The following post was written by Damjan DeNoble. Damjan just completed his first year of law school at the University of Michigan and he will be clerking at Harris Bricken this summer. Many of you may already know or know of Damjan from his days managing the Kro’s Nest in Beijing and from his blogging at the Asia Healthcare Blog. Damjan will also be blogging a bit on mobile healthcare for Health Unbound.

By Damjan DeNoble

The big story in the China business/legal community this week is the accusations flying back and forth between Muddy Waters and Sino-Forest (see here, and here [link no longer exists], and here). I will reserve my comments on the specific situation until things develop a bit further, but I will add my two-cents about something called a “Reverse Merger” or “RTO,” the corporate structure at the center of the Sino-Forest story.

A reverse merger is a process whereby a company, usually a small to midsized firm, buys the corporate shell of a defunct American company still trading on the penny stock exchange, and then offers a secondary offering of the shares premised on its own growth potential. By entering the American stock market through this “back-door,” the firms avoid the multi-year vetting process typically required of companies doing a more typical IPO. Various enablers, who usually have stakes in the success of this “new” company, spread word of the “newly” public company’s growth potential to drum up fresh capital through a secondary offering of stock.

These reverse mergers have become a popular way for Chinese companies to get listed in the United States. However, a number of problems, including a lack of transparency in the RTO’s home country of China, as well as language, distance and cultural barriers make it difficult for investors to know exactly what they are getting.

In China, problems of transparency and language are especially acute, which should be no surprise for regular China Law Blog readers.

Writing for investor mega-portal Seeking Alpha, Alfred Little explains how easy it is for Chinese companies to secure doctored paperwork that overstates their profits:

Bank statements, confirmation letters and contracts of all types, government filings, ownership certificates and tax invoices are all paper documents easily forged by dishonest management with the help of a few dishonest bank and government officials…Dishonest management can keep turning paper into gold until investors decide the “paper” evidence of profits and growth are contradicted by the reality of the business.

Alfred goes on to link to a stark illustration of one such fraud operation in action (make sure to check out the video):

As shown in this astonishing surveillance video, even a group of Rodman & Renshaw investors who took the time and expense to visit CBEH’s factory were easily fooled by management that simply staged production activity that day. Dozens of additional surveillance videos (see the same link) showed that prior to the Rodman investor visit the factory was not producing any biodiesel at all, despite management repeatedly publicly claiming the factory was operating at 100% of capacity.

Paul Gillis, writing on his truly valuable China Accounting Blog [link no longer exists], further explains how in China this type of fraud is likely to be perpetrated with the help of officials working in local branches of the “Big Four” banks, where oversight from the central headquarters is not as strong:

You have to read between the lines a bit here, but the rash of scandals and auditor resignations related to the bank confirmation process indicate that some local bank branch personnel may have cooperated with the fraud.

China MediaExpress (CCME) lost its auditor Deloitte and its NASDAQ listing in March. Deloitte resigned after raising issues related to the reliability of the bank confirmation process, among other things.  Deloitte had requested that the bank confirmation process be re-done at the bank’s head office.  The company apparently refused, leading to Deloitte’s resignation.  This appears to indicate that Deloitte could not trust the confirmations signed by branch offices of the bank, suggesting that the process was corrupted in some way.  I would agree with Deloitte’s assessment that the bank headquarters would not participate in perpetuating a fraud, and it appears management knew that too and that is why they refused to agree, even though it likely doomed the company.

Three other recent cases illustrate that the problem is not isolated. China Century Dragon Media, Inc.’s auditor, MaloneBailey, resigned shortly after its IPO because the company was unwilling to provide authorization to the bank so that the auditor could obtain official bank records directly from the bank’s record keeping system. MaloneBailey resigned from another China client, China Intelligent Lighting and Electronics, Inc., citing accounting fraud including forged bank statements. It has not been a good audit season for MaloneBailey, who resigned from yet another U.S. listed Chinese company, NIVS Intellimedia Technology Group, Inc. because of “massive accounting fraud involving forging (the) Company’s accounting records and forging bank statements”.

It should be no surprise then that many in the investment and legal community view China RTOs with open disdain. This is not to say that RTOs are illegal. Rather, RTOs are shunned because they are underregulated. As Scott Eden points out in an excellent piece in The Street, called, “SEC Probes China Stock Fraud Network“:

Reverse mergers…are perfectly legal in the U.S., and have been used in the past to give birth to solid public companies, including the parent company of the New York Stock Exchange itself. If there is a flaw in the process, the flaw is that it allows stock manipulators to circumvent regulatory scrutiny.

In effect then, an investor buying stock in a Chinese-owned RTO corporation is opening herself up to the possibility of purchasing stock in a company that has circumvented the system twice; once in China where it inflated its price through fraudulent bank valuations, and then again in the US where domestic enablers inflated its price through hype based on inaccurate or even blatantly invented information.

If it turns out that the RTO is “a lemon,” or worse, a fraudulent lemon, investors are hard pressed to get their money back because of the inherent difficulties of doing business with Chinese companies. For more on China difficulties check out our previous posts on guanxi and on kickbacks for a sampling).

On the other hand, there are many strong Chinese companies entering through the so called RTO “mincing machine,” a phrase used by Peter Fuhrman, CEO of China First Capital and editor of the excellent China Private Equity blog, to describe the American industry that has sprung up around bringing Chinese companies to US-listed stock exchanges. Peter is of the mind that American RTO “mincing” machines are a bigger threat to Chinese businesses that go public through them than they are to American Investors:

In my experience, there is one catastrophic risk for a successful private company in China. Not inflation, or competition, or government meddling. It’s the risk of doing a bad capital markets deal in the US, particularly a reverse merger or OTCBB listing.  At last count, over 600 Chinese companies have leapt off these cliffs, and few have survived, let alone prospered. Not so, of course, the army of advisors, lawyers and auditors who often profit obscenely from arranging these transactions.

Not before time, the US Congress and SEC are both now finally investigating these transactions and the harm they have done to Chinese companies as well as stock market investors in the US.

He goes on to point out that while American companies that do RTOs are generally the weakest businesses in the American market, this is not true for Chinese companies. Rather, many Chinese companies are duped, more or less, by unscrupulous stock pushers in the US into doing an RTO stock listing, when in fact an IPO makes a lot more sense:

[M]y original reason for starting China First Capital over two years ago was to help a Jiangxi entrepreneur raise PE finance to expand his business, rather than doing a planned “Form 10” OTCBB.

We raised the money, and his company has since quadrupled in size…The likely IPO valuation: at least 10 times higher than what was promised to him from that OTCBB IPO, which was to be sponsored by a “microcap” broker with a dubious record from earlier Chinese OTCBB deals.

In general, the only American companies that do OTCBB IPOs are the weakest businesses, often with no revenues or profits…


The advisors who promote OTCBB IPO and reverse mergers always say it is the fastest, easiest way to become a publicly-traded company. They are right. These methods are certainly fast and because of the current lack of US regulation, very easy. Indeed, there is no faster way to turn a good Chinese company into a failed publicly-traded than through an OTCBB IPO or reverse merger.

How can this China RTO mincing machine be stopped, or at least regulated?

Paul Gillis advocates for systemic change on the China side:

China’s banking industry is dominated by four large state-owned banks, known as China’s Big Four. They are assuming considerable risk from the illegal and unauthorized confirmations and false statements being provided by branches. These banks need to put in control systems and training to try to put a stop to these activities.  It is in their own interest to do so.

But there may be a more effective way to deal with this.  I call for the Big Four accounting firms, the Big Four banks and the CICPA to get together to work out a system for online confirmations. The Big Four has the expertise, and ought to also have a ton of self-interested motivation to get this fixed.  An online confirmation system would allow auditors, after receiving client permission, to confirm bank balances online from the headquarters database of the banks.   This process would add significant integrity to China’s financial system.

Peter Fuhrman points out how greater oversight on the American side could go a long way towards protecting both investors and the good Chinese companies in danger of being defrauded by mincing mills:

The US government is finally beginning to evaluate the damage caused by this “mincing machine” that takes Chinese SME and arranges their OTCBB or reverse mergers. According to a recent article in the Wall Street Journal, “The US Securities and Exchange Commission has begun a crackdown on “reverse takeover” market for Chinese companies. Specifically, the SEC’s enforcement and corporation-finance divisions have begun a wide-scale investigation into how networks of accountants, lawyers, and bankers have helped bring scores of Chinese companies onto the U.S. stock markets.”

In addition, the US Congress is considering holding hearings. Their main goal is to protect US investors, since several Chinese companies that listed on OTCBB were later found to have fraudulent accounting.

But, if the SEC and Congress do act, the biggest beneficiaries may be Chinese companies. The US government may make it harder for Chinese companies to do OTCBB IPO and reverse mergers. If so, then these Chinese firms will need to follow a more reliable, tried-and-true path to IPO, including a domestic IPO with CSRC approval.

In the meantime though, investors should take precautions by doing due diligence of any China-based companies or stocks they wish to invest in by working with parties without a stake in the outcome of the investment. Investors should seek out parties who are non-players in the RTO investment game when they wish to investigate a Chinese RTO and the network of investors, auditors and lawyers who facilitated the stock listing. See our post from a few days ago, How to Really Really Investigate a Chinese Company.

Doing business with companies across the world is more than a gamble, it is a risk that can be rigged so as to have no possibility of reward and many China RTOs have been so rigged.

You have been warned.

  • Paul Anton Schittek

    Indeed, buyer beware.
    Companies looking to access the US securities markets via reverse merger and investors buying stock of companies that completed reverse mergers should be wary of the potential complications associated with such transactions.
    The reverse merger has been marketed as a cheaper and faster alternative to doing an IPO, which is not necessarily true. The law firms and financiers who advertise the reverse merger as such often overstate the value of a public securities listing in the US. They make it seem as though any company can get listed on NASDAQ, as opposed to simply languishing in the pink sheets. Some of these financiers post pictures of themselves standing with Greenspan (probably after a conference that they paid mightily for) on their websites.
    For those in China interested in this subject, there will be a talk on reverse mergers held in Shanghai, on the morning of June 30th at the Shanghai Renaissance Hotel at Zhongshan Park.

  • nulle

    I am not surprised about this occuring in the chinese accounting and securities business. Asians in general will test the system and see what they can get away with. I feel sorry for the owners/founders of good chinese companies taking the RTO route…however, given the current state of information flow in China (where the CCP actively controls) and the lack of rule of law (and corruption) in China (applicable to other Asian regions as well)
    I am not surprised that Rodman and Renshaw got duped when they showed up in China…I seriously suggest NOT sending anyone that is NOT chinese (AND wasn’t born in China) to do surprised inspections OR send inspection teams with mixture of non-mainland/taiwanese Chinese and regular personal because your target could easily been tipped off when they showed up in the local area.
    For those who are inspection companies, I seriously suggest get multiple number of staff separately into the region ahead of the inspection to surveil your target and avoid detection.
    it truly is “caveat empreor” buyer beware

  • Bob Walsh

    I joined a company back in 2000 which had operations in Nanjing, an HQ in Vancouver, and an OTCBB listing obtained by an RTO of a Florida shell. The company was later to somehow list on the TSE, after much stock price manipulation (and the ministrations of a species of reptile known as a “stock promoter”), but its price never made it back even close to where it was when we started.
    Unfortunately, all of the elements present in the company were a perfect broth of all of the things that have come to light about Chinese companies taking the RTO route. Significantly:
    1) Numerous related party transactions with entities controlled by the CEO. None of these transactions benefitted the company but greatly enriched the CEO.
    2) A poorly DD’d acquisition of a Chinese manufacturing unit for well above fair value.
    3) A CFO/Comptroller who were not mainlanders, or even based in China.
    The company was taken over by a pretty good outfit from Shaanxi in 2005. They were coveting the company’s listing, and hoping it might be a good vehicle for raising expansion funding. What they found out, however, was that no matter how healthy the balance sheet of the combined companies might be, the listing’s reputation was pretty sullied, and that raising money was out of the question.
    In 2008, the CEO made a buy-out offer that shareholders accepted, and he took the company private again. When I met him last spring, he said he would never consider taking any of his companies public again, and certainly not by the route he took in 2005.
    Working with a dozen or so early-stage biotech research companies in China, I find that almost all have been assaulted at one point in time by that “army of advisors, lawyers, and auditors” advocating a backdoor listing by RTO, and I advise them in turn to run away screaming.
    To each company I cite the example given above, and the point is usually taken, especially when the costs of maintaining a listing in a credibly compliant fashion are explained.

  • ollumi

    Yeah these vehicles still exists and fast ones are being pulled all the time by both sides due to complete unfamiliarity with one another across the oceans.
    I do have an objection to Professor Gillis’ plan. Given that those banks are state first and company second, I find his recommendations to be off-target and impractical. It’s not that his vision wouldn’t help, it’s just that it won’t happen any time soon because it doesn’t really address the real interests of the parties involved. Neither those banks nor those who manage to climb to a regional head tier are stupid, they act rationally and pragmatically in reaction to systemic factors.
    Don’t be contaminated by the “Emperor is brilliant, but his subordinates are all rotten” contagion.