SEC Commissioner Luis Aguilar, in a speech Monday about capital formation, highlighted a disturbing trend that seems to be challenging capital formation and investor protection.  He referred to a spike in private companies merging with a public shell company as a way of going public - with Chinese companies having grabbed recent headlines.  While acknowledging that the majority may be legitimate businesses, "a growing number" are proving to have "significant" accounting issues or are "outright vessels of fraud."  This has led to trading suspensions and other enforcement actions, Mr. Aguilar told attendees at the Council of Institutional Investors Spring Meeting.

        Ways to Access the Public Markets.  The traditional IPO remains the gold standard - complete with robust disclosures, time to review and consider them, backed up by real liability that puts the risk of false statements on the people in the best position to ensure accuracy, not on the investors.  All that's further supported by due diligence efforts by underwriters and auditors. 

A second way is Exchange Act registration of a class of securities, rather than through registration of a public offering - e.g., when the company reaches a certain size and has a class of equity securities that is considered widely-held because of its number of shareholders, it's required to provide public disclosures.  However, unlike a traditional IPO, there is no underwriter performing due diligence.

A third common but lesser known way is the reverse merger into a public shell, or where a public shell merges into a private company, a so-called “backdoor registration.”  Before the transaction, the public shell company no longer has substantive operations, but its public company registration remains in effect.  The transaction gives the formerly private company the credibility and access to capital of being registered as a public company, without any of the vetting from underwriters and investors that companies undergo when they perform a traditional IPO.

        Increased Backdoor Registrations = Growing Problems.   Since January of 2007, there have been over 600 backdoor registrations - 1/4 of them by companies from China and the China region.  A growing number of them are proving to have significant accounting deficiencies or being vessels of outright fraud. 

e.g. - 2 companies that were numbers 1 and 2 on the Investor’s Business Daily 100 have now been shown to have significant issues. One had to restate its earnings and was delisted just last week;  the other has admitted that at the very least 2 of its manufacturing contracts didn’t actually exist.

Last Friday, the SEC suspended trading in another Chinese company that became public in the U.S. through a shell.  This was the 2nd SEC trading suspension imposed on Chinese companies in this situation in the month of March alone. 

Nasdaq and NYSE Amex also have recently suspended trading in several of these companies.

The use of backdoor registrations to gain entry into the U.S. public market by Chinese companies also has raised some unique issues, even compared to mergers by U.S. companies, including:  (i) there appear to be systematic concerns with the quality of the auditing and financial reporting; and  (ii) even though these companies are registered here in the U.S., there are limitations on the ability to enforce the securities laws, and for investors to recover their losses when disclosures are found to be untrue, or even fraudulent.

        Difficulty in Prosecuting Violations.   The SEC has found that backdoor registrations make if more difficult to prosecute violations.  Enforcement against falsehoods in the context of these companies is difficult.  The documents and people who have the information about the company and whether there was misconduct are often outside the reach of subpoena power.  However, notwithstanding these obstacles, our staff is committed to doing everything they can with the resources we have. The SEC has already brought cases and will continue to do so.

In one case, the SEC launched a formal investigation against Chinese printing equipment maker Duoyuan Printing on concerns it filed false documents, failed to maintain adequate financial records and deceived its external auditor, Deloitte Touche Tohmatsu. 

Mr. Aguilar noted that the SEC has launched an internal task force to probe fraud by overseas companies listed on U.S. exchanges.  He added that SEC staffers are "committed to doing everything we can."  

For further details, go to:  [SEC Commissioner Speeches, 4/4]