The big story in the China business/legal community this week is the back and forth between Muddy Waters and Sino-Forest (see here).I will reserve my comments on the specific situation until things develop further, but I will add my two-cents about something called a “Reverse Merger” or “RTO,” the corporate structure at the center of the Sino-Forest story.
A reverse merger is a process whereby a company — usually a small to midsized one– buys the corporate shell of a defunct American company trading as a penny stock and then offers a secondary offering of the shares premised on its own growth potential. By entering the American stock market through this “back-door,” you avoid the multi-year vetting process typically required of companies doing a more typical IPO. Various enablers, who usually have stakes in the success of this “new” company, spread word of the “newly” public company’s growth potential to drum up fresh capital through a secondary offering of stock.
These reverse mergers have become a popular way for Chinese companies to “go public” in the United States. However, a number of problems, including a lack of transparency in the RTO’s home country of China, as well as language, distance and cultural barriers make it difficult for investors to know exactly what they are getting.
Seeking Alphaexplains how easy it is for Chinese companies to secure doctored paperwork that overstates their profits:
Bank statements, confirmation letters and contracts of all types, government filings, ownership certificates and tax invoices are all paper documents easily forged by dishonest management with the help of a few dishonest bank and government officials…Dishonest management can keep turning paper into gold until investors decide the “paper” evidence of profits and growth are contradicted by the reality of the business.
As shown in this astonishing surveillance video, even a group of Rodman & Renshaw investors who took the time and expense to visit CBEH’s factory were easily fooled by management that simply staged production activity that day. Dozens of additional surveillance videos (see the same link) showed that prior to the Rodman investor visit the factory was not producing any biodiesel at all, despite management repeatedly publicly claiming the factory was operating at 100% of capacity.
Paul Gillis, on China Accounting Blog, explains how in China this type of fraud is likely to be perpetrated with the help of officials working in local branches of the “Big Four” banks, where oversight from the central headquarters is not as strong:
China MediaExpress (CCME) lost its auditor Deloitte and its NASDAQ listing in March. Deloitte resigned after raising issues related to the reliability of the bank confirmation process, among other things. Deloitte had requested that the bank confirmation process be re-done at the bank’s head office. The company apparently refused, leading to Deloitte’s resignation. This appears to indicate that Deloitte could not trust the confirmations signed by branch offices of the bank, suggesting that the process was corrupted in some way. I would agree with Deloitte’s assessment that the bank headquarters would not participate in perpetuating a fraud, and it appears management knew that too and that is why they refused to agree, even though it likely doomed the company.
Many in the investment/legal community view China RTOs with open disdain. As Scott Eden points out in an excellent piece in The Street, called, “SEC Probes China Stock Fraud Network“:
Reverse mergers are perfectly legal in the U.S., and have been used in the past to give birth to solid public companies, including the parent company of the New York Stock Exchange itself. If there is a flaw in the process, the flaw is that it allows stock manipulators to circumvent regulatory scrutiny.
Investors buying stock in Chinese-owned RTO corporations are opening themselves up to the possibility of purchasing stock in a company that has circumvented the system twice; once in China where it inflated its price through fraudulent bank valuations, and then again in the US where domestic enablers inflated its price through hype based on inaccurate or even blatantly invented information.
If the RTO is “a lemon,” or worse, a fraudulent lemon, investors are hard pressed to get their money back because of the inherent difficulties of doing business with Chinese companies.
How can this China RTO mincing machine be stopped, or at least regulated?
Paul Gillis advocates for systemic change on the China side:
China’s banking industry is dominated by four large state-owned banks, known as China’s Big Four. They are assuming considerable risk from the illegal and unauthorized confirmations and false statements being provided by branches. These banks need to put in control systems and training to try to put a stop to these activities. It is in their own interest to do so.
But there may be a more effective way to deal with this. I call for the Big Four accounting firms, the Big Four banks and the CICPA to get together to work out a system for online confirmations. The Big Four has the expertise, and ought to also have a ton of self-interested motivation to get this fixed. An online confirmation system would allow auditors, after receiving client permission, to confirm bank balances online from the headquarters database of the banks. This process would add significant integrity to China’s financial system.
Peter Fuhrman points out how greater oversight on the American side could go a long way towards protecting both investors and the good Chinese companies in danger of being defrauded by mincing mills:
The US government is finally beginning to evaluate the damage caused by this “mincing machine” that takes Chinese SME and arranges their OTCBB or reverse mergers. According to a recent article in the Wall Street Journal, “The US Securities and Exchange Commission has begun a crackdown on “reverse takeover” market for Chinese companies. Specifically, the SEC’s enforcement and corporation-finance divisions have begun a wide-scale investigation into how networks of accountants, lawyers, and bankers have helped bring scores of Chinese companies onto the U.S. stock markets.”
In addition, the US Congress is considering holding hearings. Their main goal is to protect US investors, since several Chinese companies that listed on OTCBB were later found to have fraudulent accounting.
But, if the SEC and Congress do act, the biggest beneficiaries may be Chinese companies. The US government may make it harder for Chinese companies to do OTCBB IPO and reverse mergers. If so, then these Chinese firms will need to follow a more reliable, tried-and-true path to IPO, including a domestic IPO with CSRC approval.
In the meantime though, investors should take precautions by doing due diligence on any China-based companies or stocks in which they wish to invest. Investors should seek out parties who are non-players in the RTO investment game to investigate a Chinese RTO and the network of investors, auditors and lawyers that facilitated the stock listing.
You have been warned.
