Seasoning Requirements: Regulating Chinese Companies And Reverse Mergers

On October 26th the SEC closed debate on a proposal to adopt “seasoning” requirements for companies listed on public exchanges, such as NASDAQ and NYSE. The proposed seasoning requirements aim to protect investors from a rash of accounting scandals perpetrated by companies that have avoided normal reporting and auditing requirements through the strategic use of reverse mergers. Many of the companies that have been engaging in reverse mergers and perpetrating these accounting scandals have been based in China, which have caused US investors to flee from Chinese equities.

Julie Allen, partner and head of Proskauer Rose LLP’s capital markets team, explains that a reverse merger is the acquisition of a public company by a private company where the public company is the ultimate surviving entity and the private company’s shareholders acquire control of the public company. This scheme allows the private company to forego the arduous and costly Initial Public Offering (IPO) process. Essentially, the private company becomes an SEC reporting company, with rights to offer securities on public exchanges, without having to file an IPO registration statement with the SEC, an important vetting process that protects investors. Typically, the public entity acquired in the reverse merger is merely a shell company with no meaningful operations. While legal, reverse mergers are prone to fraudulent and abusive use, particularly by foreign companies seeking access to American capital markets. Recently, regulators and legal experts have kept close watch on China-based companies who view this method as an easy and cheap way to raise capital in the US.

The ABA reports that some China-based reverse merger companies lack employees or customers, and some have reported falsely elevated profits. As a result, many Chinese companies have been subject to regulatory action and shareholder lawsuits. For instance, the SEC suspended trading of China-based Changjiang Mining & New Energy’s (CHJI) stock after discovering irregularities in the company’s public filings. CHJI began trading on the NASDAQ exchange after a reverse merger with a Nevada corporation called North American Gaming and Entertainment Corp., a failing video poker machine business.

Stock exchange seasoning requirements aim to push back against reverse merger companies by delaying the listing of a reverse merger company for a certain period of time. Specifically, Nasdaq proposes to “prohibit a reverse merger company from applying to list [on the exchange] until the combined entity has traded in the U.S. over-the-counter market, on another national securities exchange, or on a foreign exchange for at least six months following the filing of all required information about the Reverse Merger transaction, including audited financial statements, to the [SEC].” David Feldman, partner at Richardson and Patel, argues that the seasoning rule will have a “chilling effect of discouraging exciting growth companies from pursuing all available techniques to obtain the benefits of a public [sic] listed stock and greater access to capital.” Feldman notes that many Chinese companies who have gone through the reporting and auditing requirements of an IPO have later been found to engage in accounting frauds similar to those receiving attention because of reverse mergers, and thus it is unlikely that the regulatory focus on reverse mergers would remedy the problem. In contrast, Richard Rappaport, CEO of Westpark Capital Inc., generally agreed with the seasoning requirement and its potential to curb regulatory violations.

NASDAQ’s CEO predicts that implementation of seasoning requirements is likely. The seasoning requirements remain the best solution to prevent continued fraud from reverse merger companies and provide some protection for American investors looking for opportunities in emerging economies like China. Debate over the necessity of seasoning requirements appears to be just another episode in the struggle for US regulators to control the growing influence of less-regulated emerging economies on US capital markets.