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Reverse Takeover: How Fraudulent Chinese Companies are Deceiving U.S. Investors
By admin April 14, 2018

Recently, a documentary film called The China Hustle thoroughly described how some Chinese companies deceived U.S investors through Reverse Takeover. Meanwhile, Alibaba, the Chinese e-commerce giant, claimed the title of the largest global IPO ever, surpassing the Agricultural Bank of China’s IPO offer by almost 3 billion dollars (Forbes.com). Therefore, it is critical to understand how such kind of fraud works in order to separate the bad, faudulent companies from the good ones.

In 2011, Reverse Takeover fraud emerged in large numbers. Generally speaking, as rules developed through time, the number of private companies moving to the public sphere had been heading downward during the last decade. However, in 2010 alone, there were 42 China-based companies that launched an IPO. In June, 2011, the SEC warned investors in a public bulletin that “many companies either fail or struggle to remain viable following a Reverse Takeover,” and further stated that “instances of fraud and other abuses involving Reverse Takeover companies” were being reported. In the same year, 15 China-based companies were desisted.

But how could these problematic companies get listed in the first place? The short answer is: Reverse Takeover. Reverse Takeover, according to Damjan DeNoble, is a process whereby a company, usually a small to midsized firm, buys the corporate shell of a defunct American company still trading on the penny stock exchange, and then offers a secondary offering of the shares premised on its own growth potential. As a private, usually China-based, company became the owner of a public company, that private company was treated as a public company as well. Such process was called Reverse Takeover or Reverse Merger Takeover.

The problem of Reverse Takeover is that the obvious information asymmetry gives private companies a huge space to commit fraud. For example, AlfredLittle.com, an investment opinion website with a special focus on companies operating in China, once pointed out that it is extremely easy for some China-based companies to overstate their profit with different kinds of paperwork. “Bank statements, confirmation letters and contracts of all types, government filings, ownership certificates and tax invoices are all paper documents easily forged by dishonest management with the help of a few dishonest bank and government officials…Dishonest management can keep turning paper into gold until investors decide the “paper” evidence of profits and growth are contradicted by the reality of the business.” Other companies, as the documentary highlighted, even hired “actors” and “actresses” to make investors believe that the operation of this company was doing well.

Such kind of fraud is hard to be supervised due to three reasons: First, investors from the United States have limited access to what was actually going on in China because the two countries have different cultures, languages, social norms and laws. Second, Chinese governments might face a jurisdiction problem when they try to regulate such behavior because the victims are U.S investors. Third, the intermediary, usually the investment banks, has no motivation to reveal the true information because those China-based private companies are their clients.

Despite these hindrances, Reverse Takeover fraud can still be fixed in the market. First, most of these companies cannot maintain a normal operation on a daily basis. It is important for short companies or the SEC to go to China and check the real situation. Further, China and the United States can work together to form a bilateral supervision system so that U.S investors can suit China-based companies more easily when they are delisted. It would be wise for the Chinese government to voluntarily supervise Reverse Merger Takeovers so that the reputable Chinese companies such as Alibaba can maintain a good reputation in the U.S market, an index that is critical for any company to gain investment from the U.S investors.

For more information:

https://www.firstpost.com/world/reverse-acquisitions-how-chinese-cos-get-a-backdoor-listing-in-us-markets-144970.html

https://www.reuters.com/article/us-china-ipo/leapfrogging-the-ipo-gridlock-chinese-companies-get-a-taste-for-reverse-takeovers-idUSKCN0XW2HV

https://www.gsb.stanford.edu/insights/charles-lee-how-well-do-chinese-reverse-mergers-perform

https://en.wikipedia.org/wiki/Reverse_takeover

https://www.chinalawblog.com/2011/06/reverse_mergers.html

https://www.washingtonpost.com/business/china-electric-motors-reverse-takeover-leads-to-major-losses-numerous-lawsuits-in-us/2013/09/20/7bb975d8-1eec-11e3-8459-657e0c72fec8_story.html?utm_term=.a129c4fe80d7

https://www.bloomberg.com/news/articles/2017-09-08/-china-hustle-warns-next-big-crisis-born-in-reverse-merger-mud

https://www.forbes.com/sites/ryanmac/2014/09/22/alibaba-claims-title-for-largest-global-ipo-ever-with-extra-share-sales/#1ad2773c8

https://www.forbes.com/sites/ryanmac/2014/09/22/alibaba-claims-title-for-largest-global-ipo-ever-with-extra-share-sales/#1917f9108dcc


Thanks for sharing !


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