On June 9, 2011, the SEC issued an Investor Bulletin about investing in companies that enter the U.S. capital markets through reverse mergers. A reverse merger in this context refers to a situation in which a private operating company accesses the U.S. capital markets by merging with an existing public company, typically a "shell company" with no operations or assets of any kind. Pursuant to a reverse merger transaction, shareholders of the private operating company exchange their shares for shares of the public company so that they own a controlling interest of the shell company post-transaction. In addition, the management of the private operating company also becomes the management of the combined company. As a result, post-closing, the combined company looks very similar to the private operating company but with a public float.
After a short discussion of why a company would pursue a reverse merger ? to facilitate its access to the capital markets in a manner that is perceived as quicker and less costly than a traditional initial public offering ? and where reverse merger company securities are listed or traded, the SEC discusses some of the risks associated with investing in reverse merger companies and warns investors to proceed with caution when considering whether to invest in reverse merger companies. These risks, according to the SEC, include:
- Many companies either fail or struggle to remain viable following a reverse merger.
- As with other kinds of investments, there have been instances of fraud and other abuses involving reverse merger companies.
- Some foreign companies use small U.S. auditing firms, some of which may not have the resources to meet their auditing obligations when all or substantially all of the private operating company's operations are in another country. The lack of resources may lead to a failure to identify circumstances where these companies may not be complying with the relevant accounting standards.
The Bulletin continues by listing some of the more common risk factor disclosures that are used by reverse merger companies in their public filings. It also discusses six reverse merger companies that had their stock suspended from trading by the SEC in recent months, and states that the SEC has recently revoked the securities registration of "several" reverse merger companies.
The Bulletin concludes with a reminder that investors should be careful when considering investing in the stocks of reverse merger companies and provides the following tips:
- Research the company in question.
- Review the company's SEC filings.
- Be aware of the risks of companies that do not file reports with the SEC.
- Be skeptical of information received.
In addition to the Bulletin, SEC Chairman Mary L. Schapiro stated in a letter to Rep. Patrick McHenry (R-N.C.),that the SEC is working with the PCAOB and other regulators to identify problematic audit practices and auditor conduct with respect to reverse merger companies registered with the SEC. The SEC and the PCAOB, for instance, have expressed concern that U.S. auditors may be issuing opinions on financial statements based almost entirely on work performed by a non-U.S. firm that is not registered with the PCAOB. Additionally, SEC Commissioner Luis Aguilar recently called attention to a rise in accounting issues from Chinese reverse merger companies, and staff members of the SEC have publicly stated that they have seen an increase in auditor resignations from non-U.S. reverse merger companies, which raises concerns of fraud in those companies.
This Bulletin comes at a time when there is substantial press about Chinese public companies that are the subject of class action lawsuits alleging, among other things, accounting and reporting misrepresentations, some of which were cited in the Bulletin. Many of these Chinese public companies ? approximately 150 since 2007 ? became public through a reverse merger. By some counts, almost 25% of all securities lawsuits filed in 2011 were against Chinese companies. In addition, Nasdaq has jumped on the bandwagon by proposing additional listing requirements for reverse merger companies, including allowing the listing of a reverse merger company's stock only after a six month trading period as a reporting company and maintaining a bid price of $4 per share or higher during at least thirty of the sixty trading days immediately preceding the filing of the listing application with Nasdaq.
While there have always been and there always will be bad actors in the reverse merger space, as the recent press clearly demonstrates, not all reverse merger companies are engaging in fraud. However, the Bulletin specifically singles out reverse merger companies – while alluding to foreign operating companies – as entities to be concerned about from an investor protection viewpoint. It is interesting to note, however, that the suggestions made by the SEC in the Bulletin would apply to any company, whether U.S. or foreign, whether small or large and whether public through a traditional IPO or by way of a reverse merger. Furthermore, many of the risk factors cited by the SEC in the Bulletin are not specific to reverse merger companies. Accordingly, while we applaud the SEC for raising investor awareness of potential bad actors and seeking to teach investors what they need to know to protect themselves, we feel the SEC has unfairly targeted a legitimate way for companies to go public in the U.S.