This is a repost of an entry from my investing blog made on September 10 2010.
A long article titled "Beware of this China Export" appeared as the feature story on the Barron's on August 28 2010 (link here). The article tells the story about one particular "backdoor" for foreign, especially small, tiny, no name Chinese companies to gain access to North American investors' money, the reverse merger into public shell companies. The article subsequently went on to discuss the mediocre performance of this category of stocks. I don't necessarily agree with the conclusion of underperformance made by Leslie Norton and Bill Alpert, because there are so many issues of comparing a group of stocks performance to that of an index (Halter USX China Index in this case), such as survivorship bias, index composition etc. I do strongly believe that fraud, the biggest risk implied by the article, is very real when investing in such particular asset class. In fact, early in my career, I had experience of doing portfolio performance analysis, attribution and backtesting. I strongly believe if the important factor of survivorship bias has been properly accounted for and adjusted in such comparison, the reverse merger group's performance would have turned out to be a lot worse than the index. Why? Simply because not all those RTO companies made their way from OTCBB to a listed exchange and even into the Halter index. A lot of them were delisted to pink sheet or became non-compliant in SEC reporting. If the definition of the general RTO group is to include those non-survivors, the true performance is a lot worse than it looks.
Regardless of how one thinks the performance should be calculated. I think the market has seen a large number of blowup recently in RTO stocks as the result of companies' earnings restatements, discovery of fraud, misleading presentation to investors. I am going to explain, from my personal point of view, why there is such rampant behavior of fraud in RTO Chinese stocks based on what we have seen over the past year or two. Every phenomenon started with a basic demand and ends up having some financial incentives being driver of a bubble.
Now let's take a look at the various participants, interested parties and their roles behind the RTO game:
1. Micro, small Chinese companies (RTO candidates/companies) - the demand for capital
2. Local stock promoters/bankers/consultants (local bankers) - providing services to RTO candidates on restructuring, preparation for auditing, US listing and introducing investment bankers
3. Investment bankers - providing the underwriting services
4. PIPE investors - Usually hedge funds or private equity funds providing the initial capital to RTO companies
5. Service providers - Lawyers, auditors, PR agencies and IR firms that promote stocks
6. Stock exchanges - Providing a marketplace or platform for the RTO stocks to make themselves visible to the public, PIPE investors to exit and further fund raising to take place
7. Public market investors - demand for a piece of the high growth "China story"
The RTO game starts with a small Chinese businessman with an immediate or short term need for funding, but due to the small size of its business or other restrictions (sometimes his/her business is simply a money raising scam) he/she couldn't get a loan from a local bank or possibly attract the attention of local Chinese investment funds. A local banker tells them that they can easily raise $10-50 million or more by going public in the US. The local bankers then introduce the company to service providers such as Chinese/US lawyers, accounting consultants, auditors as well as US investment bankers. With some coaching by the local and US investment bankers, the RTO candidates get the reverse mergers complete and typically raise some small amount (relatively) of money from hedge funds that specialize in this game. The hedge funds (PIPE investors) typically require the companies to sign some restrictive terms along with the financing, such a "make-good" provision that includes unrealistically high earnings growth target or allocation of part of the financing proceeds to hire a specialized service provider, an IR firm. The game goes on with the RTO company miraculously achieve the revenue/earnings targets in the "make-good" provisions (hey, this is China, anything is possible) and get their stocks uplisted to a national stock exchange. Here, the IR firms or PR agencies promote the companies to naive public market investors such as mutual funds, pension funds and retail investors, so the stocks liquidity (hopefully) improve a lot. PIPE investors find a market for their shares purchased at ultra-low valuations. Investment banks get to underwrite a series of larger secondary offering of common stocks. The RTO company take home millions of investors money.
Victory is declared by all game participants, except for the ones still holding the stocks. The local bankers takes home some consulting fees and perhaps free equities as kickers. The service providers get either a lucrative one time or recurring revenue. PIPE investors make good money by dumping their stocks after the companies being heavily promoted. Underwriters earns huge commission or fees by selling stock offerings to investors. Stock exchanges happily collect listing fees. Lastly, public market investors get to own some "fabulous" stocks with exponential upside potential, until the day they realize the companies are lying to them about their own financials.
This game happens because there is very little repercussion for Chinese businessmen for defrauding US investors, so the incentive for exaggerating their own businesses' prospect are so strong, especially considering some investment bankers kept knocking on their doors offering to help raise some cash. At the same time, US investors have very little, if any, recourse against the fraudulent Chinese companies, because their courts can't subpoena records from China and have no jurisdiction over businessmen residing in China. The service providers are all happy to get paid and why do they care about the fate of investors.
The SEC simply has too many items on its agenda to look at such low priority problem. Ultimately, it comes down to the investing public to wake up from the frenzy about these money-raising scams. Because it was originally an investor's own greed and appetite for risk taking that got themselves into such trouble.
My advice to investors on how to spot a RTO fraud:
1. Always check whether there's stock promoters behind the stock - an example of a notorious stock promoter is the RedChip Companies, which disguises itself as a research firm and makes disclosure of getting paid for promoting clients' stocks in the bottom of their webpage or publication with tiny fonts. Don't take my word for it, go to their website and check out how many of their valuable clients are penny stock fraud. A different example is the notorious Benjamin Wey from the New York Global Group, who represent both a stock promoter in the US and a local consultant/banker in China. Wey's NYGG has orchestrated the RTO of numerous, at best, very questionable Chinese companies, whose stock prices have been artificially pumped up and subsequently fallen to "the dollar store". There're also quite a number of indications that companies taken public by NYGG are quite possibly total frauds.