Backdoor IPOs and Reverse Mergers: A Chinese Recipe for Scandal

Backdoor IPOs and Reverse Mergers: A Chinese Recipe for Scandal

by Tony D’Altorio, Investment U Research
Tuesday, June 14, 2011

Since 2007, more than 150 Chinese companies have been listed in the United States through reverse mergers or backdoor IPO listings.

These types of listings happen when Chinese firms merge with a U.S. publicly traded shell company. Many of these listings are found on less regulated stock exchanges such as the Pink Sheets, the OTC Bulletin Board and NYSE AMEX.

These reverse mergers and backdoor procedures allow Chinese companies to become public without the regulatory rigors involved in a traditional initial public offering (IPO).

In recent months, short sellers have attacked a large number of these types of Chinese companies – accusing them of fraud or other wrongdoings. This has caused shares of these companies to tumble and have inflicted huge losses on unlucky investors…

Investing in China Becomes Unsettling…

With so many of these reverse merger and backdoor Chinese companies now under a cloud of scandal, investors in China are getting increasingly unsettled.

Especially since the United States is at the center of this storm. In the past six months alone, more than 25 New York-listed Chinese companies disclosed accounting discrepancies or saw their auditors resign.

Most of these firms are small and slipped onto the exchanges in the past few years through the reverse merger process described above.

Regulators are now reversing that process.

• Nasdaq and NYSE Euronext halted trading in the shares of at least 21 small- and micro-cap Chinese companies in the past year. Five such companies were altogether kicked off of the exchanges.

• Facing investors’ ire, the SEC is investigating many of these companies as well as the network of U.S. auditors and public relations firms who marketed such companies to the U.S. investing public.

Some U.S. investors are worried whether they can take the financial statements of any Chinese company at face value.

For instance, look at software firm Longtop Financial Technologies (NYSE: LFT). It listed in New York in 2007 via an IPO, not through a reverse merger. Last month the company’s auditor, Deloitte, accused Longtop of “very serious defects,” including faking its bank statements. Longtop said it is conducting its own internal investigation.

As the scandals mount, many investors are dumping U.S.-listed Chinese stocks. They’re fearful of further price declines or perhaps not being able to sell their shares due to trading halts.

Protecting Against Fraudulent Chinese Stock Listings

So what should investors do? How can they protect themselves against fraudulent Chinese companies?

One way recommended by my colleague, Carl Delfeld, is to avoid the smaller companies. He pointed to a study showing that 60 percent of China backdoor listings reported less than $50 million in annual revenue or assets.

There’s another logical way investors can avoid most of these fraudulent companies…

• Do a little bit of homework and look to see if these companies are listed either on mainland Chinese stock exchanges or in Hong Kong.

• Not surprisingly, you’ll find that the vast majority of these companies aren’t listed in their home market.

• The fraudsters running these companies know they can’t dupe local investors, who would be well aware if they are or are not legitimate companies in China.

One former executive at one of these firms was even quoted as saying that American investors will buy anything “as long as it has ‘technology’ in its name.”

He may be on to something. Many of the recent “hot” Chinese IPOs listed in the United States are technology companies that are not listed in China.

Investors need to keep in mind that investing in Chinese companies should be no different than investing in other companies. Do your homework and your due diligence. Caveat emptor.

Good investing,

Tony D’Altorio