The Continuing Chinese Attraction for Reverse Mergers

[Editor's note: Chinese approached me at different times last year, asking about reverse mergers and backdoor listings. These are legal methods whereby a private company merges with a listed shell company, thus becoming a listed company itself.
According to practitioners, Chinese salivate over the idea of going public in the U.S. and have been attaching themselves to the form like limpet mines on a U-Boat. This Wall Street Transcript panel entitled "China’s Obsession with Reverse Mergers" devoted a panel on just this topic last year. This Heller Ehrman white paper, "U.S. Listing Options for Hong Kong and Chinese Companies," dated August, 2003, shows dissemination of the idea that reverse mergers are possibilities for Chinese companies, but note the firm's distinct, well-reasoned hesitation in recommending the form.
I as well was not encouraging to my guests, not least because of the reputation traditionally attached to those who make use of the reverse merger. But the Chinese with whom I spoke noted with distinct relish what they believed was a faster and cheaper avenue by which they could be listed in the U.S, which assumpion is not necessarily the case. More importantly, they believed that the reverse merger would eliminate burdensome disclosure requirements the IPO process presented. Remember that many Chinese companies have serious financial difficulties which due diligence often exposes -- the Black Scrim of Death for many who lust to list.
Then the SEC issued rules last year compelling the production of additional financial documentation in the event of a reverse merger. One might think that would have stopped the show for Chinese companies, but, according to China Confidential's investigative reporting, it hasn't. With gratitude to its anonymous author who has kindly consented, we reproduce the post in full below.]
From China Confidential
More Chinese Firms Likely to Go Public in US
New rules governing Initial Public Offering (IPO) issuances could encourage more Chinese companies to go public in the United States through so-called reverse mergers with listed or over-the-counter (OTC) shell companies.
The rules, which the China Securities Regulatory Commission (CSRC) released in draft form before the week-long Labor day holidays, are aimed at upgrading the quality of listings.
The CSRC wants companies to have accumulated profit of at least 30 million yuan (approximately $3.7 million) and combined revenues of no less than 300 million yuan over the preceding three-year period prior to floating shares.
In contrast with China and most countries in the world, securities laws in the US are based on disclosure, not merit, though the nation’s leading stock exchanges–the New York Stock Exchange, NASDAQ, and the American Stock Exchange–all have their own rules and requirements governing listings and related matters. The US Securities and Exchange Commission (SEC), the agency responsible for administering federal securities laws, has no profitability rule. It does not approve the prospectus, or registration statement, of a company–issuer in securities parlance–seeking to sell shares in an IPO or secondary public offering. Instead, the SEC clears a company’s registration statement–an important distinction.
After clearing the Commission, as US securities lawyers say, the registration statement is “declared effective” and the issuer is then free to trade on an electronic trading system known as the OTC Bulletin Board, where the only meaningful listing requirements, apart from basic corporate governance rules, are the filing of quarterly and annual reports with the SEC, including audited financial statements, and timely disclosure of all materially important events and developments through special SEC filings and the preparation and dissemination of press releases.
“Disclosure is the operative word,” says a New York-based US securities lawyer. “The US system is designed to provide a level playing field for all investors. Everyone is supposed to have access to the same information before making investment decisions.”
For small to mid-cap domestic and foreign issuers, the reverse merger method–whereby a publicly traded shell issues so many shares to acquire an operating company that it becomes the surviving entity–has historically been a popular fast-track alternative to typically more time consuming, costlier IPOs. But because reverse mergers have also often been abused by shady penny stock promoters and brokerage firms, the SEC recently tightened rules for these deals, requiring merged companies to file audited financial statements within days of closing their transactions.
Despite predictions to the contrary, the new SEC rules have not been a significant deterrent to Chinese companies seeking to go public in the US by merging with shells.
“All the filing requirement did was weed out smaller, suspect companies,” a veteran Wall Street investment banker tells China Confidential. “Companies that want to go public but are not large enough to qualify for traditional IPOs are still drawn to reverse mergers.”
Securities lawyers who have represented Chinese and other foreign issuers report that their clients are usually surprised by the relative ease with which it is possible for virtually any company with more than a few hundred shareholders to go public in the US, though the country’s ongoing reporting requirements–and civil and criminal penalties for misrepresentation and corporate mismanagement–seem severe to many overseas executives.
“It’s the cost of going public that shocks them,” says one high-priced New York lawyer. “Depending on the size of the company and the complexity and nature of its business and financial history, a reverse merger could easily exceed $300,000 in legal and accounting fees.”

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