Chinese Reverse Mergers Research
Wanting Xu
Introduction
Since the end of 2000, a lot of Chinese companies have gone public on U.S. stock
exchanges through a “reverse merger” (RM).1 This rapid growth in the number of Chinese
RMs (CRMs) listed on U.S. markets drew media attention, when a number of them were accused
of accounting fraud. In July 2010, the PCAOB issued “Staff Audit Practice Alert No. 6” that
highlights emerging trends in work performed for CRM clients by U.S.-registered accounting
firms. The alert noted that some accounting firms may not be conducting audits of CRMs in
accordance with PCAOB standards, chiefly AU 543, “Part of Audit Performed by Other
Independent Auditors” (AU 543). According to the PCAOB, this section establishes
requirements that apply when an auditor uses the work and reports of other independent auditors
or contractors.
In summer 2010, the SEC also began investigating the audit practices of Moore Stephens
Wurth Frazer & Torbett, LLP (MSWFT), a U.S.-registered PCAOB accounting firm that had
several CRM clients. In December 2010, the SEC issued a cease and desist order against
MSWFT after finding the company had failed to follow applicable professional standards,
including PCAOB standards, in reviewing the financial statements of China Energy Savings, Inc.,
a CRM. Following this SEC order, more than 24 CRMs announced auditor resignations, most
of which were U.S.-registered auditors. The SEC, NASDAQ, and the NYSE have suspended
trading, halted trading, or delisted the securities of at least 29 CRMs citing, among other reasons,
public interest concerns, removal of audit opinions, failure to respond to information requests,
failure to comply with SEC requirements, and failure to evidence compliance with initial listing
standards. On June 9, 2011, the SEC issued an investor bulletin warning investors of the
potential risks of investing in CRMs.
The first part of the paper talks about what is the reverse merger and why pursues a reverse
merger. In the second part, I will exam some litigation involved CRM companies and spot the
issues appear in CRMs. Furthermore, because of the series of CRMs’ financial scandals in
2011, the short-sellers published scathing reports, regulators cracked down, and investors ran for
the exits. Third, I will argue that whether the U.S. investors and officials may have
A reversed merger , also referred to as a “reverse takeover” or a “backdoor listing”, is a process whereby a private
company is merged into a public company and the private company’s management team takes over the combined
publicly traded company. At the time of the merger, the public company is typically a “shell” company (i.e., a
non-operating entity that had gone through bankruptcy and is now dormant). The U.S. Public Company
Accounting Oversight Board (PCAOB) reports that between 2007 and 2011 over 150 Chinese companies, worth
$12.8 billion, entered U.S. markets through RMs (compared to only 50 Chinese firms that filed for IPOs over this
time period).
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overreacted.
I.
Reverse Merger:
A. What is a Reverse Merger?
Many private companies, including some whose operations are located in foreign countries,
seek to access the U.S. capital markets by merging with existing public companies. These
transactions are commonly referred to as “reverse mergers” or “reverse takeovers (RTOs).”
In a reverse merger transaction, an existing public “shell company,” which is a public
reporting company with few or no operations, acquires a private operating company—usually
one that is seeking access to funding in the U.S. capital markets. Typically, the shareholders of
the private operating company exchange their shares for a large majority of the shares of the
public company. Although the public shell company survives the merger, the private operating
company’s shareholders gain a controlling interest in the voting power and outstanding shares of
stock of the public shell company. Also typically, the private operating company’s
management takes over the board of directors and management of the public shell company.
The assets and business operations of the post-merger surviving public company are primarily, if
not solely, those of the former private operating company. Investor Bulletin: Reverse Mergers
B. Why Pursue a Reverse Merger?
A private operating company may pursue a reverse merger in order to facilitate its access to
the capital markets, including the liquidity that comes with having its stock quoted on a market
or listed on an exchange. Private operating companies generally have access only to private
forms of equity, while public companies potentially have access to funding from a broader pool
of public investors. Although IPO and RM are sometimes portrayed as alternative ways for a
private firm to go public, in fact a majority of RM firms were never IPO-eligible. A reverse
merger often is perceived to be a quicker and cheaper method of “going public” than an initial
public offering (IPO). The legal and accounting fees associated with a reverse merger tend to
be lower than for an IPO. And while the public shell company is required to report the reverse
merger in a Form 8-K filing with the SEC, there are no registration requirements under the
Securities Act of 1933 as there would be for an IPO. In addition, being public may give a
company increased value in the eyes of potential acquirers. Why would a company do a
reverse merger instead of an IPO?
II. Investment and Litigation Related to Chinese Reverse Merger Company
Shares of Chinese reverse merger companies (CRMs) listed on U.S. exchanges have fallen
almost 50 percent in 2011 as CRMs have come under increased scrutiny from U.S. regulators.
The Securities and Exchange Commission (SEC) has issued an investor warning related to the
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accounting and disclosure practices of CRMs, and the Public Company Accounting Oversight
Board (PCAOB) has published a research note identifying potential concerns in audits performed
by U.S.-registered accounting firms. The SEC has also launched a number of investigations
against and suspended trading in some CRMs.2 A lot of these companies are also being named
in shareholder class actions.
Since the beginning of 2010, plaintiffs have filed at least 33 securities class actions alleging
violations of Section 10(b), Rule 10b-5, or Section 11 in matters involving CRMs. For the
CRMs named in these complaints, the aggregate market capitalization decline during the putative
class periods was greater than $8 billion, and the average market capitalization decline was $250
million. Seven out of the 33 complaints name an investment bank as co-defendant, including
five complaints that allege violations of Section 11.
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The SEC has launched investigations into the disclosure practices of at least 17 CRMs, including (1) China Sky
One Medical (CSKI), (2) Fuqi International (FUQI), (3) Rino International Corporation (RINO), (4) China Green
Agriculture (CGA), (5) Duoyuan Printing (DYNP), (6) China Century Dragon (CDM), (7) China Intelligent
Lighting & Electronics (CIL), (8) China Expert Technology, Inc. (CXTI), (9) China 9D Construction Group
(CNAG), (10) China Media1 Corp. (CMDA), (11) China Digital Media Corporation (CDGT), (12) China Mineral
Acquisition Corp. (CMAQU), (13) China Technology Global Corp. (CTGLE), (14) China Yuchai International
Limited (CYD), (15) Greater China Corp. (GCHC), (16) China Continental, Inc. (CHCL), and (17) China Energy
Savings Technology, Inc. (CESV) (see, for example, http://sec.gov/litigation/admin.shtml).
The SEC has suspended trading in at least six companies, including (1) Heli Electronics Corp. (HELI), (2) China
Changjang Mining & New Energy Co. (CHJI), (3) RINO International Corporation (RINO), (4) Advanced
Refractive Technologies (ARFR), (5) HiEnergy Technologies, Inc. (HIET), and (6) Digital Youth Network Corp.
(DYOUF) (see SEC Investor Bulletin: Reverse Mergers, June 9, 2011).
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a. China Electric Motor, Inc.
SRKP 21, Inc. (“SRKP 21”) was incorporated in the State of Delaware on October 11, 2007
and was originally organized as a “blank check” shell company to investigate and acquire a
target company or business seeking the perceived advantages of being a publicly held
corporation. FORM 10-SB
According to Form 8-K, on March 3, 2009, SRKP 21, Inc. entered into a Share Exchange
Agreement with Attainment Holdings Limited, a British Virgin Islands corporation
(“Attainment”); Excel Profit Global Group Limited, a British Virgin Islands corporation and sole
shareholder of Attainment (“Excel Profit”) and, with respect to certain portions of the agreement,
certain designees. The Company agreed to issue an aggregate of 17,029,630 shares of its
common stock to Excel Profit and the designees in exchange for 100% of the share capital of
Attainment. The Company also agreed to have cancelled 5,016,390 shares of common stock and
6,131,945 warrants prior to the closing of the Share Exchange. Immediately after the closing of
the Share Exchange, on May 6, 2009, SRKP 21 changed its corporate name from “SRKP 21, Inc.”
to “China Electric Motor, Inc.” (“Company”) Our shares of common stock are not currently
listed or quoted for trading on any national securities exchange or national quotation system.
On March 31, 2011, the Company issued a press release announcing the filing of a Form
12b-253 with the Securities and Exchange Commission to extend the filing of the Company’s
Annual Report on Form 10-K for the fiscal year ended December 31, 2010. The Company is
unable to file its Annual Report on Form 10-K for the year ended December 31, 2010, within the
prescribed time period due to possible discrepancies concerning the Company’s banking
statements that were very recently identified by the Company’s auditors in the course of their
audit of the Company’s consolidated financial statements for the fiscal year ended December 31,
2010. The Company’s board of directors has formed a Special Committee to investigate the
possible discrepancies identified by the Company’s auditors. The Special Committee has been
authorized to retain counsel and other professional firms to assist it with its internal investigation.
The Company has also delayed its fourth quarter and full year 2010 earnings release and investor
conference call, until its Annual Report on Form 10-K is filed. Form 8-K
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The SEC Form 12b-25 is usually a red flag for investors, indicating that something is not right with a company. It
either means that management is incapable of ensuring that basic tasks are performed or that the company is
experiencing major financial trouble. Since the SEC Form 12b-25 requires companies to indicate whether or not any
major changes from the prior year's report are expected, it is crucial that investors review this filing as soon as they
become aware of it.
Using data collected by China’s National Bureau of Statistics (NBS), Piotroski and Zhang (2012) assemble a sample
of non-public Chinese firms that are ex-ante qualified to engage in an IPO on China’s stock exchanges. In China, all
industrial companies with sales of more than RMB 5 million are required to report their financial data to the NBS
via a standardized set of financial forms. Their sample of “exchange eligible firms” consists of 28,152 firm-year
observations over the period 2001 to 2008, where the underlying non-public industrial firm was financially eligible
to engage in a Chinese IPO at the start of the calendar year. Of these observations, only 440 firms subsequently
engaged in an IPO offering in one of China’s two domestic stock exchanges.
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One April 1, 2011, the Rosen Law Firm, P.A. announced that it has filed a class action
lawsuit on behalf of investors who purchased the securities of China Electric Motor, Inc. in the
period from January 29, 2010 to March 30, 2011, to recover damages for violations of federal
securities laws.
According to the plaintiffs, China Electric filed an accurate set of books with
Chinese regulators while filing a second set of books with the U.S. Securities and Exchange
Commission and included in the IPO registration statement "grossly overstated revenue, gross
profit, income from operations, net income, and cash and cash equivalents." "The fabricated
SEC numbers were designed to lure U.S. investors," the plaintiffs said in court papers and, as a
result of the alleged securities violations, the value of the stock fell 97 percent from the offering
price to 14 cents per share. It is currently trading at 6 cents. The suit alleged the underwriters
failed to conduct reasonable due diligence in connection with the offering. The Rosen Law
Firm Representing Investors in Securities Class Action Charging China Electric Motor, Inc. With
Securities Violations -- CELM Later, the SEC issued Registration Withdrawal Request because
the Company’s current ineligibility to register securities on registration statements on Form S-3.
This case ended up with a $3.7 million settlement4. China Electric, which makes
small motors for household appliances, will pay $2.75 million of the settlement. Numerous
securities actions against U.S.-listed Chinese companies have been based on alleged
discrepancies between financial reporting to the SEC and Chinese regulators. Laurence Rosen of
the Rosen Law Firm, the lead plaintiffs' counsel in the China Electric case, has filed more than
30 such cases over the past few years. China Electric's $3.7M Securities Settlement Approved.
b. Advanced Battery Technologies, Inc.
The company is a Delaware corporation with offices in New York that, through subsidiaries,
owns two Chinese operating companies. On March 30, 2011 an analyst firm called Variant
View Research issued a detailed report revealing the adverse information to the market. When
these details of the Company's financial condition came to light on March 30, 2011, the price of
Advanced Battery's stock fell over 40%, damaging investors. The Complaint alleges that the
Company made a number of misrepresentations in its public filings with the Securities Exchange
Commission and in its press releases. Namely, that: (1) the Company misrepresented certain of
its distribution arrangements; (2) that Advanced Battery paid $1.5 million to acquire another
company that appears to be fake because its location and existence could not be verified; (3) that
Advanced Battery paid $20 million to purchase a company, but failed to disclose the related
party nature of the transaction; and (4) the Company misrepresented that it owned a Company
subsidiary when it did not, or the Company failed to disclose that the Company entered into a
related party transaction with the Company's Chairman and CEO which resulted in the owner of
that subsidiary being the Chairman and CEO, and not Advanced Battery. The Rosen Law Firm
Representing Shareholders in Class Action Lawsuit Charging Advanced Battery Technologies
With Securities Fraud - (ABAT) According to the complaint the plaintiff alleges that behalf of
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"The Court finds the settlement is fair, reasonable and adequate."
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investors who purchased the common stock of Advanced Battery Technologies, Inc. (NASDAQ:
ABAT) during the period from March 16, 2009 through March 29, 2011, that Advanced Battery
Technologies made a number of misrepresentations in its public filings with the Securities
Exchange Commission and in its press releases.
The allegations raised in the CRM cases, like the allegations in the two cases described in
detail above, fall into two basic categories: Inadequate disclosures involved related-party
transactions (see Tongxin, China Valves Technology, and China Integrated Energy), and
accounting irregularities or accounting improprieties (see China Media Express, China
AgriTech, ShegndaTech and NIVS Intellimedia Technology Group). The larger pattern is that
there seems to be a growing number of Chinese and China-linked companies that are announcing
concerns related to the accounting and reported financial statements.
c. Public Company Accounting Oversight Board Report
Kenneth Sharp, the U.S.-based global leader of assurance services at Grant Thornton, says
reverse mergers as a concept has been around for a long time and while it has its benefits, it also
raises questions about transparency. He said “within the U.S., there is nothing wrong with them
per se. It may be quicker and cheaper, and certainly there is nothing illegal or inherently wrong
with it. But it is much less transparent than the traditional IPO route where you file a registration
statement, you have due diligence and reviews by the SEC and so forth.”
The rash of lawsuits has arisen at the same time that the Public Company Accounting
Oversight Board raised concerns in a March 14, 2011 report about accounting and auditing
standards at Chinese companies that have conducted IPOs in the U.S. or that have become U.S.
publicly traded companies through reverse mergers. The report identifies a number of factors
that may undermine the ability of audit firms to complete their audit functions completely or
effectively. In light of the concerns in the PCAOB report, it hardly comes as a surprise that
accounting concerns are coming to light in connection with some of these Chinese firms.
ORA staff identified the current auditors for 157 of the 159 CRM companies. (Two
companies no longer file financial statements with the SEC.) As of March 31, 2010, triennial
accounting firms, as a group, audited the largest number of CRM companies, both by number
and by market capitalization. Triennial accounting firms audited 147 companies, or 94% of the
total. This represents 97% of the total market capitalization of CRM companies, or $12.4 billion,
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as of March 31, 2010. The remaining CRM companies are audited by an accounting firm
inspected by the PCAOB annually. 10 U.S. firms audited 116, or 74% of the CRM companies,
and Chinese registered accounting firms audited 38, or 24%. Canadian registered accounting
firms audited three CRM companies.
It appeared that U.S. firms provided audit services by having most of the audit performed
by another firm or by assistants engaged from outside the firm without complying with PCAOB
standards applicable to using the work and reports of another auditor or supervising assistants.
In the Alert, the Board’s inspection staff observed audit quality concerns in certain audits in
which U.S. registered accounting firms performed audits of companies with substantially all of
their operations in another country.
The Board's inspection staff has also observed situations in which U.S. registered firms
have engaged assistants from outside the firm for audit work on companies with substantially all
of their operations in another country. In order to perform audit procedures for an issuer
operating in the China region, a U.S. firm engaged a consulting firm whose personnel could
speak and read the language of the area in which the issuer's operations were located. However,
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the Board's inspection staff concluded that the U.S. registered firm's involvement in the audit
work performed by the consultants was insufficient for the firm to assert that the audit provided a
reasonable basis for the firm's opinion on the financial statements. The Alert describes some
key considerations in determining the appropriate level of the firm's involvement in audit work
performed by assistants from outside the firm, for example:
“whether the auditor has adequate information about the knowledge, skill and
ability of assistants engaged; whether the auditor is able to plan and supervise the work
of the assistants engaged; whether the auditing procedures performed by assistants from
outside the firm in combination with the auditor's own work provides sufficient
competent evidential matter for an audit opinion; whether the assistants engaged have
appropriate language skills; whether the auditor would have the ability to comply with
the Board's documentation requirements. In addition to these considerations, the Alert
reminds auditors about other obligations under the standards of the PCAOB when
engaging assistants from outside the firm.”
III. Are Chinese reverse merger firms inherently toxic?
The study, led by Charles Lee, professor of accounting at Stanford Graduate School of
Business, found that, although accounting integrity and corporate governance problems with
Chinese firms are well documented, a number of other economic factors could favor the pool of
CRMs listed in the U.S. First, rapid development of China’s economy has given rise to many
promising start-ups. Second, until recently, private equity and venture capital funds are
relatively scarce in China, leaving many entrepreneurs in want of capital. Over the past decade,
IPO-eligible firms in China have far outnumbered the actual firms allowed to IPO each year.5
These factors suggest that CRMs could derive from a relatively high quality candidate pool. In
short, despite the negative publicity generated by highly salient anecdotes, the overall quality of
the CRMs is an open empirical question.
Interestingly, the better performance of the RMs is largely due to CRMs. At the beginning
of their public life, CRMs have higher market capitalization, lower leverage, higher profitability,
and more positive operating cash flows than U.S. RMs. Over the next three years, CRMs
continue to fare better than either their U.S. counterparts or a group of
exchange-industry-date-size matched firms. The CRM advantage is multi-dimensional, and is
evident in terms of: profitability, current ratio, book leverage, operating cash flows, upward
mobility in exchange tiers, percentage of firms with qualified audit opinions, survival rate,
Using data collected by China’s National Bureau of Statistics (NBS), Piotroski and Zhang (2012) assemble a
sample of non-public Chinese firms that are ex-ante qualified to engage in an IPO on China’s stock exchanges. In
China, all industrial companies with sales of more than RMB 5 million are required to report their financial data to
the NBS via a standardized set of financial forms. Their sample of “exchange eligible firms” consists of 28,152
firm-year observations over the period 2001 to 2008, where the underlying non-public industrial firm was
financially eligible to engage in a Chinese IPO at the start of the calendar year. Of these observations, only 440 firms
subsequently engaged in an IPO offering in one of China’s two domestic stock exchanges.
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market liquidity, as well as stock returns. Contrary to popular media perception, the data shows
no evidence that CRMs are systematically more problematic than similar firms already trading
on the same exchange.
This picture presents the proportion of firms that moved up in terms of their exchange tier
(e.g., from Pink Sheet to OTCBB or NMS, or from OTCBB to NMS), or were acquired.
In the article, the writer split the sample of RMs between U.S. and China, he found that U.S.
RMs generally underperform their control firms, while CRMs generally outperform. CRMs are
healthier than U.S. RMs on Day 1 (they are larger, less levered, more profitable, less likely to
have a qualified audit opinion, and more likely to be at the Growth or Mature stage of the
business life cycle). Over the next three years, the two groups diverge even further in terms of
performance. While most (55.1%) of the CRMs either move up in exchange tier or are acquired,
only a minority (19.7%) of the U.S. RMs do so. The CRMs also outperform the U.S. RMs in
each of the next three years in terms of their profitability, cash flows, likelihood of receiving a
qualified audit opinion, survival rate, and changes in market liquidity. These improvements are
also reflected in future market returns, as CRMs generally outperform their control firms over
the next three years. He shows that most of this return difference is not attributable to
differences in exposure to the Chinese economy. When he uses a difference-in-difference
design, CRMs clearly outperform their U.S. RM counterparts. The results are robust to
multivariate controls for any residual differences in firm size and the cash flow life cycle stage of
each firm. Shell Games: Are Chinese Reverse Merger Firms Inherently Toxic?
Even though legitimate issues remain with the structural integrity of corporate governance
in Chinese firms, the study indicates that the current Sino-phobic reaction to CRMs is overblown.
The set of CRMs admitted to U.S. markets have performed well compared to matching firms
already listed on the same exchange. This is true even after accounting for the wave of negative
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sentiment against CRMs during 2011. Indeed, the findings suggest the problems identified in
the press are more appropriately attributed to risks endemic to the markets in which RMs reside,
rather than to issues specific to China, per se.
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