Form 10

US Government Acts to Police OTCBB IPOs and Reverse Mergers for Chinese Companies

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In my experience, there is one catastrophic risk for a successful private company in China. Not inflation, or competition, or government meddling. It’s the risk of doing a bad capital markets deal in the US, particularly a reverse merger or OTCBB listing.  At last count, over 600 Chinese companies have leapt off these cliffs, and few have survived, let alone prospered. Not so, of course, the army of advisors, lawyers and auditors who often profit obscenely from arranging these transactions.

Not before time, the US Congress and SEC are both now finally investigating these transactions and the harm they have done to Chinese companies as well as stock market investors in the US. Here is a Chinese language column I wrote on this subject for Forbes China: click here to read.

As an American, I’m often angry and always embarrassed that the capital market in my homeland has been such an inhospitable place for so many good Chinese companies. In fact, my original reason for starting China First Capital over two years ago was to help a Jiangxi entrepreneur raise PE finance to expand his business, rather than doing a planned “Form 10” OTCBB.

We raised the money, and his company has since quadrupled in size. The founder is now planning an IPO in Hong Kong later this year, underwritten by the world’s preeminent global investment bank. The likely IPO valuation: at least 10 times higher than what was promised to him from that OTCBB IPO, which was to be sponsored by a “microcap” broker with a dubious record from earlier Chinese OTCBB deals.

In general, the only American companies that do OTCBB IPOs are the weakest businesses, often with no revenues or profits. When a good Chinese company has an OTCBB IPO, its choice of using that process will always cast large and ineradicable doubts in the mind of US investors. The suspicion is, any Chinese entrepreneur who chooses a reverse merger or OTCBB IPO either has flawed business judgment or plans to defraud his investors. This is why so many of the Chinese companies quoted on the OTCBB companies have microscopic p/e multiples, sometimes less than 1X current year’s earnings.

The US government is finally beginning to evaluate the damage caused by this “mincing machine” that takes Chinese SME and arranges their OTCBB or reverse mergers. According to a recent article in the Wall Street Journal, “The US Securities and Exchange Commission has begun a crackdown on “reverse takeover” market for Chinese companies. Specifically, the SEC’s enforcement and corporation-finance divisions have begun a wide-scale investigation into how networks of accountants, lawyers, and bankers have helped bring scores of Chinese companies onto the U.S. stock markets.”

In addition, the US Congress is considering holding hearings. Their main goal is to protect US investors, since several Chinese companies that listed on OTCBB were later found to have fraudulent accounting.

But, if the SEC and Congress does act, the biggest beneficiaries may be Chinese companies. The US government may make it harder for Chinese companies to do OTCBB IPO and reverse mergers. If so, then these Chinese firms will need to follow a more reliable, tried-and-true path to IPO, including a domestic IPO with CSRC approval.

The advisors who promote OTCBB IPO and reverse mergers always say it is the fastest, easiest way to become a publicly-traded company. They are right. These methods are certainly fast and because of the current lack of US regulation, very easy. Indeed, there is no faster way to turn a good Chinese company into a failed publicly-traded than through an OTCBB IPO or reverse merger.


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Ethics and Investment Banking – how disreputable advisors, bankers and lawyers damaged Chinese SMEs through OTCBB listings, reverse mergers

 

Qing Dynasty bowl from article by China First Capital

 

Back again in Shenzhen, with plenty of food for thought, as well as food for the belly. I go through the same “immersion program” whenever I arrive back here: it involves stopping for a plate of dumplings or bowl of noodles once every 30 paces. Or anyway, it certainly seems that way. 

The food for thought, as always, centers on ways to deliver enhanced value and service to clients and business partners. We have a set of core principles, that we build our business on, and that collectively represent our main differentiators. They are disarmingly simple – to work with integrity and honesty,  and always put the success of our clients’ first. We know that if we do this, our own success will follow. 

Simple, but not nearly as universal as they should be in our business. A lot of investment banking, IPO and advisory work in China has bordered on the criminal. Hundreds of SME companies were damaged, if not destroyed, by advisors, lawyers and others who neglected entirely to put their clients’ interests first. Instead, they pushed for companies to take various fast routes to IPO in the US, typically reverse mergers, OTCBB Listings, Form 10, SPAC deals. The reason: the advisors, lawyers, bankers all made a pile of money, quickly, through these kinds of deals. When things turned sour, as they often did, the advisers, bankers and lawyers were generally nowhere to be found, and the Chinese companies were left in dire straits.

Obviously, the bosses of the Chinese companies were complicit, since they agreed to these kinds of schemes to achieve a fast IPO. But, in my experience, the bosses main sin was that of ignorance. They simply didn’t understand all the workings of these kinds of deals, or even the fee-structure that would disproportionately reward the advisers, lawyers and bankers. In other words, the Chinese bosses didn’t do their DD, didn’t check the dismal track record of the many Chinese companies that already opted for OTCBB listings or reverse mergers.

I sometimes think the Chinese term for IPO, “上市” ( “shang shi”) has magical, intoxicating effect on some Chinese bosses. They hear it and suspend all their normal caution and suspicion. Soon, they end up agreeing to what are often truly disastrous transactions that don’t even deserve the name IPO.

There are, by some estimates, several hundred Chinese companies now listed on the OTCBB that are somewhere between “on life support” and “clinically dead”. Their share prices fell steeply immediately after listing (by which time the advisers, bankers and lawyers all pocketed their fees and lined up their next victims) and are below $1. There is little to no liquidity. They often trade at PE multiples of 1-2x. The costs of retaining the OTCBB listing are bleeding the companies of badly-needed money. They have no chance to raise additional capital, nor to do much of anything (except waste money on Investor Relations firms) to lift their share price.

I get angry just thinking about this. I’m offended that people in my field of work would be involved in such self-serving, greed-ridden transactions. Secondly, it’s also brought a lot of harm, and sometimes complete failure, to what were very good Chinese SME companies that once had bright futures, until they had the misfortune of putting their financial futures in the hands of these advisors.

Of course, the guiding principle behind all investment decisions must be “caveat emptor”. Chinese bosses clearly didn’t “caveat” enough. That’s regrettable. But, the gains made by the advisors, lawyers and bankers were so enormous, and so ill-gotten. That’s the heart of the matter: Chinese companies were ruined so that a bunch of ethically-challenged finance people could get rich.  For me, this is contemptible.  How these people sleep at night I don’t know.

I do know this: we try to do everything we can to make it less likely that a good Chinese SME goes the same route, and ends up in the same sad condition. One way is through information. We’re producing Chinese-language materials meant to explain the hazards of transactions like OTCBB listings and reverse mergers. Our plan is to distribute the materials as widely as possible, both online and off. It may not put the bad guys out of business, but at least it will make it easier for Chinese SME bosses to know which questions to ask, what kind of track record to look for or, more often,  run away from.

I’ll be sharing soon on this blog  the English version of some of this information.

 

 

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