Reverse Mergers: A Looming U.S.-China Showdown over Securities Regulation?

As the U.S. and China tussle over high-profile trade disputes and geopolitical tensions, a scuffle in yet another arena — the securities market — has been brewing and threatens to boil over soon, say experts. U.S. securities regulators are frustrated in their efforts to go after Chinese companies that listed on U.S. stock exchanges through transactions known as "reverse mergers," attracting investors often with allegedly fraudulent financial disclosures.

On December 3, the U.S. Securities & Exchange Commission charged the Chinese affiliates of the so-called Big Four accounting firms of violating U.S. securities laws by refusing to produce audit documents to help the SEC in its investigations of Chinese reverse merger firms. The auditors claim they are unable to comply without breaking Chinese law against sharing state secrets. Meanwhile, the U.S. Public Company Accounting Oversight Board (PCAOB), which oversees auditors of U.S.-listed companies, has been negotiating with China to conduct joint inspections with the China Securities Regulatory Commission (CSRC) of China-based auditors of U.S. listed companies — without success, so far.

Former SEC Chairperson Mary Schapiro said that the Chinese government brushed off her request for help during her trip to Beijing in July. "We will fight hard to try to secure recovery for U.S. investors," she told ABC News before she left her post in December. "But it's harder when we don't have the cooperation of the foreign government."

In an interview with Knowledge@Wharton, PCAOB chairman James Doty said his agency has made progress in negotiating with China but will have to take stronger measures if China delays or rejects the request for joint inspections."If theChinese authorities continue to put up obstacles to legally required inspections of firms that have chosen to register in the U.S., the PCAOB will have to reevaluate the status of those firms in our system," he stated.

If the PCAOB can't inspect auditors of U.S.-listed companies, by law, it has to deregister those auditors. That, in turn, may well lead to deregistration from U.S. exchanges of companies that employ those auditors, including the China-based affiliates of many U.S. and multinational companies. "We are mindful of the potential consequences," said Doty. "The PCAOB will work to find the least disruptive solution. Any action the Board takes will be a result of thorough and thoughtful deliberation. But ultimately, our charge is to implement and enforce policy decisions embedded in U.S. law to protect the interests of investors in quality audits."

'Foreign Law on Chinese Soil'

The tepid response so far by China may be due in part to China's recent once-in-a-decade leadership change last November, experts suggest. Doty noted that there has been progress since his talks began with Chinese regulators in summer 2011. The PCAOB participated in an observational visit of a Chinese regulatory auditor inspection in October 2012 and extended the proposal for joint inspections the following month. According to Doty, the lack of compliance with PCAOB inspections may only end up hurting Chinese companies. "The worst case scenario is the present one: Our market's protections are not extended to investors in Chinese companies trading here; and Chinese issuers and auditors will continue to be viewed with suspicion in any market that takes pride in market integrity and confers a premium on listings," he said. Today, the PCAOB carries out inspections of auditors in some 40 countries, recently reaching agreement with many European countries, such as Switzerland, Germany and the Netherlands, that had concerns about looser U.S. standards on data privacy.

For its part, the Chinese government is reluctant to open the door to foreign regulation of domestic entities. "China has had an unpleasant history with foreign intervention dating back to the Opium Wars and the Japanese occupation," says Paul Gillis, an accounting professor at Peking University's Guanghua School of Management. "China is very sensitive to foreign regulators trying to enforce foreign law on Chinese soil against Chinese people." Adds Wharton finance professor Franklin Allen: "My guess is that the government is not that concerned, because of the relatively minor amounts involved with these companies. The bigger problem is that the financial system in China really needs a lot of reform to give access to small- and medium-sized enterprises."

At issue is an obscure transaction, called reverse mergers or reverse takeovers, through which hundreds of Chinese companies, mostly small- and medium-sized, have listed in recent years on U.S. exchanges, such as the NASDAQ or New York Stock Exchange. Reverse mergers, conducted correctly, are legitimate in the U.S. Through these transactions, companies — both domestic and foreign — can access U.S. capital markets by merging with a U.S.-listed "shell" company. The process gives the new owners operating and management control of the combined company — and access to capital more quickly and with fewer advisory, accounting and legal costs than a straightforward initial public offering (IPO).

In 2005 and 2006, U.S. securities markets, competing with foreign exchanges, actively sought new registrants, says James Feltman, senior managing director at Mesirow Financial Consulting in New York. With the help of U.S. middlemen, such as underwriters and investment banks, many Chinese companies found a way to list. According to the PCAOB, in their heyday, Chinese companies entered into 159 of 603 U.S. reverse mergers completed between January 1, 2007, and March 31, 2010, with U.S. companies making up most of the rest. At the end of the first quarter of 2010, the 159 Chinese firms had a combined market capitalization of US$12.8 billion, less than half the US$27.2 billion market capitalization of the 56 Chinese companies that completed U.S. IPOs over the period covered by the PCAOB report.

In 2011, reports from U.S. shortsellers, such as Muddy Waters Research and Citron Research, called attention to alleged frauds by some of these companies. One report, for example, asserted that a Chinese company claimed to own fictitious retail stores in financial statements to investors. Amidst such allegations, many auditors of Chinese reverse merger companies resigned, and the U.S. SEC started taking enforcement action against the companies and their advisors. The SEC has charged 64 individuals and companies with fraud so far and revoked the registration of 50 entities. Meanwhile, U.S. plaintiffs' attorneys are trying to recuperate investors' losses from these companies and their advisors. Last year, one in four federal securities class action lawsuits involved Chinese reverse merger companies, according to a studyby the Securities Class Action Clearinghouse at Stanford Law School and Cornerstone Research in Boston.

A Larger Problem

As the era of Chinese reverse mergers winds down and the cleanup begins, what are the lessons that can be learned? The reverse merger scandal is "just a symptom of a much larger problem," says Allen. "Many of the companies are not big [players], and they don't have good access to capital directly because the Big Four banks in China lend to state-owned enterprises. That's the distortion in the Chinese financial system, and it's something they have to deal with very soon." For now, "financial reform is somewhat on hold because of the leadership transition," says Allen. "Things may start moving in a few months when Xi Jinping becomes President."

Peking University'sGillis agrees: "If China starves its entrepreneurial companies of capital, it risks damaging indigenous innovation with negative long-term implications to China's competitiveness." Certainly, says Gillis, "Chinese regulators seem to be coming around to the view that Chinese companies need access to foreign capital markets. While China's own stock markets have developed rapidly in recent years, they do not have the capacity to deal with the current needs of China's entrepreneurial sector."

The problem now: The door to U.S. exchanges is essentially closed to smaller Chinese companies, thanks to the reverse merger scandal. "Don't expect a lot of Chinese companies to register in the U.S. in the next year or two," says Mesirow Financial's Feltman, who investigates Chinese reverse merger companies for clients in litigation and non-public companies owned by Chinese interests. "Reverse mergers are dormant — some might say dead — and there's no opportunity for any meaningful amount of new IPOs for them in U.S. markets, either. Clearly, there's a cloud over Chinese-based companies, in part because of some outliers in terms of bad press."

Instead, smaller Chinese companies are more likely to go private or consider listing on the Hong Kong Stock Exchange, say some experts. Yet, Hong Kong isn't an easy option, either. "Hong Kong isn't part of the Mainland regulatory system," Allen notes. "Companies listed in Hong Kong have to have real audits and different permissions." Of course, listing in Hong Kong becomes a more likely route if Chinese regulators are more willing to cooperate with Hong Kong regulators than with U.S. counterparts. "If the CSRC believes they want to cooperate with the regulatory regime in Hong Kong, but not us, it's up to them," says Feltman.

Alternative Sources

In the meantime, small- to medium-sized Chinese enterprises are turning to the alternative banking system or their own retained earnings — both fueled by China's economic growth — for capital, says Allen. The alternative banking system, where investors find borrowers through mutual acquaintances, thrives because "there are a lot of people with cash and not very good places to invest," he says. Meanwhile, a few regional and other banks in China, such as Inner Mongolia's Baoshang Bank and China Merchants Bank, are trying to start a new business lending to smaller companies, Allen notes. Rather than rely on go-betweens who know borrowers personally, these banks are learning to employ more modern risk assessment tools to make lending decisions. As such, they may rely more heavily on auditors for their decisions. "It takes time to build these institutions and years to train auditors," says Allen. "They just don't have the background yet."

Longer-term, the Chinese government likely would want Chinese companies to register on Chinese exchanges, according to experts. Says Gillis: "Eventually, we will see most Chinese companies looking to Chinese stock exchanges to raise capital.Chinese investors and Chinese regulators are better able to evaluate these companies than foreigners.But this will take some time."

Meanwhile, U.S. investors in Chinese reverse merger companies face limited prospects recuperating their losses."The biggest challenge is recoverability," says Joseph White, a partner at Saxena White law firm in Boca Raton, Fla., which has brought cases against Chinese reverse merger firms on behalf of U.S. investors. "In most cases, the assets are all overseas, and the only asset in play is the insurance policy–usually at US$1 million to US$3 million, where the damages are US$30 million to US$50 million." Plaintiffs' attorneys are also going after U.S. middlemen who lured Chinese firms into reverse mergers. Los Angeles investment bank Westpark Capital and New York investment bank Rodman & Renshaw, now in bankruptcy, are defendants in many shareholder lawsuits, notes Philip Kim, a partner at the New York-based Rosen Law Firm, lead counsel in over a dozen Chinese reverse merger shareholder cases.

Yet, despite the unsavory experience of many U.S. shareholders' first encounter with Chinese stocks, eventually interest in Chinese investments will return, experts predict. "The expected growth in China's economy means investors cannot stay away for long," says Gillis.

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