Over the past several months, US capital markets have seen a dramatic pattern of irregularities connected with a number of Chinese reverse merger (CRM) companies. Certain CRM companies, also known as reverse takeover (RTO) companies, have been buffeted by allegations of financial misstatement, fraud and other governance shortfalls. The result has been a significant loss of shareholder value, accompanied by a flurry of US government attention and enforcement.
What is a reverse merger company?
Reverse mergers are a long-established method for attaining public status. They are created when a non-listed company purchases a majority of shares in a largely dormant but still SEC registered company. By doing so, the private company in essence purchases the publicly traded status of the "shell." In recent years a number of Chinese companies have actively pursued this path. In the period from January 2007 to 31 March 2010, the Public Company Accounting Oversight Board's Office of Research and Analysis determined that out of the 603 reported reverse merger transactions, 159 of those involved mostly small-cap companies from China.
The attraction of the reverse merger strategy has been a greatly reduced time to the US capital markets for overseas companies, as well as a considerable streamlining of the traditional IPO process. Unlike a traditional IPO, in a reverse merger scenario there is no underwriter performing due diligence. This strategy has also been attractive to private equity investors, who perceive reverse mergers a potential shortcut to realizing greater value out of their China portfolio companies, presenting them to a US market eager for ways to tap into China market growth opportunities.
What risks have emerged related to CRM companies?
As with any shortcut, the benefits also come with potential risk. A hazard related to reverse mergers is that many companies that would benefit from the added scrutiny and transparency typical of the pre-IPO experience are not subject to such a process.
This lack of pre-listing examination appears to be a primary driver of fraud exposure with CRM stocks. Per media reports, at least 15 CRM companies have been subject to SEC inquiries and investigations in the past year, with that number growing by the week. The issues have not been limited to a particular sector or region of China, with recent cases involving the environmental technology, luxury goods, media and agricultural sectors, to name a few.
US stock analysts have estimated that lost market capitalization related to CRM fraud allegations may be in excess of USD $34 billion. This exposure is not only limited to direct investors in the companies but also indirectly to those investing in exchange-traded funds. The SEC has reportedly established a dedicated task force to conduct a wide scale investigation of CRM companies, as well as into the network of stock promoters, investment bankers, auditors and law firms who assisted these companies in the reverse merger process.
As of 31 March 2010, the PCAOB reported that the largest number of CRM companies –94% of the total, 97% of the total market capitalization –are audited by accounting firms that are scheduled to be inspected only every three years, or are not subject at all to PCAOB oversight. In December 2010 the SEC reached a settlement with one of the most active CRM audit firms and with one of its partners.
Getting to the real numbers
Beyond the obvious problems of alleged insufficient diligence and/or malfeasance on the part of those auditors and advisers currently under investigation, we note that even in the best of situations and with the best of intentions, detecting financial irregularities in small cap Chinese companies is a uniquely challenging prospect. Some of the auditing challenges include instances of:
- Collusion between local bank branches and company executives in the cash confirmation process
- Collusion between vendors / customers and company executives in the sales and purchase confirmation process
- Off book or underreported liabilities
- Questionable land use rights for physical facilities
- Widespread use of false tax invoices, or even legitimate substitute invoices used in collusion with external companies to obscure the true nature of transactions
- Round-tripping of payments to inflate revenues, using a network of undisclosed related parties
Schemes such as these raise the degree of difficulty for auditors, and if anything underscore the need to conduct the process of public listing with more diligence, not less. However, the lure of the China market and the "search for alpha" among investors has thrust a number of these companies onto US exchanges ill-prepared for the transparency that public listing requires.
How stakeholders can address CRM risks
To be sure, for every person involved in the reverse merger process who may have turned a blind eye to the risks existing with CRM companies, there is an institutional investor, an audit committee member or other stakeholder who was or continues to be unaware of their exposure. These stakeholders are now nervously contemplating a two-front liability, with motivated securities regulators on one side and the plaintiffs bar on the other.
What can well-intentioned stakeholders do to confront CRM risk? We suggest three modes of action to reduce the exposure:
- Assertive diligence: While the widespread alarm regarding the current universe of CRM companies has served to cool if not freeze the reverse merger pipeline, the reverse merger strategy will remain a legal and potentially attractive option for US listing for the foreseeable future. Equity investors, auditors and financial advisors can use this period of intense scrutiny of Chinese SMEs as an opportunity to demand more direct access to the books and records of investees, as well as more rigorous methods of financial due diligence and validation (including forensic due diligence techniques such as forensic data analytics and external inquiries).
- Crisis management: CRM audit committees, regardless of whether they are yet subject to formal investigation, are already flooded with the demands of unhappy investors, initial inquiries by the SEC, or the threat of class action lawsuits. The CRM issue has reached a tipping point which requires the governance structure of these companies (particularly independent boards) to develop a crisis management plan to address the controversy. Central to this process are three main objectives 1) gain better visibility into the company, 2) establish a credible and constructive line of communication with relevant regulators, and 3) anticipate and manage public / investor relations damage. The identification of the right advisory team (securities lawyers, forensic accountants, public relations consultants) at as early a stage as possible will help prevent a potentially tenuous situation from becoming a full scale emergency.
- Remediation: For those CRM companies that have not yet been touched by regulatory investigation or allegations of fraud, it is an opportunity to confirm initial understandings of the company's financial viability and the accuracy of books and records. This can be accomplished through targeted one-off audit testing, or procedures added to standard year-end audits. Audit relationships can also be re-evaluated or put to tender to ensure appropriate scoping and credentials. Private equity investors should consider this to be a strategy that will either provide their portfolio company with a cleaner bill of health or help identify and mitigate potential future issues.
It is clear that, given the number of existing CRM companies, the enduring attraction of the "China Market", and competition for deals within the China private equity sector, that the CRM fraud issue could be with us for the foreseeable future. It is then up to those who own and lead those companies to confront that reality –by understanding the risk, gathering the right team around them, and to take a proactive approach before the issue is beyond their control.
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