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Anh Hoang
Anh Hoang
Articles (264)  | Author's Website |

Reverse Mergers: A Short Guide for Chinese Firms to U.S. Investors

August 04, 2011 | About:

Recently, Reuters has published the special report on Chinese short-cuts to Wall Street by doing the backdoor IPO or reverse merger. Originally there were two guys named Timothy Halter and Zhihao John Zhang who brought two Chinese companies who made power steering systems and manufacted vitamins and weight loss supplements to U.S. market, called Tiens Biotech. Then it created the boom for reverse mergers, and their main clients are Chinese. According to the report, more than 400 Chinese companies have caught this opportunity.

Reuters has examined around 122 cases of Chinese reverse mergers in the U.S., the rise and fall of their stock market price, then compared this with their peak price. The day of July 10, 2011, they saw the total $18 billion market capitalization had totally disappeared. The majority of them had auditing issues and compliance issues. From March this year, around 30 Chinese companies’ auditors resigned and around the comparable number were delisted from the U.S. exchanges.

The reverse merger is the scheme that used the “shell” companies, which have no operating business (no core, just cover), and those “shells” would be used to be the acquirer of Chinese operating business. Reuters has explained how the reverse merger has been done: A deal would start from the shell broker. The broker then acquires the shells, which were domiciled in friendly states like Delaware, Utah or Nevada. Then the broker sells the shells to an operating company which would like to be listed in the U.S. exchange. The acquirer would be automatically the publicly-trade company, which would be accessed immediately to U.S. investors without much scrutiny. The buyer of the shell normally based in a tax heaven country, and controls the operating business in China. That is why when I dig into the annual report or prospectus of U.S.-listed Chinese companies, I find the corporation holding metrics and the acquisition metrics quite complicated.

According to the PrivateRaise, one in three U.S. reverse mergers are Chinese. Currently there are around 1,200 dormant public companies in the U.S., and they can be sold as cheaply as $30,000. When the broker resells them, the cost might be as high as 10 times that amount. In 2007 and 2008, high-quality shells could be bought for $800,000 by Chinese customers.

The most important issue for U.S.-listed Chinese companies is the accounting issue. In order to be a reverse merger, the acquirer has to hire an auditor registered with the Public Company Accounting Oversight Board (PCAOB). In the U.S., the PCAOB reviews small auditing firms only once every three years. Reuters has given one example of the small firm CBN, led by Todd Chisholm to audit Hendrx. According to their SEC filings, Hendrx (HDRX.OB), the maker of devices that purify, filter and generate water from moisture in the air, didn’t make money and is being sued for alleged contractual fraud and patent infringement.

However, Todd Chisholm gave the company a clean bill of health, even questioning the capability of the company's going concerns. Then the PCAOB found the audits to be grossly inadequate. The auditor had used non-experienced native Chinese in the audit period. The result is the company once worth $37 million at its boom, now stays at less than a penny in the OTC.

And above is just the case for a small auditor. Even with one of the big four, KPMG with ShengdaTech company where Goldman Sachs (NYSE:GS) held 7.6%, the auditor resigned in April as there were serious discrepancies in its bank statements and representations of customers. Or ChineAgritech, held by Carlyle Group, was delisted from Nasdaq in May, after a short seller noticed the company’s factories idle and suppliers non-existent.

I was personally involved with several positions in U.S.-listed Chinese companies; there was a medical firm, two mobile producing firms, and one noodle maker company. When I look at the operating history, the financial ratios and the balance sheet, everything looked very good, and those were trading at very low multiples. So if any value investor looks at a profitable business but it is trading below net working capital, he/she would get very excited. In some cases, the profit has been deterioratinged, and in some other cases, the profit is still very good but the share price keeps falling down. It might indicate a further increasing margin of safety, or the fraud hasn’t been discovered yet.

The link of Reuters’ report can be found here.

About the author:

Anh Hoang
Money manager in global equities, especially in U.S. and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam.

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