The ‘alien’ is equally adored and vilified in American pop-culture, whether it be the moustachioed gun-toting Mexican bandito hot footing it over the border or the bug eyed, tentacle waving visitors from outer space. Corporate America now faces a new and real invasion by a class of aliens that are far dryer than either of these romanticised notions and whose white-collared pursuits, whilst presenting a risk to the American investing public, would certainly not pique the interests of Messrs Mulder and Scully. These ‘aliens’ are foreign companies, mainly Chinese businesses, that are obtaining a listing on US stock exchanges – and thereby access to American investors through “backdoor registrations”.
What is a backdoor registration?
A backdoor registration takes place when a privately owned business takes effective control of a publicly listed US shell company, thereby automatically gaining the public company’s listing on an American stock exchange.
The way this is done is that the public shell company is actually the “acquirer” of the private operating business, which is treated as the “acquiree”. However, through a reverse merger, although the public company is the surviving entity, the private business’s board moves over to take control of the public company. The “acquiree” then becomes the “acquirer” for accounting purposes.
Right now, there is a rash of reverse mergers by Chinese owned private businesses on the lookout publicly listed US shell companies. The Chinese buyers are assisted by US based promoters who identify suitable targets and arrange for a reverse merger to take place.
Lack of scrutiny
A reverse merger is an entirely legal way for companies to obtain listing quickly and more cheaply than the traditional Initial Public Offering (IPO) route. However, the reason they are cheaper and quicker than IPOs is that they avoid the scrutiny and rigorous due diligence associated with an IPO. The company is not even required to file a Registration Statement under the Securities Act 1933 or the Exchange Act 1934.
Are Chinese reverse mergers a real problem?
The short answer is, yes. In the US, both the Securities and Exchange Commission (SEC) and the Public Company Accountant Oversight Board (PCAOB) have launched significant investigations into the subject in the last year.
In a recent research note, the PCAOB found that between January 2007 and 31 March 2010 there was 603 reverse mergers. Most were entirely US based. However, of the total 603, 159 were Chinese reverse mergers. Not surprisingly such figures are stimulating the current press interest in the trend.
The lack of due diligence at registration does not necessarily present a problem. The main problem is that numerous Chinese reverse mergers have recently either been subject to de-listing or have seen trading in their securities halted. Primarily because of deficiencies in the audit procedures and irregularities in the financial statements of the Chinese reverse mergers.
For example on 21 March 2011, the SEC suspended trading in Heli Electronic Corp. because of concerns about the accuracy and completeness of the information in the company’s public filings relating to the company’s cash balances and accounts receivable. The company had also failed to disclose that its independent auditor had resigned due to accounting irregularities.
Less than a fortnight later, the SEC suspended trading in RINO International Corporation. The company had failed to disclose that the external law firm and forensic accountants hired by the company’s audit committee to investigate allegations of financial fraud at the company had resigned after reporting the results of that investigation to the board.
These examples reveal some of the investments dangers involved. For regulators, the key issues are protecting investors and making sure they are given material information that might inform their assessment of the companies. In the name of investor protection, the SEC recently revoked the registrations of at least eight Chinese reverse mergers.
The contagion has now spread. Chinese reverse mergers and the difficulties they now find themselves in have started to cause problems for Chinese companies that have reached the American market through IPOs. These companies have in recent months started to become the subject of speculative investor actions.
Impact on London underwriters
The listing of Chinese reverse mergers represents a real D&O risk even where the company is entirely legitimate. Indeed, there are claimant law firms in the US whose raison d’être is purely to commence class actions against publicly listed companies. Right now, Chinese reverse mergers are a favoured target and there are already several class actions in the US that have impacted on the London market.
Over a quarter of such mergers since March 2007 have involved Chinese companies. So it is, perhaps, not surprising to discover that, so far this year, Chinese reverse mergers have accounted for a significant proportion of the class actions commenced in America. As at 18 April, 61 securities class actions had been filed in the US with 14 (or 23 percent) of those actions relating to Chinese reverse mergers. Of those 14 actions, 10 were filed in the month of April.
It would be all too easy for underwriters to be over-cautious and to simply turn their backs on Chinese companies seeking D&O cover at this time. However, that is simply not commercially viable given the obvious significance of that market and would be grossly unfair to the Chinese businesses seeking D&O insurance who are genuine. Underwriters can take steps to minimise their exposure to the risk that they encounter one of the few Chinese reverse mergers looking to take advantage of US investors.
The warning signs
The difficulty underwriters will face is the same as that the investing public and regulators in America have already encountered. On the face of it many Chinese reverse mergers look sound and present a compelling picture (and some, no doubt are sound). However, given that these companies are many thousands of miles away and with the associated language, cultural and regulatory differences and barriers it simply is not possible to absolutely verify the picture presented.
Even the appointment of, and endorsement by, a large US auditor cannot be seen as conclusive proof that a Chinese reverse merger is a genuine concern with correct and true financial statements. Indeed there are a number of well-known and highly regarded audit firms currently under investigation by the SEC for their part in failing to spot overstatements of revenue and other inaccurate financial statements put out by Chinese reverse mergers.
Not wanting to milk the analogy too much, Chinese reverse mergers will not turn up asking to be taken to your leader, instead, think of it as the ‘Invasion of the Body Snatchers’. At first glance Chinese reverse mergers appear to be normal, reputable and healthy listed companies. But in reality they have been taken over and are controlled by a wholly different beast.
From our review of the Chinese reverse mergers that have turned sour, we think the warning signs include:
- A recent listing in the US
- Changes in (or resignation(s) of) auditors
- Incorporation in the British Virgin Islands or Cayman Islands (or other similar offshore jurisdiction) but with its main corporate base in China
The Proposal Form is your friend
The Proposal Form and placing information should tackle:
- The question of listing in the US - where listing has occurred, the prospective insured should be asked when and how it took place.
- If the prospective insured is a Chinese reverse merger then it would be prudent to ask questions about its US filing and regulatory history. In particular whether it has ever had to restate its financial statements and whether it has ever had to restate or been the subject of regulatory investigations relating to the accuracy and content of its financial statements and filings.
- It would also be wise to examine closely the audit history of any Chinese reverse merger. In particular:
- Does the prospective insured retain local Chinese auditors and/or US auditors?
- Who presently acts as auditor and how long have they been in place?
- What are the prospective insured’s procedures for appointment and rotation of auditors?
- Have any auditors resigned or been replaced during the previous six years? If so, why did the auditor resign or why was it replaced?
- The detail of the prospective insured’s incorporation. This can be done by way of questions in the proposal form and requests for sight of incorporation documents.
Backdoor registrations and Chinese reverse mergers represent a serious risk both to investors and the unwary underwriter. While it is difficult to eliminate the danger entirely underwriters can take action to minimise the risk provided they are alive to it and take steps to illicit further information from Chinese companies in respect of their audit history, incorporation, financial statements and registration in the US.
This is not simply a hyped up conspiracy theory, it is a real risk and whilst it might not yet be time to don your tin foil hat every time a Chinese company comes looking for D&O cover is certainly time to exercise caution.