Beware of “Reverse Mergers”

Posted on July 6th, 2011 at 9:23 AM

            The SEC (Securities and Exchange Commission) recently issued a warning to investors considering an investment in what are known as “reverse mergers” or “reverse takeovers (RTOs).”  Let’s examine why the SEC is concerned.

            Preliminarily, reverse mergers are transactions that allow a private company (often located in a foreign country) to access funding opportunities offered by the U.S. capital markets by merging with an existing company that already is publicly traded in the U.S.  The publicly traded company is a “shell company” with few or no operations; the private company has operations. According to the SEC, in the transaction, the private company essentially takes over the publicly traded shell company.  Although the shell company survives the merger, the private company’s shareholders gain a controlling interest in the voting power and outstanding shares of stock of the public shell company.  Likewise, the private company’s management takes over the board of directors and the management of the public shell company.  Finally, the assets and business operations of the post-merger surviving company become primarily, if not solely, those of the former private company.

            Reverse mergers are an appealing option for private companies.  The SEC notes that reverse mergers are a cheaper, easier and faster way for a private company to “go public” in lieu of an initial public offering (IPO).  That is because there are lower legal and accounting fees, and no SEC registration requirements apart from the public shell company’s having to file a Form 8-K with the SEC reporting the reverse merger.  Once the reverse merger occurs, shares of the reverse merger company may be listed and traded either on an exchange or over-the-counter (OTC).  On an exchange, the company must satisfy both initial and continuing listing standards.  By comparison, in the OTC market, the SEC warns that there may be circumstances that make it difficult for investors to discern whether a particular company is a reverse merger entity.  Moreover, with respect to some OTC companies, the SEC cautions that investors may have “trouble obtaining information about the management, operations, financials, and other important aspects of a company.”

            Beyond those hurdles, the SEC advises caution when considering an investment in reverse merger companies.  Among the concerns cited:

  • Many companies either fail or struggle to remain viable;
  • There have been instances of fraud or other abuses; and
  • Some companies use small U.S. auditing firms that lack resources to identify violations of accounting standards, especially for foreign-based companies.

To illustrate the last point, the SEC recently charged a California-based auditing firm (Moore Stephens Wurth Frazer &Torbet, LLP) with improper professional conduct in connection with its annual audits and quarterly reviews of the financial statements of China Energy Savings Technology, Inc.  The auditing firm consented to the SEC order and remedial sanctions.

            The SEC’s warning provides a number of helpful risk disclosures for investors to consider.  Included among them are:

  • The companies lack public company management and operations experience, may not have effective internal controls over financial reporting, and will incur significant costs to comply with corporate governance and reporting requirements; and
  • Because no brokerage firm brought the companies public (through an IPO), the brokerage firms may have no interest in covering the companies, recommending their shares, or conducting any secondary offerings on behalf of the companies in the future.

Further, the SEC’s warning details recent enforcement actions involving reverse merger companies.  Essentially due to the companies’ failure to report current, accurate and complete information, the SEC has suspended trading in: Heli Electronics Corp. (HELI), China Changjiang Mining & New Energy Co. (CHJI), RINO International Corporation (RINO), Advanced Refractive Technologies, Inc. (ARFR), HiEnergy Technologies, Inc. (HIET), and Digital Youth Network Corp. (DYOUF).  Additionally, the SEC recently has revoked the securities registration of several reverse merger companies due to their failure to make required periodic filings.  Once this happens, the SEC reminds one that no broker, dealer or national security exchange can execute a trade in the stock unless the company files to re-register its stock.

As a result of the substantial risks involved with reverse merger companies, the SEC warns investors to:  1) research the company; 2) be wary of companies that do not file reports with the SEC; and 3) generally be skeptical.  The SEC cautions, “If you cannot obtain current, reliable information about a company and its stock, this may not be a suitable investment for you.”  That is sound advice!


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