October 6, 2011

Regulatory Responses to Reverse Merger Fraud

Kenyataan Akhbar

Regulatory Responses to Reverse Merger Fraud

Amidst the growing burden from fraud accusations related to the reverse mergers of Chinese companies into public shells, the recently proposed rule filing by the New York Stock Exchange to adopt more stringent listing requirements is the latest step in the protecting the integrity of U.S. capital markets and investment dollars. As a result, more strict rules are being created. Under the proposed rules developed by the NYSE, a reverse merger company would not be eligible for listing unless the combined entity had, immediately preceding the filing of the initial listing application:

(1) traded for at least one year in the U.S. over-the-counter market, on another national securities exchange or on a regulated foreign exchange following the consummation of the reverse merger and (i) in the case of a domestic issuer, filed with the Commission a Form 8-K including all of the information required by Item 2.01(f) of Form 8-K, including all required audited financial statements, or (ii) in the case of a foreign private issuer,filed the information described in (i) above on Form 20-F;

(2) maintained on both an absolute and an average basis for a sustained period a minimum stock price of at least $4; and

(3) timely filed with the Commission all required reports since the consummation of the reverse merger, including the filing of at least one annual report containing audited financial statements for a full fiscal year commencing on a date after the date of filing with the Commission of the filing described in (1) above.

In addition, a reverse merger company would be required to maintain on both an absolute and an average basis a minimum stock price of at least $4 through listing.”

The proposed rules would require companies to have a seasoning period that would allow auditors more time to identify control weaknesses and misstatements due to fraud.

The measure by the NYSE follows a similar proposal by NASDAQ that was filed with the SEC a few months prior.

According to Nasdaq’s filing, a reverse merger company would not be eligible for listing “until six months after the combined entity submits all required information about the transaction, including audited financial statements, to the SEC. Further, Nasdaq proposes to require that the company maintain a $4 bid price on at least 30 of the 60 trading days immediately prior to submitting the application. Finally, under the proposed rule, Nasdaq would not approve any Reverse Merger for listing unless the company has timely filed its two most recent financial reports with the SEC if it is a domestic issuer (this could be two quarterly filings or a quarterly and an annual filing) or comparable information if it is a foreign private issuer.”

While the additional assessment period will help auditors identify control weaknesses and fraud, there are risks related to the quality of the auditing practices between the U.S. and China. According to PCAOB reports, a substantial number of audits are performed by Chinese and small U.S. accounting firms – perhaps without the appropriate knowledge of PCAOB auditing requirements and U.S. GAAP issues. This has led to the replacement of smaller audit firms with more experienced companies.  In addition, more than two dozen accounting firms have resigned from engagements based upon suspicions of fraud and improper accounting treatment. In July, the PCAOB visited China to have a discussion with Chinese financial regulatory bodies. The goal of the trip was to develop cross border auditing standards and allow access to each nation’s audit work papers. In a release issued by the SEC, it believes that the trip was a step in the right direction towards achieving these results.

While cross border audit standards have not yet been achieved, this has not stopped U.S. regulatory agencies from taking action to mitigate the risk of reverse merger fraud. The PCAOB has issued Staff Audit Practice Alert No. 6 and Staff Research Note #2011-P1 to ensure that audit firms are following appropriate auditing standards. The SEC recently took an enforcement action based on a firm’s audit of a Reverse Merger company. The SEC suspending  trading in a number of reverse merger entities such as Heli Electronics, China Changjiang Mining & New Energy, and RINO International.

With this string of action, the regulatory bodies have sent a message that they will take action to prevent a new wave of financial reporting fraud.