Fortune Cookie reads : “Every excess becomes a vice.”

Investors have alleged widespread accounting irregularities and other problems at dozens of the Chinese companies that reverse-listed in the U.S., causing share prices to nosedive. Since March, some 30 Chinese firms have seen their auditors resign and at least 25 have been delisted from U.S. exchanges.
$18 BILLION GONE

A Reuters examination of a cross-section of 122 Chinese reverse mergers on U.S. markets found that between each stock's peak trading price and July 10, 2011, those companies saw a total of $18 billion of their market capitalization vanish.

Reuters interviewed nearly 100 industry participants and examined financial records of dozens of Chinese companies to paint the most detailed picture yet of the network of dozens of players involved in the reverse-mergers boom.

That industry hinges on a handful of leading "shell brokers" such as Halter who purvey paper companies; investment banks who specialize in financing a firm after a reverse merger; and auditors, usually small shops, who are lightly regulated in the U.S.--and not at all in China and Hong Kong. The controversy has stirred up new tensions between Washington and Beijing, which held talks on the matter in July. The Public Company Accounting Oversight Board, the U.S. auditing watchdog, issued a report in March about potential problems with the audits of Chinese companies formed through reverse mergers. The Securities and Exchange Commission has set up a working group to examine Chinese reverse mergers, and the Federal Bureau of Investigation has opened its own broad investigation, say people familiar with the situation.

The Chinese reverse-merger boom and bust offer insight into a little-understood corner of American business: the widespread use of shell companies, which can offer their owners a way to minimize regulatory scrutiny. The U.S. in recent years has called for much greater transparency in global business transactions. But on American shores, opaque shell companies are rife.

"It appears that some Chinese firms have seen a way to access the strongest public markets in the world, but through the weakest area of enforcement," says Republican Rep. Patrick McHenry, a member of the House Committee on Oversight and Government Reform.

REVERSE GEAR

A reverse merger hinges on a shell company-a firm without meaningful assets or operations, used as a vehicle for transactions-that's already listed on a stock exchange.

A deal typically starts with a so-called shell broker, anyone from a small shop to a larger firm such as Halter's. Brokers acquire shells, often domiciled in a secrecy-friendly state such as Delaware, Utah or Nevada. The broker then sells the U.S. shell to an operating company seeking to trade on a U.S. exchange-a transaction which, unlike an initial public offering, isn't overseen by regulators.

The acquiring firm thus becomes a publicly-traded company, with access to U.S. investors - but without the time, expense and scrutiny of a traditional initial public offering. Companies are incorporated under state rather than federal law, and so the federal overseer of stock flotations, the Securities and Exchange Commission, doesn't as a matter of course review reverse mergers until after the deal is done.

In Chinese deals, the buyer is often a holding company based in Delaware, the British Virgin Islands or other tax haven, which in turn controls the actual operations on mainland China. This structure complicates the ability of U.S. regulators to dig into the accounts of the resulting firms.

In recent years, one in three U.S. reverse mergers involved a Chinese operating company. In 2010, 260 reverse mergers were completed, according to deal tracker PrivateRaise. Of those, 83 deals involved operating companies in mainland China.

There are more than 1,200 dormant public companies in the U.S., PrivateRaise says. They can be purchased for as little as $30,000, then sold by shell brokers for as much as 10 times that amount or more. Brokers say that in 2007 and 2008, the peak of the market, Chinese firms would pay up to $800,000 for a high-quality shell, one with no lingering liabilities. Reverse mergers, to be sure, are a legitimate way to gain access to capital for smaller companies that can't afford a full-fledged initial public offering or don't need to raise large sums. The problem isn't the technique, defenders argue, but rather people who misuse it.