Dune Lawrence’s detailed view of the Chinese reverse merger market through the eyes of retired Texas investor John Bird in Bloomberg Businessweek will be getting a lot of attention this weekend.
The piece goes into Bird’s investigation starting in 2009 of Chinese companies such as Sky One that were showing what seemed like impossibly fast financial growth. Through investigation of SEC and the State Administration for Industry & Commerce run by a Chinese agency he found their revenue and sales numbers didn’t match up. He aggressively shorted on Sky One and this year he made a profit of over $1 million on the stock which is now being investigated by the SEC.
It is an effective analysis of what is occuring with Chinese reverse takeovers and the growing impact it is having on retail investors.
First, how did we get to here:
- Since 2004 there are more than 350 small Chinese companies that have listed in the U.S. in a process called a reverse merger, in which an operating Chinese company takes over an all-but-defunct publicly traded U.S. shell company
- These Chinese companies trade on U.S. stock exchanges but because their assets are in China they are not regulated by the SEC but by a Chinese agency called the State Administration for Industry & Commerce (SAIC)
- Listing in the U.S. through a reverse merger is easier than joining the main exchanges in China where local companies face a long waiting period and have profitability requirements
- A U.S. reverse merger can take as little as three months and cost under $1 million in fees.
- The impact of these mergers is large and involves major players owning shares of these mergers such as Oppenheimer Main Street Small Cap Fund and the PowerShares Golden Dragon Halter USX China Portfolio
- According to Roth Capital Partners the reverse merger market size has reached 94 companies trading an average of 50,000 shares per day with a total market value of $20 billion
- These events show significant flaws in U.S. market regulation since the Chinese companies operate on their own terms and leave injured parties and the SEC without power
- Congress and the SEC have started to investigate these transactions and audit these Chinese companies. Congress is considering holding hearings their main goal being to protect U.S. investors since many Chinese companies doing these reverse mergers were found to have fraudulent accounting
- If investors can detect the difference between fraudulent Chinese companies and the real deal they can do very well
- This market has released an army of shorting investors and regulating that will be a challenge.