Sorting Through the Chinese Reverse Merger Debacle

Watching the headlines about Chinese reverse mergers could really turn a potential investor off the idea of owning part of a company that took advantage of that shortcut to trading on the public market. The SEC recently issued a broad warning about investing in companies that went public through this process, but it’s nothing that we didn't already know.

I want to use this piece as a jumping-off point for a discussion on this ordeal with the great minds here on Investor Uprising. My underlying belief is that, from the company’s perspective, going public via a reverse merger is much more advantageous than an IPO, and is simply a misunderstood process.

A reverse merger (also known as a “reverse take-over,” or RTO) occurs when a private, actively operating company (Op Co.) is acquired by an inactive, “worthless” shell/holding company (Hold Co.) that is currently listed on a public exchange. Hold Co. then typically changes its name to reflect its new operations unit (Op Co.). Ownership and control of Hold Co. is usually transferred to the previous owners of Op Co. Additional shares are then issued and purchased by new investors, achieving the desired cash influx for Op Co.

Reverse mergers are by no means unique to Chinese companies, but exposed fraudulent activity -- more easily masked by this low-barrier method of going public -- has been focused on Chinese firms lately.

The advantages for a company to take this route versus an IPO are none other than our friends Time and Money. US IPOs can take a year or more before the company sees any additional investment, and listing on a Chinese exchange takes more than two years, whereas a reverse merger could be finished within 30 days. This timing is essential for growth companies that need to stay ahead of the curve. IPOs are also far more expensive and are, in many cases, prohibitively expensive for smaller firms.

What does the extra time and money of an IPO buy us as potential investors? More due diligence, for sure -- more parties are involved with and responsible for an IPO than a merger. On the flip side, the majority of an investment bank’s profitability from an IPO is based on its promotion and marketing skills -- how much it can hype up the stock. We would almost certainly pay more for a share of stock through an IPO than through an RTO, based on those economics alone.

So if the typical RTO is for a smaller, time-crunched, less-scrutinized firm, I would expect a higher company failure rate based on the risk that those elements imply. But really, we just need to do our own due diligence (arguably more so than a larger, more popular company with a consistent track record) to properly evaluate the company.

Here are a few key items I pay attention to when I evaluate a Chinese RTO stock, essentially my checklist for legitimacy.

1. Auditor credibility: Small, inexperienced CPA firms throw up a red flag for me. I understand the company might not be able to afford an audit from the Big 4, but I’d like to see some credibility, size, proximity, resources, and experience in the firm hired to conduct due diligence and verify the accuracy of the financials. If an auditor resigns because of an inability to rely on management information, as in the China MediaExpress Holdings Inc. (CCME.PK) case, I would walk away. Auditor churn is also a red flag -- I look for consistency here.

2. Analyst coverage: Has an independent party with experience in the industry thoroughly analyzed and formally recommended the firm? A great example of this is the company I recently recommended, Guanwei Recycling Corp. (Nasdaq: GPRC). (See: Recycling Opportunities in China.) Joe Giamichael of Global Hunter Securities initiated coverage of the firm last year. You can read his full write-up and brief plug on The Street.

3. Trading volume: Is there enough daily volume in the stock so that my transaction would be a mere blip on the radar? If there is no liquid market for the security, I won’t trade it.

4. SEC versus SAIC reporting “fraud”: For some reason, it seems that this is a huge, hot-button issue, but from what I’ve gathered, it’s actually pretty simple. SEC filings are audited and are in compliance with Sarbanes-Oxley, if the auditor is registered with the Public Company Accounting Oversight Board. So to claim they are fraudulent is a serious accusation against the auditor as well as the company. The SAIC is not in charge of taxes in China. It’s similar to the Secretary of State, which handles business registry.

Taxes are filed locally with the SAT, and those numbers are not publicly available. The accuracy of SAIC reports is not taken seriously and given no weight in China. There is little incentive for a company to put any effort into these reports. Chinese accounting rules are also different; one of the major differences is that wholly-owned subsidiaries (which is the case for almost all RTOs) report separately from their parent (shell) company, so the SAIC filing for a shell company should report substantially different numbers than on a 10-K.

What do you look for in a young Chinese company? Obviously, there’s a market here that should not be completely shunned. So what do we need to do to separate the wheat from the chaff?