After a series of high-profile frauds and stock collapses by Chinese companies that went public in the United States using reverse mergers, major U.S. stock exchanges are putting new rules in place to make such maneuvers more rigorous and respectable.
The New York Stock Exchange and Nasdaq recently added new rules that require companies wanting to go public via a reverse merger to file an annual report with the Securities and Exchange Commission, list for at least one year on an over-the-counter or a regulated foreign exchange, and keep a minimum share price.
Over the last few years, the reverse merger has become the go-to method for Chinese companies to obtain a listing on a U.S. exchange. The Chinese companies acquire a U.S. defunct company still registered with an exchange, file a Form 8-K to disclose the change in ownership, and adopt the former company's ticker symbol. The company can then begin trading and can register to issue more shares to raise capital. The method offers the prestige and access to capital that a U.S. exchange listing brings, without the cost and scrutiny of going through a formal initial public offering.
That deal has not worked out so well for shareholders. Dozens of Chinese companies that used reverse mergers to go public have experienced accounting frauds or been forced to fire their auditors, restate earnings, or worse. Reverse-merger companies that have experienced stock plunges this year following accusations of fraud include China Media Express and Duoyuan Global Water.
Not all reverse mergers are listed on U.S. exchanges. For example, allegations against Chinese timber company Sino Forest—which obtained a listing on the Toronto Stock Exchange using a reverse merger—cost hedge fund Paulson & Co. more than $500 million when the stock price tumbled as a result.
“The rule is targeted at Chinese reverse mergers,” says Irwin Kishner, partner at law firm Herrick Feinstein. He says the proposed rules by Nasdaq, NYSE, and NYSE Amex are the result of the self-regulatory exchanges trying to curb the listing of some Chinese companies due to highly publicized alleged accounting fraud cases.
The SEC has launched enforcement inquiries into more than 24 Chinese reverse merger companies that have disclosed auditors' resignations, accounting problems, or both. In response, the NYSE and Nasdaq have proposed additional listing requirements on reverse mergers.
Nasdaq went first, proposing its new listing requirements for reverse merger companies in May. Stocks of foreign companies that use the reverse merger process will have to trade for more than a year either on a U.S. over-the-counter or a regulated foreign exchange.
Reverse merger companies are also required to file an annual report with the SEC containing audited financial statements for a full fiscal year prior to completion of the listing. In addition, Nasdaq will require the companies to maintain a minimum share price of $4 for at least 30 out of the most recent 60 trading days.
“What they are realizing now in China is that the reverse merger does not work and the proposed rules will help offer protection to both U.S. investors and Chinese companies.”
—Richard Rappaport,
President,
U.S.-China Chamber of Commerce
The NYSE and NYSE Amex proposed nearly the same rules in July, although the exchanges did not propose a specific duration for the $4 trading minimum. The NYSE is also proposing a waiting period of up to a year. “The proposed rule will add the requirement for a seasoning period prior to listing to provide greater assurance that the company's operations and financial reporting are reliable,” said the NYSE in a statement.
The NYSE also provided an exception to the rules for reverse merger companies that commit to raising at least $40 million in a subsequent or simultaneous public offering. Nasdaq did not provide any exemption to its proposed additional listing requirements.
The SEC is currently reviewing the proposals. Neither Nasdaq nor the NYSE could be reached for comment on when the new rules might take effect.
According to Kishner, the exchanges are trying to curb reverse mergers, also known as a triangle listing, while promoting the more traditional IPO route for Asian companies trying to tap into U.S. capital markets.
FELDMAN'S FEARS
In the comment letter excerpt below, David Feldman, a partner at Richardson & Patel, voices his concern against the NYSE's proposal:
I strongly object to the premise of the proposed “seasoning” requirement, and believe a broad brush application to all transactions of a particular type may have the chilling effect of discouraging exciting growth companies from pursuing all available techniques to obtain the benefits of a public listed stock and greater access to capital while still maintaining appropriate investor protections.
The Exchange's justifications include (1) allegations of accounting fraud, (2) suspension of trading or registration of some reverse merger companies, (3) an SEC enforcement action against an auditing firm involved with reverse mergers and (4) the issuance of an SEC bulletin on reverse mergers.
In response to these points, I am surprised to see such a dramatic proposal in response to “allegations” of fraud. Virtually all of these allegations involve Chinese companies that completed reverse mergers. The proposal fails to note that a number of other Chinese companies that completed full traditional initial public offerings face the very same allegations. In addition, many of the Chinese companies facing allegations went public through a reverse merger followed by a fully underwritten, SEC-reviewed public offering before a single share of stock traded. So if these allegations turn out to be true, it would not be a result of the manner in which the companies went public ...
... If it not possible to reject this proposal, I propose an exemption for any firm commitment underwritten public offering. If there is to be a minimum to be raised to obtain an exemption from seasoning, I propose it be much lower than $40 million, maybe $15 million. In a firm commitment public offering of that size with an SEC and Financial Industry Regulatory Authority (FINRA)-registered underwriter, investors are provided the same level of protection as in a $40 million offering.
I also propose that, if any seasoning is required, that trading of the stock not be a requirement. A period where all SEC filings are made timely and completely and can be examined by Exchange officials would seem sufficient. To require the maintenance of a price that is the same as the expected initial price on the Exchange is unfair and unrealistic to achieve on the OTC markets. And an Exchange application should be able to be processed during the seasoning period.
Finally, the timing should mirror the Nasdaq proposal and be limited to a six month seasoning period.
In 2010, at the SEC's Government-Business Forum on Small Business Capital Formation, SEC Chairman Mary L. Schapiro said, “Reliable data suggests that small businesses have created 60-to-80 percent of net new American jobs over the last ten years. Making sure small businesses can attract the investments they need to grow and thrive is vital to America's economic recovery.”
Let us hope that the Commission's actions mirror Chairman Schapiro's words by doing all it can to reduce impediments to capital formation for these key engines of the American economy, with an appropriate balance to ensure that small company investors are well protected.
Source: David Feldman Comments on NYSE Proposed Additional Listing Requirement.
David Feldman, partner at law firm Richardson & Patel, however, calls the new rules from the NYSE and Nasdaq an unneeded response to allegations that haven't been substantiated. “They seem to feel that IPOs are the only legitimate way to go public, yet they forget about the $2 billion fines levied against every major underwriter of IPOs for illegal activities in the late 1990s,” he says. “This sudden piling on by regulators and exchanges based on suggestions by the financial press and short sellers continue to puzzle me.”
Feldman argues that the NYSE Amex should have less-stringent rules for reverse mergers. “It makes no sense for Amex and the NYSE to have the same standard when every other requirement for listing and maintaining a listing is lower on Amex than NYSE,” he says.
The proposed rules also fail to distinguish Form 10 listings from backdoor reverse-merger companies, Feldman says. He says the former listing process is equivalent to a traditional IPO and does not compromise investor protection. Form 10 listing requires a company to go through rigorous filing, regulations compliance, and registration activities with regulators and other governing agencies, before trading can begin.
Richard Rappaport, chief executive officer at WestPark Capital, says that if the proposed rules are adopted without taking such arguments into consideration, many small companies will be forced to trade on smaller OTC boards or seek listing in other foreign markets.
Support in China
Some Chinese corporate representatives are applauding the proposed rules. Siva Yam, president of the U.S.-China Chamber of Commerce, says the reforms could go a long way toward protecting Chinese owners who pursue U.S. markets. “Many of the Chinese private companies' proprietors do not understand how the reverse mergers in the United States work, and some of them who were involved in reverse mergers in the past have informed me of losses they incurred in such deals,” he says.
According to Yam, a U.S. broker typically charges fees ranging from $300,000 to $500,000, 10 percent of the gross proceeds from the successful listing, and additional expenses of up to $200,000 to help Chinese companies complete reverse mergers. He says many Chinese executives have little or no prior knowledge of the accounting and regulatory requirements of U.S. regulators and get little help from their brokers.
Says Yam: “What they are realizing now in China is that the reverse merger does not work and the proposed rules will help offer protection to both U.S. investors and Chinese companies.”
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