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Thursday, June 9, 2011

SEC Commissioner's speech on capital formation - discusses Chinese RTO's

SEC Commissioner Luis Aguilar speech on capital formation where he discusses the abuses of reverse mergers and specifically the Chinese reverse mergers.  The link to the full speech is here.


Certain Foreign Companies Abusing U.S. Capital Formation Process

With that foundation, I would like to highlight a disturbing trend that seems to have challenging implications for capital formation and investor protection. 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.
There are a lot of different ways for companies to access the public markets, but not all of them are equal. They differ in the quality of the disclosures, the time investors and the SEC typically have to consider them, and the protections that investors have against false and fraudulent statements.
The traditional IPO remains the gold standard. In a traditional IPO, the SEC and the public receive robust disclosures, along with the time to review and consider them, backed up by real liability that puts the risk of false statements on the people in the best position to ensure accuracy, not on the investors. In addition, underwriters and auditors engage in due diligence which enhances the disclosure quality.
Another way to access the public markets is Exchange Act registration of a class of securities, rather than through registration of a public offering. For example, when the company reaches a certain size and has a class of equity securities that is considered widely-held because of its number of shareholders, it is required to provide public disclosures. However, unlike a traditional IPO, there is no underwriter performing due diligence.
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.”27 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.28 Notwithstanding the SEC rulemaking of a few years ago to respond to abuses involving shell companies,29 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.30
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.31 One of these companies had to restate its earnings and was delisted just last week.32 The other has admitted that at the very least two of its manufacturing contracts didn’t actually exist.33 Just last Friday, the SEC suspended trading in another Chinese company that became public in the United States through a shell.34 This was the second SEC trading suspension imposed on Chinese companies in this situation in the month of March alone.35 Additionally, NASDAQ and NYSE Amex have recently suspended trading in several of these companies.36
I support all of the efforts to address these problems. The SEC staff has been working collaboratively and tirelessly with many others to investigate and shed light on this situation. It has been widely reported that the SEC set up an internal task force to investigate fraud in overseas companies with listings on U.S. exchanges, with particular emphasis on companies engaging in these mergers to achieve backdoor SEC registration. The staff’s hard work has yielded, and will continue to yield, results.
In the world of backdoor registrations to gain entry into the U.S. public market, the use by Chinese companies has raised some unique issues, even compared to mergers by U.S. companies. Two important ones are:
  • First, there appear to be systematic concerns with the quality of the auditing and financial reporting; and
  • Second, even though these companies are registered here in the U.S., there are limitations on the ability to enforce the securities laws, and for investors to recover their losses when disclosures are found to be untrue, or even fraudulent.
I am worried by the systematic concerns surrounding the quality of the financial reporting by these companies. In particular, according to a recent report by the staff of the Public Company Accounting Oversight Board (PCAOB), U.S. auditing firms may be issuing audit opinions on the financials, but not engaging in any of their own work.37 Instead, the U.S. firm may be issuing an opinion based almost entirely on work performed by Chinese audit firms. If this is true, it could appear that the U.S. audit firms are simply selling their name and PCAOB-registered status because they are not engaging in independent activity to confirm that the work they are relying on is of high quality. This is significant for a lot of reasons, including that the PCAOB has been prevented from inspecting audit firms in China.
Moreover, the PCAOB noted that these issues were layered on top of other factors that may have a negative impact on the audit, including:
  • The need to understand the local language;
  • The use of local audit firms or personnel from an outside audit firm to complete a portion of the audit work;
  • Additional travel time and expense; and
  • The need to understand the local business environment in which the client operates.
An additional problem with these backdoor registrations is that there may be difficulty in prosecuting violations. Enforcement against falsehoods in the context of these companies is difficult. The documents and people who have the information about the company and whether there was misconduct are often outside the reach of subpoena power. However, notwithstanding these obstacles, our staff is committed to doing everything they can with the resources we have. The SEC has already brought cases and will continue to do so.
Nonetheless, investors should still be aware that the SEC and private plaintiffs may have a more difficult time enforcing their remedies and that recovery for investor losses could be limited. For one thing, the persons to punish and the assets that could satisfy a judgment may be located outside of the United States and harder to access. In addition, remedies obtained in the United States may not be enforceable in foreign countries, where the bulk of the assets might reside.
The consequences of the growing problems in this area has real significance, because it has been reported that billions of U.S. savings and investment dollars have been entrusted with these companies.38
Finally, and to return to our earlier topic of capital formation, it’s important to see the connection between capital formation and strong enforcement of securities laws. We have seen clearly that capital formation is improved with solid disclosures – but what happens when the disclosures are lies? That’s when we need strong enforcement. Capital formation is strengthened when investors have confidence that the laws will be obeyed and that, when they’re not, that the fraudsters will be made to pay. Moreover, strong enforcement – by providing deterrence - helps to ensure the disclosure is truthful and complete in the first place. Where savings and investments are allocated under inadequate or false information the environment for capital formation is negatively affected. That is why I’ve been a consistent advocate for a robust enforcement program and an adequately funded SEC. My hope is that potential fraudsters are scared into telling the truth to avoid the consequences.

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