Monday, April 4, 2011
In a speech before the Council of Institutional Investors Annual Conference, SEC Commissioner Luis Aguilar addressed the investor protection problems presented by the recent trend of foreign private issuers going public in the U.S. market through the "back door" of a reverse merger. As explained by Commissioner Aguilar:
In recent years, we have seen a spike in private companies merging with a public shell company as a way of going public. While it is Chinese companies that have grabbed recent headlines, the problems coming to the forefront would not necessarily be limited to companies based in China.
A common but lesser known way of accessing the public markets is the reverse merger into a public shell, or where a public shell merges into a private company, a so-called “backdoor registration.” For those of you not familiar with these types of mergers, what typically happens is a private company seeking to go public merges with a public shell company. Before the transaction, the public shell company no longer has substantive operations, but its public company registration remains in effect. The transaction gives the formerly private company the credibility and access to capital of being registered as a public company, without any of the vetting from underwriters and investors that companies undergo when they perform a traditional IPO.
Since January of 2007, there have been over 600 backdoor registrations. Over 150 of these have been by companies from China and the China region. Notwithstanding the SEC rulemaking of a few years ago to respond to abuses involving shell companies, we are seeing increasing problems. While the vast majority of these Chinese companies may be legitimate businesses, a growing number of them are proving to have significant accounting deficiencies or being vessels of outright fraud.
As just one example of this phenomenon, two companies that were numbers 1 and 2 on the Investor’s Business Daily 100 have now been shown to have significant issues. One of these companies had to restate its earnings and was delisted just last week. The other has admitted that at the very least that two of its manufacturing contracts didn’t actually exist. Just last Friday, the SEC suspended trading in another Chinese company that became public in the United States through a shell. This was the second SEC trading suspension imposed on Chinese companies in this situation in the month of March alone. Additionally, NASDAQ and NYSE Amex have recently suspended trading in several of these companies.
Commissioner Aguilar went on to discuss recent findings by the PCAOB on audit concerns involving companies from the China region.