Reverse Mergers 2011

Reverse Mergers

China Issuance Booms, but Questions Linger

Over the past few years, People’s Republic of China (PRC) issuers have increased the size of their footprint in U.S. equity markets. The main reason: transactions known as Chinese Reverse Mergers or CRMs, which provide a vehicle for companies to gain access to U.S. markets more quickly and less expensively than via a traditional initial public offering (IPO). In a reverse merger, a private company effectively merges with a public shell company, avoiding more stringent rules associated with filing an IPO. These transactions enable issuers to bypass costly investor roadshows while streamlining the disclosure requirements that accompany public offerings. This approach has become more popular with PRC companies than traditional IPOs: Between January 2007 and March, 2010, 159 PRC companies with a combined market value at the end of that period of $12.8 billion entered U.S. markets through reverse mergers, according to the Public Company Accounting Oversight Board. In comparison, only 56 PRC companies filed IPOs during that period.

Yet, despite investor demand for PRC issuers, a cloud over CRMs has begun to appear, due to earnings misstatements, concerns over accounting practices, and allegations of fraud. As a result, the soundness of corporate governance and financial reporting has been called into question for a number of PRC-based issuers. In some cases, concerns have escalated into investigations and litigation, causing headaches for audit committees, boards, management and even the auditors who have signed off on the accuracy of financial reports.

This paper will seek to explore some of the issues that have arisen around CRMs, identify red flags that may indicate the existence of such issues, and discuss initiatives that can be taken to mitigate the risk of their occurrence.

REGULATORS TARGET CRMs

In 2011, as the number of PRC issuers entering the U.S. continued to rise, so did the negative sentiment toward CRMs. Between February and May 2011, three securities class action lawsuits were filed against PRC companies. Regulators have begun to examine auditors of PRC issuers in CRMs and indicated that they may also look into the roles played by law firms and investment banks in these transactions.

Problems encountered by CRMs have centered on misrepresentation of financial data, including, in some cases, fraud. Subsequent cases brought by the Securities and Exchange Commission (SEC) related to these issues have resulted in trading suspensions and the revocation of some companies’ registration statements. In March, the SEC issued a letter to Congress highlighting several investigations into PRC issuers and inquiries into U.S. audit firms regarding their compliance with auditing standards in connection with CRMs. In its letter, the SEC cited cases it has brought against CRMs due to market manipulations, accounting, and disclosure violations as well as actions against auditors. Between March and May 2011, more than 24 PRC companies filed 8-Ks disclosing auditor resignation, accounting problems, or both. Some have disclosed cash and accounts receivable concerns, and cited problems auditors have had in confirming these amounts. Recently, Nasdaq OMX announced it was imposing tighter conditions for companies choosing to list via reverse mergers.

WHAT CAN GO WRONG

Several key problem areas have arisen with CRMs. The first deals with cash, an area that many would believe is easily verifiable and, as a result, less vulnerable to fraud. Yet, PRC companies and/or their auditors have expressed concerns that the bank documents provided to auditors may have been forged. In some instances, auditors may have been restricted from contacting the employees of the client’s bank. Questions have also been raised over cash transfers. For example, one Chinese company made short-term cash transfers from its bank accounts to the bank accounts of three other companies in China. This occurred despite the fact that the companies had no apparent commercial relationship with one another. As a result, the ability to independently verify cash balances with the bank may be challenging and represents an area in which fraud can occur.

These issues have raised concerns at the SEC, which, in recent months has noted problems over cash balances and auditors’ difficulties in confirming amounts and has suspended trading for at least three CRM entities.

PRC issuers have also faced questions surrounding customers, revenues and receivables. Some companies are being scrutinized as a result of previously reported sales that are called into question at a later date. In other cases, reviews of accounts receivable have revealed that reported customers do not exist, contracts aren’t real, or that there are questions over the legitimacy of the customer receivable confirmations that auditors received.

Expenses and disbursements have also been examined. The most common problems involve discrepancies related to what the company’s records state and what, in fact, the actual disbursements were for. Further, there have been questions about the legitimacy of supporting documentation for expenses at some PRC issuers.

PRC companies are facing scrutiny over their operational information too. Some have faced questions after disconnects surfaced between the information filed in the PRC compared to their filings with the SE C, on items including the size of their customer base, number of employees, and operating locations.

PRC issuers have also received attention due to deficient internal controls. While weaknesses may vary from one company to the next, a common theme relates to the qualifications of accounting and finance staff at these companies. Sometimes these employees may not be adequately trained in U.S. GAAP and SE C rules. As a result, they may be unprepared for the significantly greater reporting obligations, and consequently may rely too heavily on external auditors when it comes to identifying necessary adjustments to financial reports.

PRC ISSUERS: IS THE SITUATION AS BAD AS IT SEEMS?

When considering the viability of PRC issuers in the U.S., a question arises: Is there a common theme? In other words, are all PRC issuers plagued by the same issues?

The short answer is no. It would be inaccurate to group all PRC issuers together and presume that accounting misstatements, fraud and other issues reside in all of these entities. Yet, there are red flags that executives and investors should be aware of, either to help prevent their company or investment from being classified as a problem case. Red flags, if they do appear, should be carefully considered.

IDENTIFYING THE RED FLAGS

Much focus is being given to material differences between income reported in SEC filings and that reported in the PRC.

Difficulties may arise when it comes to evaluating the accuracy of numbers reported by PRC companies. First, there is a question as to the quality of the firms that audit and sign off on the financial statements. While foreign-invested companies are required to have their financial statements audited, the auditor may not be the same one that handles the financial statements that are filed with the SEC. In addition, reporting requirements are different for companies in the PRC from those in the U.S., where the SE C oversees the disclosure of meaningful financial and other information to the public. In the PRC, key filings that are made with authorities such as the State Administration of Industry and Commerce (SAIC) and State Administration of Taxation (SAT) are done so as part of a business licensing renewal process or to calculate tax liability. Due to the differences in the reporting structures and requirements in both countries, sometimes a company’s SAIC filings in China may not match exactly its SEC filings in the U.S. This issue has surfaced for some Chinese issuers. And while it may not be a telltale sign that a company has misrepresented its financial statements, it has raised questions among investors.

Furthermore, while PRC GAAP has recently become far closer to US GAAP, there are still fundamental differences between the two, such as revenue recognition, that can potentially give rise to differences in financial statements. As a result, therecan be perfectly valid reasons for discrepancies between data contained in SE C filings and that within PRC filings, but such differences need to be better understood. A reconciliation of numbers contained in both should be fully explainable. If not, and if the differences are material, the numbers may require further scrutiny.

Other issues of concern may be related to corporate structure. Specifically, the use of variable interest entities (VIEs) and nominee directors within subsidiaries can create a barrier to a third party’s ability to understand what is truly happening in those subsidiaries. VIEs are sometimes used to allow foreign investors to invest in restricted industries. Although PRC authorities have seemingly tolerated their use, a structure that is intended to circumvent regulations may be considered a risk that could lead to action by authorities and, in turn, could materially impact a company’s viability.

Serial acquisitions and serial fundraising both raise potential questions. Why is the company pursuing such serial acquisitions? Is it to bolster its performance with the results of the newly acquired company? Is this a sustainable strategy? Is there a rational business strategy behind these acquisitions and fundraising effor ts? Does the company need the additional funds from another round of fundraising? Under normal circumstances the proceeds of an issuance are used to develop and grow a business. Yet, if there is no apparent plan for the funds raised, or the company seems to have ample liquidity, the occurrence of share transactions could be perceived as being oppor tunistic and considered a red flag. These are questions that should be addressed to satisfy the company’s stakeholders.

Another issue has involved recurring questions over auditor quality and multiple auditor changes. Companies have been hit with auditor resignations following claims by the auditor that their client impaired their ability to perform necessary procedures or provided them with falsified documents. Frequent auditor changes may also be considered a red flag, one that can be compounded if it is accompanied by director or audit committee resignations. Particular attention should be paid to the auditor’s report, not just to qualifications, but also for comments on other aspects of the financial statements. Such qualifications or comments should be evaluated.

Finally, a lack of transparency or overreliance on a particular counterparty may warrant attention. And, it should be noted that local media coverage can also be highly informative in identifying companies where there may be concerns.

MITIGATING THE RISKS

One effective way to mitigate risk is to engage in an independent forensic review of any identified red flags. Such a forensic review can consider several key areas, which can be tailored to a particular situation based on the risk exposure that exists within the various departments of an organization.

One area that is frequently considered key is related party transactions. Here, it’s important to ascertain whether customers are in fact legitimate third-party customers who possess their own, independent management. If, for example, it is found that the entities are under the same control, it may taint the integrity of customer transactions by increasing the likelihood that sales may be manipulated. Another aspect of such a review may be identifying any round-trip transactions that may exist, particularly when there are parties that serve in both a customer and a vendor capacity. In general, it’s important to identify instances in which the underlying documentation does not support transactions as they are recorded. For example, it may be appropriate to review for the existence of sales that would normally have an underlying contract. Beyond establishing whether contracts exist, it’s important to determine if they are signed, fully executed, and contain terms that are consistent with the financial reporting.

When it comes to independent third-party reviews, it’s important to recognize that there is not a “one-size-fits-all” solution. A set of procedures that may be appropriate for one company may not be right for every issuer. As a result, reviews should afford an opportunity to meet with relevant constituencies at the company, such as board members, the audit committee and management. Resources should be deployed so that a review enables a company to get to the root of the problem. The time taken to address questions over financial statements and possible fraud can often be the key factor in determining the extent to which these issues may adversely impact the company. The key in such situations is to engage experienced forensic review experts.

GOVERNANCE AND FINANCIAL REPORTING BEGIN WITH THE BOARD

For PRC companies with their eyes set on a U.S. listing, it’s important to demonstrate the quality of financial reporting and corporate governance to regulators and third parties. To do so, companies should start at the board level. PRC companies seeking to list in the U.S. should consider including on their boards of directors individuals who are experienced with reporting practices in both the U.S. and the PRC. Members of the board should be able to decipher not only between the nuances in filing requirements in each country but also the differences in how transactions are reported.

Companies that wish to issue in the U.S. should fully understand the information that they are disclosing to the market. As a result, it is important that they engage in a process of reconciling figures and explaining any anomalies that exist. The reason: when figures are disclosed and issues arise over revenue recognition, a company should be prepared to answer the difficult questions.

CONCLUSION

CRMs have fueled a boom in the number of PRC issuers entering U.S. markets. These vehicles have expedited the entry of many companies, reducing costs and subjecting them to less stringent reporting requirements. Yet, the de-listings and investor lawsuits that have plagued a number of issuers have only added to scrutiny of CRMs from regulators and the media. As an investor, it is imperative to be aware of any red flags that may indicate that the company is manipulating information and accounts to its own end. For PRC issuers hoping to list in the U.S., it is important to ensure the reliability and accuracy of audited financial statements, while avoiding any accounting or other business practices that may raise concerns for third parties. This will go a long way toward gaining investor confidence and alleviating any concerns that exist at the board level upon entrance into U.S. markets.

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