Genesis of the China Phenomenon

Starting around 2003, China began to relax its rules, making it easier to allow foreigners to own a controlling interest in a Chinese company. This allowed ultimately hundreds of Chinese SMEs (small and medium‐sized enterprises) the chance to go public and raise money in the United States. It had only been since the late 1970s that any private ownership of businesses was permitted in China.

The government surmised, in furthering its development of a “market economy,” that encouraging foreign investment into the country would be good. The savings rate among Chinese individuals had not been high, and their ability to invest in growing companies was extremely limited. They traded this ceding of local control of these companies for a new influx of capital.

China's State Administration of Foreign Exchange (SAFE) issued a series of rulemakings starting around 2005 ultimately requiring local registration of all deals with foreign special‐purpose vehicles such as shell companies. In 2006 they made it tougher for foreigners to acquire companies in certain sensitive industries or that included a well‐known Chinese brand. They also required much more scrutiny of larger deals, generally with a value in excess of $125 million. Very few reverse mergers were larger than that at the time. There also were at times limitations on the amount of funds that could be taken out of China at one time.

The flurry of regulations continued through 2008, often requiring practitioners to pivot mid‐deal and restructure things to comply with changing rules. Terms such as the slow walk and the SINA model mattered then but sadly do not now. A contingent of U.S. lawyers, accountants, and investment bankers focusing heavily on this bubble kept close tabs on the regulatory environment working with Chinese‐based players. Many of these American dealmakers found themselves making the arduous journey to China almost every month. I made seven trips myself during this time.

There were real challenges in completing Chinese reverse mergers, including due diligence, language and cultural barriers, and the financial audit. With very few exceptions, American attorneys and auditing firms had to rely on assistance from Chinese attorneys and accountants. My firm, for example, had no way to independently confirm if a Chinese company was validly existing, or if a particularly important contract was proper and enforceable under Chinese law. We took guidance from Chinese lawyers on these subjects.

Does the company really own the assets it says it does? Do we really understand all its liabilities? Are its bank balances proper? U.S. auditors did not have it easy to confirm these things, not to mention that Chinese accounting principles differ markedly from the United States.

Chinese business culture also tends to resist disclosure. This does not mean the company has done anything improper. The “lift‐the‐veil” comprehensive disclosure system in the United States did not come naturally to many Chinese executives. Instead of asking a company to simply tell us everything, specific questions were needed to which they would provide specific answers. Dealmakers developed approaches to ensure a belief that there was indeed full compliance in due diligence and disclosure.

Most active U.S. players in the space employed Mandarin‐speaking attorneys, accountants, and investment bankers to work on their transactions. Still, it was better when at least one key person in the Chinese company spoke English. Too many things would get lost in translation, or a hired interpreter would “summarize” a ten‐minute back‐and‐forth conversation in 30 seconds. This was a challenge for sure.

The Chinese business culture also is very different from the United States, as Chinese are very plodding in making key decisions. They tend to examine an opportunity or issue from all different angles before making a commitment. As I noted in the 2009 book, if Americans are indeed cowboys (and cowgirls, of course), Chinese businesspeople are more the “Whoa, Nelly!” type when looking at business deals. This can make it a little frustrating at times for get‐it‐done‐type American dealmakers. That said, the Chinese were extremely welcoming and genial hosts to their American guests.

Despite these challenges, over 300 Chinese reverse mergers were completed. Many followed a common path: (1) Combine with a shell, (2) raise $X in a private placement at the same time as the combination, and then (3) file shortly thereafter for a $5X public offering and application to a national exchange. Investment bankers perfected this approach that allowed the company to raise meaningful cash quickly at the time of the merger, and then complete a “secondary” public offering and list the stock on an exchange.

The X above was usually around $3–5 million, so the 5X was usually around $15–25 million. Some were larger. These numbers will become important when we examine the impact of the seasoning rules ahead.

My conclusion in 2009 was that the China outlook was good. To show you how wrong I can be, it is worth reprinting the last few paragraphs of my China chapter in 2009:

My two cents: The China phenomenon is exciting. I have enjoyed being a part of it. Much like other stock market bubbles, such as the Internet boom, at some point the valuations will come down to earth, and to some extent that has already begun to happen. But that does not mean that companies in China will stop wanting to be public. Even though Internet stocks crashed, the Internet as an industry continued to thrive, especially after the Google IPO several years ago.

As long as the Chinese government allows it, and we all work hard to keep the charlatans from taking advantage of the challenges in these transactions, Chinese reverse mergers appear to be here to stay.

Allegations of Fraud

Things began to unravel in 2010, not long after I published the passage above. An article on TheStreet.com in December of that year reported, “The Securities and Exchange Commission is investigating allegations that U.S. firms and individuals have joined with partners in China to steal billions of dollars from American investors through stock fraud, according to people familiar with the probe.” The same article noted that three Chinese companies already were facing investigation at that point and included reviews of a dozen more that faced other challenges and suits.

The article further noted that the SEC was targeting U.S. investment banks, auditors, law firms, and stock promoters. One challenge the regulators had was obtaining jurisdiction over alleged bad players based in China, so they were focusing on American players. At the time, some of those U.S. dealmakers were quoted as saying the allegations were overblown and involved only a few companies. Even if the ultimately 30 or so companies that faced allegations and class action lawsuits all were guilty, that would still suggest over 300 Chinese companies that went public in the United States faced no such allegations at all.

None of that mattered of course; the appearance was everything. The alleged fraud took one of several forms as has been discussed. One, simply, was the CEO stole everything and had disappeared. Cash or other assets were gone and no one could locate the founder.

The next form of alleged fraud suggested that Chinese executives bribed employees at their local bank branch. The employee could not easily change opening or closing balances on accounts, but could manipulate everything in between, allegedly creating a false increase in both revenues and expenses, making companies look bigger. Following this, auditors seeking confirmation of Chinese bank balances obtained it only from the bank's headquarters, but the damage was done.

Yet another method Chinese companies allegedly used to defraud investors was in the reconciliation of their financial statements to American accounting principles. In a number of cases it appeared that the financial statements filed with the Chinese tax authorities were different, even when adjusted, from those filed in the United States with the SEC. Some quietly noted that the penalties for filing a false tax return in China are extremely low, and companies therefore feel incentivized to cheat on their Chinese tax returns to lower their tax burden.

A number of these financial statement cases ended up dismissed or withdrawn. To succeed, plaintiffs had to prove first that the financials were indeed different after reconciliation, which was hard enough. Then, if they overcame that hurdle, they had to prove that the incorrect financials were the ones filed with the SEC as opposed to the ones filed in China. This, plaintiffs found, would be very difficult to prove.

Another alleged ploy suggested that Chinese companies claimed they had important and valuable contracts that either did not exist or were not legally binding. Other suggested bad behavior involved hiding the involvement of certain particularly questionable U.S.‐based players who were either secretly controlling companies or indirectly owning stock that should have been but was not reported.

Who Was Responsible?

The authorities and plaintiffs' attorneys, going after the U.S. players who put these deals together, asked: Where was the due diligence? Were you only focused on the payday and did you do nothing to confirm these companies were real? If these companies did proper IPOs, they would have been more careful. That is what they said.

What more, however, could American investment banks, lawyers, and auditors have done if these allegations were true? And would it have been different in an IPO, considering so many of these companies indeed completed full underwritten public offerings following their reverse mergers in which full and careful due diligence generally is the same as in an IPO?

Take the example of the allegation of different financials filed for tax purposes than in the United States. Is it really the responsibility of auditors of U.S. public companies to check the tax returns and filings in their home countries? Most auditors I have spoken to believe it is not.

The bribing of the bank employee, if it happened, also is problematic to uncover. When an official letter from the actual bank that is holding company funds is delivered to the U.S. auditors confirming the balances and transactions during a month, would any reasonable auditor (before all this) really wonder if the bank branch employee phonied up the official letter?

When a CEO orders the transfer of company assets to his personal account but the accountants do not discover that until afterward, frankly there would have been no realistic way for them to have done otherwise. Auditors do not have access to every bank transaction as it occurs. They take financial statements prepared by other accountants and then come in and check things. If a contract turns out not to be enforceable, or not to be real, the U.S. attorneys representing the company would not have had responsibility to confirm that other than to ask their Chinese counterpart to do so.

Not really any of this was something that traditional investment banks in an IPO would have been responsible to check. They do business and financial due diligence but rely heavily on the auditors with regard to financial issues. It is not their job to check if a contract is legal or if the bank balance is right or if the company files things properly with the Chinese tax authorities.

Early on in this mess, a particularly active auditing firm discovered the “bribe the bank employee” problem and immediately (and rather publicly) resigned from four public Chinese clients. All four happened to have been taken public by the same investment banking firm, also very active in China deals. Both of these firms were, in your humble scribe's opinion, unfairly vilified and thus began the finger pointing.

In the end, while no one I am aware of has completed a thorough analysis, it appears that the 30 or so cases brought in 2010 and 2011 were all either settled (in many cases with insurance) or dismissed or led to the dissolution and liquidation of certain companies. It appears that most of these companies did not think it wise to spend years in litigation leading to a trial.

The damage, however, had been done. The public valuations of all the post–reverse merger Chinese companies plummeted. A number of them went private and gave up their public status. Zero new deals were completed. It was over. It is important, however, to go through this analysis, though it would now seem moot, because it is the hysteria that followed, implying that greed on behalf of U.S. dealmakers overtook care when it is not at all clear that was the case, that led the SEC to pass the seasoning rules that effectively all but ended reverse mergers.

The responsible parties, assuming the truth of the allegations (remember only a few companies actually admitted any liability), were the fraudsters themselves. For good or bad, smart criminals sometimes get away with it despite normal safeguards. In this case, again assuming the truth, they did not, ultimately. Most of the U.S. parties involved in these deals were experienced, diligent, and yes, careful practitioners. Unfortunately, their need to rely on Chinese confirmation of what ultimately turned out in some cases not to be true made it more difficult.

The Rules Are Adopted

In June 2011, Nasdaq floated its seasoning rule proposal. The NYSE (along with the NYSE American exchange, then known as NYSE Amex) followed with theirs in August 2011. The concept would be to require companies merging with shell companies to season on the over‐the‐counter markets for a certain period before being permitted to apply to uplist to a national exchange.

The justifications offered as to why these actions were necessary were these: According to the NYSE proposal, it was (1) allegations of accounting fraud, (2) suspension of trading or registration of some reverse merger companies, (3) an SEC enforcement action against an auditing firm involved with reverse mergers, and (4) the issuance of an SEC bulletin on reverse mergers.

The Nasdaq proposal added a few more reasons, including: (1) concerns raised that certain promoters have regulatory histories or are involved in transactions that are “disproportionately beneficial” to them, (2) the PCAOB has cautioned accounting firms having “identified issues” with audits of these companies, and (3) Nasdaq's being aware of situations where it appeared that efforts to manipulate prices took place to meet Nasdaq's minimum price.

The proposals suggested that seasoning would be the best response to this because it could provide greater assurance of reliable reporting, time for auditors to detect fraud, the ability to address internal control weaknesses, and time for market and regulatory scrutiny of the company.

The proposals differed a bit from each other and from the final approved rules. In the end, the exchanges adopted, and the SEC approved, virtually identical seasoning restrictions in November 2011. In each case, a post–shell merger company must season on a market other than the larger exchange for at least one full fiscal year of the company (and file its annual report on Form 10‐K with the SEC for that year). In addition, the stock must trade for a sustained period at the minimum level required to list before uplisting, and a “firm commitment” underwritten public offering with gross proceeds of at least $40 million allows a company to bypass seasoning on any of the three exchanges. In addition, SPACs that trade over‐the‐counter would also be subject to seasoning after they complete reverse mergers.

Reaction to the Rules

A few months after the rules were adopted, in March 2012, I published commentary on this development in the Harvard Business Law Review. To summarize, I questioned both the basis of why restrictions were needed and challenged the notion that seasoning would somehow reduce or address these issues. At the time I also was working with Congress on the new JOBS Act and Title IV. But we had no idea whether it would pass and if so whether the new Reg A+ would catch on.

The seasoning restrictions clearly were a direct response to the allegations of fraud in Chinese reverse‐merged companies. A number of those companies, however, did not even go public through reverse mergers. For example, Longtop Financial, whose underwriter was Goldman Sachs and the auditors Deloitte, did a traditional IPO. Longtop was accused of bribing their bank to create phony cash balances. My argument: Reverse mergers did not create or make easier any fraud.

I further noted that trading suspensions do not imply fraud. Companies completing reverse mergers are generally earlier stage. Some do not succeed, run out of cash, and cease their SEC filings, leading to these suspensions. As to the questionable backgrounds of promoters, I argued that the exchanges already have broad discretionary authority to examine the regulatory histories of and financial arrangements made with these individuals. In any event, it was unclear to me how seasoning would reduce the risk of this problem.

It also seemed that imposing these restrictions in part because the SEC issued a bulletin warning people about reverse mergers and the PCAOB had identified issues with reverse merger audits was not sufficient substantive support for this extreme reaction. Further, the fact that there had been one enforcement action against one auditing firm does not suggest any sort of systemic problem.

It further made no sense to me that both the NYSE big board and its smaller sister, the NYSE American, imposed the same minimum $40 million offering amount to bypass seasoning given that all other listing criteria are lower on NYSE American than on NYSE. I suggested $15 million might be sufficient for NYSE American.

In sum, I felt that, unlike in the 1980s when fraud was indeed rampant in the reverse merger space, here the alleged fraud took place, if at all, in a narrow and potentially severable corner of the space, and where the same alleged fraud may have occurred in IPOs and transactions where full public offerings took place.

Our entreaties fell on deaf ears. I submitted a formal proposal to the SEC to make some changes. When I ran into a senior SEC staffer at the 2012 Conference and reminded the official that I had sent the letter, the response was, “Well, this really just isn't the time for anyone to go to the Commissioners and say we want to help people with shell companies.” And that was pretty much that.

Aftermath of Adoption of Seasoning Rules

Surprisingly, the new rules did not completely end reverse mergers. It did mean the end of the very successful model of merger and PIPE followed immediately by a $15–25 million public offering and exchange listing. Most reverse merger candidates simply are not big enough to attract a $40 million public offering to bypass the seasoning speedbump.

As previously noted, however, two buckets of deals continued undeterred as we will discuss in more detail in the next chapter. First were companies that had no problem starting their trading in the over‐the‐counter market. The second group of companies, almost entirely in the life‐sciences space, were large enough in value to complete that $40 million public offering and bypass seasoning.

Two other interesting developments also followed. First, some of us noticed a drafting error in the seasoning rules, which only applied after a merger with “an SEC reporting shell company.” A number of shells, however, trade on the OTC Pink market and are non‐reporting. One assumes the SEC did not mean to intentionally exclude them and allow companies merging with non‐reporting shells to freely uplist, but the words are very clear. When I queried an SEC staffer about it, the unofficial answer was, “I guess it says what it says.”

It took some effort but Nasdaq did agree to do one deal this way and let a company (Lipocine Inc.) uplist and trade in March 2014 after a reverse merger with a non‐reporting shell in July 2013. A few months later the SEC apparently got wind of this and the word came down: There will not be a second deal done this way. The rules were not changed but it was clear the exchanges simply were not going to allow it going forward.

A more interesting development involved more interest in private companies merging with smaller public operating companies that are not “checking the box” as a shell company. These mergers generally would be exempt from the seasoning restrictions. The rules do, however, have interesting language stating that the exchange has the right to consider a very small operating company as the equivalent of a shell company for purposes of seasoning even if it does not technically qualify as a shell under SEC rules.

A number of companies have, however, now successfully completed reverse mergers since the adoption of seasoning and promptly uplisted because their reverse merger was not a shell merger. This was problematic as will be discussed ahead since questionable so‐called “footnote 32 shells” were used in some of these deals. As noted previously, these are apparently operating companies taken public and commencing trading with an undisclosed intention immediately to find a merger candidate and spin off or shut down the business operations.

Some reverse merger deals, therefore, continue to be completed despite the challenges of the seasoning rules.