In November 2011, allegations of fraud by some Chinese companies propelled the US Securities and Exchange Commission (SEC) to announce tougher new listing standards for small companies seeking to enter the US equity market by means of a 'reverse merger' with an existing listed US 'shell' company.

In a reverse merger, an existing public company – called a 'shell' because it has few or no operations – buys a private operating company. However, the shareholders of the private company acquire all or most of the shares of the public company and therefore a controlling interest, and install their own directors and management.

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Market access

The procedure has many advantages, especially for small companies. It enables their shares to be traded on over-the-counter markets and exchanges such as the Nasdaq and the New York Stock Exchange Amex, providing access to capital and liquidity. It is cheaper and quicker than an initial public offering (IPO) – especially at a time when the IPO market has virtually dried up – with few regulatory hurdles.

The UK’s Alternative Investment Market has a similar 'reverse takeover' process. Canada offers a Capital Pool programme. Exchanges in some other countries provide other alternatives.

Red flags were raised in the US by a 2010 report by the Public Company Accounting Oversight Board within the SEC. It drew attention to serious accounting and audit problems with certain Chinese reverse merger companies in the period after January 1, 2007. Following this report, the SEC and US exchanges suspended or halted trading in 35 foreign-based reverse merger companies, citing a lack of current and accurate information about the firms and their finances. The SEC did not provide data on how many are Chinese.

The SEC’s new rule imposes more stringent listing requirements for reverse mergers. Before such a company can go public, it now has to complete a 12-month 'seasoning period' trading over the counter and filing audited financial statements with the SEC, as well as maintaining a required minimum share price for 'a sustained period' or else close a $40m public offering at the time of listing.

Gaining experience

The thinking behind the new SEC rule, especially the one-year seasoning period, is to provide time for reverse merger companies to get accustomed to operating as a public company and to establish a track record before they are listed, says Harvey R Kelly, co-head of the global corporate investigations practice at management consulting firm AlixPartners.

For many, reverse mergers are the only way to attract capital, since they are too small to launch IPOs

Domestic companies face similar challenges. However, foreign companies accustomed to very different business cultures and unfamiliar with the US’s Generally Accepted Accounting Principles are at heightened risk. “Somebody who is not knowledgeable about the rules and laws could break a regulation without even being aware of it,” says Mr Kelly.

He advises firms considering reverse mergers in the US to select highly experienced legal counsel and a top-notch auditing firm familiar with the necessary disclosures. Investors should carefully analyse the risk-revenue relationship, the company’s track record, its financial statements and the quality of management.

Size issues

Meghan Leerskov, editor of The Reverse Merger Report published by DealFlow Media, notes that even in the best years, Chinese reverse mergers have never been more than one-third of all US reverse mergers. The rest are mainly domestic, though small companies from many countries have used the process. For many, reverse mergers are the only way to attract capital, since they are too small to launch IPOs.

"Most people don’t expect the new SEC rule to have much impact because so few of these companies move from a bulletin board to a major exchange," says Ms Leerskov.

However, David N Feldman, a partner in the New York law firm Richardson & Patel and author of a book on reverse mortgages, strongly opposes the rule. He says it is illogical and fears it will make it more difficult for small companies to raise capital. Still, he says capital remains available in the US for foreign domestic companies with a strong growth story.