder and assumes the public listing of the American parent company.

It’s a way to skirt the IPO process,” Brown says in an interview with AdvisorOne about his blog post. “With the help of U.S.-base law firms, they engage in revenue exaggeration; they also might says they have four campuses when they really have two, and they might claim a technology edge on an American company. In this way, they’re able to capital formulation.”

He adds they've been able to subvert the more highly scrutinized public offering process that would normally have weeded them out.  By "cleaning up" shell companies, which should not be trading or available to begin with, the disease gets a foothold first on the pink sheets and then onto the American Stock Exchange “where the real grifting can begin.”

Once the company is listed, insiders to the deal then sell and the original auditors resign and trading is halted, sometimes for days. When trading resumes, it is for a fraction of the original share price.

He refers to White Collar Crime columnist Walter Pavlo, who has collected a slew of recent examples on his blog at Forbes, including:

  • China Electric Motor – Shareholders lawsuit filed claiming underwriters violated federal securities laws by issuing materially false and misleading information.
  • China Natural Gas – Class action lawsuit alleges directors and officers issued materially false and misleading statements.  CFO of company resigned in late 2010.
  • Duoyuan Printing – SEC investigating company for fraud, NYSE delisted April 4, 2011
  • China MediaExpress Holdings, Inc. – Deloitte quit as auditor because “no longer able to rely on the representations of management”.  CFO resigned. Stock trading halted March 11
  • China Agritech – Shareholder lawsuit pending.  Dismissed its auditor Ernst & Young.
  • China Sky One Medical – Under investigation by SEC.
  • Orient Paper, Inc. – Re-auditing previous financials due to license issues with previous auditor (Davis Accounting Group)

The SEC's Mary Schapiro is aware of the epidemic and is now on the case.

"They were looking into these on a case by case basis, but with one occurring every day since May 1, they realize they need to look at them in totality," he says.

He writes in his blog that the "smart thing to do would be to halt the entire shell company process in its entirety right this minute until we can get the rules up to a standard that will protect investors outright from these foreign liars and thieves."

“Capital formation can wait 15 minutes while we get our act together and crack down on this disgusting shell syndicate,” Brown writes.


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