Op-Ed Commentary: Chris Devonshire-Ellis
Feb. 9 – Chinese companies in the United States that have been acquiring listings through the “reverse merger” method have been coming under intense scrutiny after an American investor found serious fraud within one of the stocks he had been following. Over 350 Chinese companies have been listed in the United States via this method, in which an operating Chinese company takes over an all-but-defunct publicly traded U.S. shell company. The investor concerned, John Bird, had been tracking the stock of a company called China Sky One Medical, a manufacturer of medical products such as “magnetizing” hemorrhoid ointments and patches that would “dispel fat.” Sky One, according to its annual report filed just a few days earlier, was selling out of its inventory every seven days.
That speed of inventory turnover, reckoned Bird, made no sense, and said in his words, “It’s like somebody telling you they just drove over here at 600 miles per hour. It’s not going to happen.” Delving deeper into the company, Bird, himself a retired inventory manager, found an entire web of company structures concerning China Sky One that defied SEC rulings. According to this article in Businessweek Sky One, Bird found, was a combination of Comet Technologies and American California Pharmaceutical Group. Comet Technologies was a “blank check” company, incorporated in Nevada, with no business other than finding a promising acquisition. American California Pharmaceutical Group was a holding company for Harbin Tian Di Ren Medical Science and Technology, which had been making over-the-counter medicines based on Chinese herbal remedies since 1994 in the northern city of Harbin. The shares of the new company, merged and renamed China Sky One Medical, finished 2006 at US$8 and climbed 75 percent in 2007, to US$14, as the company promised it was stepping up-market from wart-removal spray to gene recombination techniques; the stock also likely benefited from the seemingly unquenchable enthusiasm for China’s prospects. In 2008, Sky One moved from the OTC Bulletin Board to the American Stock Exchange and then to the Nasdaq Composite Index.
Bird turned up credit reports on Harbin Tian Di Ren from providers in Britain, India, and China. The numbers in all three matched each other, but they did not match the SEC filings. After two months of e-mails and phone calls, Bird reached a woman named Terry at Qingdao Inter-Credit Services, a credit report provider, who sent Bird the filings it used. They were from a Chinese agency called the State Administration for Industry & Commerce (SAIC). For Bird and those who followed him, the SAIC filings were “like getting X-rays of a terminal patient,” he says. “It was dead stock walking.”
The SAIC is the Chinese government agency responsible for market supervision, regulation, and enforcement. According to the filing, Sky One’s operating unit, Harbin Tian Di Ren, had 2008 sales of RMB6.93 million, roughly USD1 million at 2008 exchange rates. Yet to the SEC, Sky One reported 2008 sales of USD91.8 million, with Harbin Tian Di Ren accounting for at least 65 percent, or USD59.7 million. Bird ordered reports to trace Sky One customers and suppliers—the paperwork showed companies too small to generate the orders or inventory Sky One posted.
Listing in the United States through a reverse merger is easier than joining the main exchanges in Shanghai and Shenzhen, where local companies face a long waiting period and profitability requirements. A public market for startups, ChiNext, only started in October 2009. A Hong Kong listing on the Growth Enterprise Market also presents hurdles, with minimum thresholds for cash flow and expected market capitalization. A U.S. reverse merger, by contrast, can take as little as three months and cost under USD1 million in fees, according to CCG, a Los Angeles investor relations firm that specializes in Chinese companies. In 2010, 78 Chinese companies listed in reverse mergers, according to DealFlow Media figures as of Jan. 6, adding to the 294 that did so from 2004 through 2009. The Sky One deal cost between US$600,000 and US$800,000, according to Charles Hung Jr. of American Eastern Group, the Los Angeles investment firm that set it up.
Bird’s involvement would evolve from irritation that a company could get away with making a claim that so obviously defies basic business logic to the conviction that many pieces of the Chinese miracle that trade in the United States are, in his words, “flat-ass” frauds. And what started as a retiree looking into a company has turned into a dispute that has drawn in other shorts, the Securities and Exchange Commission, auditors, and, according to recent reports, the U.S. House Committee on Financial Services. It has also revealed significant flaws in U.S. markets and how they are regulated. Although the stocks trade on U.S. exchanges, and thus project a sense of having to play by American rules, the assets and the principals of many of the companies reside in China. The companies operate on their terms, leaving injured parties and the SEC powerless. Bird says the carnage is just beginning. “The whole thing has no place to go but to blow up,” he says. “That’s a rational position for an investor to start with, that every one of these Chinese reverse mergers is a fraud.” The FCPA has already announced it is targeting China based subsidiaries of American businesses, it may now have a deeper problem on its hands.
The sums involved, according to Businessweek are not small: “The capital at stake is significant. Shares of such reverse mergers are held by many funds available to retail investors, including Oppenheimer Main Street Small Cap Fund (OPMSX) and the PowerShares Golden Dragon Halter USX China Portfolio, and are scooped up by small-cap index funds. Roth Capital Partners, an investment bank in Newport Beach, Calif., that has been one of the most active in helping such Chinese companies raise money, recently tried to measure the Chinese reverse merger market. It came up with a list of 94 companies with market capitalizations of between $50 million and $1 billion that trade an average of at least 50,000 shares daily, with a total stock market value of more than $20 billion.”
The result is increased interest in the actual financial viability of the reports issued to the U.S. authorities of the other 350 Chinese companies that have reversed themselves into becoming U.S. listed, in addition to the entire structuring and monitoring process that companies have to go through to list. The need to conduct due diligence in China is going to become more critical as investors demand to know how viable the stock really is. It’s a process that our firm, Dezan Shira & Associates is very familiar with, having on too many occasions seen situations arise whereby the case for presentation being made to list was riddled with serious flaws. We may, as a result, have missed out on lucrative fees through raising uncomfortable objections, but at least the firm’s credibility over work was not compromised. It seems our long-held views that many such listings contain dubious claims and background structures is now becoming a reality. When it comes to due diligence in China, there’s no excuse for using a U.S. firm with no practical experience of the law, the methods used to abuse that law, and the various styles of misrepresentation that take place. Its why we’ve run, this past week, a series devoted to due diligence in China, on analyzing financial reporting, and the identification of corporate structures behind such businesses. The information and expertise is out there. If more professionalism and care had been taken and balanced against the desire to obtain fees and list Chinese companies, this type of fraud need not have occurred. I personally suspect similar problems within Hong Kong and Toronto, to name just two, while the recent decision to allow Chinese companies to use mainland auditors to file accounts in Hong Kong may further relax the level of scrutiny mainland based companies have when listings in overseas markets.
Chris Devonshire-Ellis is the founding partner of Dezan Shira & Associates, a foreign direct investment practice with ten offices and 19 years experience in China. The firm provides as part of its range of services due diligence into Chinese companies in China. Please email the practice at email@example.com or download the firm’s brochure here.
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