Chinese RTO BUSI 3001 SBLCWeek 3(4), Spring 2014

Charles Mo & CompanyMarch 17, 2014

Reverse Take Over/Reverse Merger In a Traditional Merger, the acquirer company retains the parent legal entity/structure,

issues stocks or cash to buy out the acquired company. Thus the acquired company may cease to exist or becomes a subsidiary of the Acquirer.

In a Reverse Merger, the acquirer company is in name only, probably is a dormant company, and does not own any assets. but will retain the legal entity after the reverse merger. The acquired company wanting to go public injects itself with its own assets into this dormant company in exchange of stocks.

The dormant company usually is a US listed penny stock or a shell company traded over the counter

Injecting company’s management takes over control of the new RTO company, changes its name, offers additional shares to the public.

Initial capital/expenditure for attorneys, accountants, investment advisors are paid by the injecting company.

Only through a secondary offering or private placement will an RTO company receives funding of capital.

This is a shorter route to get listed in a US Exchange without going through the formal and rigorous process of an IPO.

From 2007 through March 2010, 159 Chinese companies listed in the US through reverse takeovers,. 3 times the number of Chinese IPOs in the US.

Disadvantage of an RTO Chinese company going through RTO must spend capital in

advance to execute the purchase of the US RTO unlike IPO which receives capital from the capital market.

Fees for investment bankers, attorneys, and accountants may amount to multiple million and as high as 7-9% of the capital raised.

Sometimes raising the capital never happens since institutional investors shuns away from the OTC stocks.

The RTO company may subject itself to hundreds thousands of dollars in annual tax liabilities and regulatory compliance costs since now the RTO company is subject to US tax regulations.

So why do Chinese companies still go for the RTO?

First generation of Chinese entrepreneurs are relatively naive in the art of raising capital.

Chinese entrepreneurs see any public listing as a pride and a marketing tool.

Chinese entrepreneurs face enormous hurdles of securing local capital and financing.

Black market interest rate has reached as high as 200% per year It is more attractive to raise financing through public listing

overseas. Unfairly taken advantage by unscrupulous foreign investment

bankers/attorneys

Advantages of an RTO

Immediate public trading status Lesser cost than an IPO Less stock dilution Unlike IPO, the process of going public and raising capital are

separate. A company can go public without raising additional capital.

RTO is less susceptible to market condition than that of an IPO IPO may take a year or more to complete, but an RTO can be

completed in as little as 30 days

Where can you list in the US for an RTO?

OTCBB - Over-The-Counter Bulletin Board Pink Sheet – National Quotation Bureau NASDAQ - Nat Assoc of Sec Dealers Automated Quotations NYSE – New York Stock Exchange NYSE Euronext – Former American Stock Exchange

Number of Chinese firms listed in the US via Reverse Takeover vs. IPO ( from 2007 through March 31, 2011)

Reverse Mergers: 159 from a total of 603

IPO : 56 from a total of 433

Source: PCAOB

Casualties of RTO companies in 2011 26 Chinese companies delisted in 2011 in the US

stock exchange Reasons got delisted from major exchanges

Traded under $1 Failure to meet disclosure requirement Financial status questioned

Who can suspend the public trading of a stock? SEC NASDAQ NYSE

SEC ability to discipline the delisted Chinese companies is limited

RTO s are legal, but the SEC can’t extend its jurisdiction into China

So SEC can’t subpoena documents and people. With company assets and most senior executives in China, the

US has limited scope to enforce any decisions against them.

Media Express listing MediaExpress programs entertainment and sells ad space on video screens

installed in buses. Listed its shares through a reverse takeover on NYSE Euronext’s American

Stock Exchange in October, 2009 Raised $46 million In January 10, 2010 Mr. Greenberg’s Starr International poured in $30 million

in a private placement MediaExpress continued to report rapid growth in earnings. In October, 2009,

Starr Itl poursed in additional $13.5 million In November, short sellers started to become suspicious at ME’s return on

assets were three times higher than the next best competitor. Muddy Waters Research reported fewer than half of the 27,200 buses than

ME claimed.

Couldn’t or shouldn’t the CPAs and the Investment advisors and underwriters foresee fraud problems?

Longtop Financial Technologies The company shares were delisted from the NYSE in August, 2011 SEC is trying to enforce a subpoena for files related to audits Muddy Waters, a short selling research firm charged the company’s

financial statements as unfairly stated. The auditor Deloitte China resigned as a consequence and citing

problems of verifying cash balances. Fake revenues and fake cash were reported.

Deloitte contented that handing over the audit work paper would trigger violation of China’s state secrets laws

Possible lawsuits against auditors, management, and board of directors.

Cease and Desist on Delist - Relist

Buy cheap China companies listed on NASDAQ, AMEX Take them private

Bain Capital to spend $100 million taking NASDAQ listed China Fire & Security Group private

Abax Capital planned buyouts of NASDAQ listed Harbin Electric and Fushi Copperweld for more than $700 million

Caveat Companies may not look as undervalued Lots of problems with RTO Class action lawsuits

Relist in China CSRC may view these delisted companies as not listable

Risks of a public company gets de-listed

Class action shareholders lawsuit Derivative lawsuit Lack of sufficient coverage in D&O insurance

When joining the board of directors of a US listed Chinese company, you must carefully consider the following conditions.

Must have D&O insurance in any US public company Know the management and see to it that they are ethical Know the company well and at a minimum visit their plant(s) Know the accounting rules in the SEC

Fallout from the SEC decision27_01_2014_017China Critizes Rulings on Auditors

China criticized a decision by a U.S. judge that rekindled a longtime accounting dispute between the two countries and hammered the shares of U.S.-traded Chinese companies, even as China said it would negotiate with U.S. regulators over a solution.

Temporarily suspends the China affiliates of the big Four accounting firms from auditing U.S.-listed companies,

cast a cloud over U.S.-traded Chinese companies and Western multinationals with significant operations in China. It could also confound the plans of Chinese companies considering New York listings

The Big Four accounting firms - PricewaterhouseCoopers, Deloitte Touche Tohmatsu, KPMG and Ernst & Young—have said they would appeal

The ruling, if it stands, could leave more than 100 Chinese companies that trade in U.S. markets without an auditor

Baidu Inc.’s American depositary shares fell 6.2% Thursday and 1.35% Friday, while 58.com Inc.’s slid 6.7% Thursday and 6.2% Friday. Qihoo 360 Technology Co.’s shares declined

3% Thursday and 9% Friday

China ’state capitalism’

Developing country – also a rising superpower Leaders don’t assume the market is pre-eminent State power is essential to maintain stability and

growth One party line and one party rule Model with track record of getting things done Western belief shaken in

efficacy of markets Competence of politicians

Example of quick establishment of an industry China has the world’s largest solar energy industry A shortage of polycrystalline silicon in 2007 – the main raw

material for solar panels 5 producers in the US all taken or bought by Japanese, Koreans, and

Taiwanese prices soared hitting $450 a kilogram in 2008 BJ’s response was swift

Development of domestic polysilicon supplies as national priority Money poured in from state owned companies and banks Local governments expedited approvals for new plants Mr. Zhu Gonshan an entrepreneur magnate raised $1 billion dollar for a

plant, started production within 15 months. In just a few years, he created one of the world’s largest polysilicon

makers, GCL Poly Energy Holding

China’s sovereign wealth fund bought 20% of GCL Poly for $710 million

Today China makes about a quarter of the world’s polysilicon and controls roughly half of the global market for finished solar power equipment

State capitalism -

World’s biggest exporter Second largest economy in the world Rise of powerful state-led economy

China Russia

State run economy can decide Entire new industries Can tilt the playing field against the private sector

China’s practice Mercantilism Piling up wealth in the central banks 3.2 trillion in foreign exchange reserves

Market share of top 10 solar manufacturers, 2009 China has aggressively sought green technology

First Solar ( US) 10% Suntech Power (China) 7 Sharp (Japan) 6 Q-cells (Germany) 5 Baoding Yingli (China) 5 Ja Solar (China) 5 Kyocera (Japan) 4 Trina (China) 4 Sunpower (US) 4 Gintech (Taiwan) 3

Vast majority of the industry controlled by state companies

Government owns almost all major banks Government owns all three major oil companies All three telecom carriers Major media firms

Beijing is now the biggest sources of revenue growth for Caterpillar

Biggest buyer of commercial jets outside the US

Beijing’s goals Wean China off expensive foreign technology

Open door policy launched by Deng Xiao Ping In 1978 brought waves of foreign technology firms

Microsoft Motorola Setting up R&D centers

National Medium and Long term Plan Blueprint for turning China into a tech powerhouse by 2020 Doubling R&D spent from 1.3% to 2.5% of GDP Green technology

Cheap land Export tax breaks Free apartment for 3 years for executives

Example Deng Xunming

China born US citizen Pioneer of America’s solar industry Whose innovations light up the first solar powered billboard of NY

Times’s Square Xunlight Corp

Nurtured by US financial aid Embraced by politicians Pulled in more than $50 million in state and federal grants, loans and tax

credits, partly to bringing jobs to Toledo, Ohio

HuaWei Example Huawei Technologies Co – a privately held

telecommunications equipment maker has its overseas expansion supported by China Development Bank,

In 2004 CDB extended a five year, $10 billion dollar credit line Routinely lends money to foreign buyers to finance their purchases of

Huawei products Revenues risen 200% in the past 5 years Has become one of the top three telecommunications companies

along with Nokia Siemens Networks and telefon AB LM Erricsson Sprint Nextel excluded Huawei and fellow Chinese telecom company

ZTE Corp from a contract valued at billions of dollars because US fears of company has ties to military.

Europe also indicated complaints about Huawei because of its unfair advantage from government subsidy

What do you need to know if you sit on the board of a US listed company

What liability you may face? O & D insurance

Shareholder lawsuit Derivative lawsuit

How do you know that the Chinese companies in the US carries adequate liability insurance?

Board compensation Corporate governance Appointment of Auditor

What if the auditor resigns Filing requirement

Definitions

Secondary offering - The issuance of new stock for public sale from a company that has already made its initial public offering (IPO).

IPO = initial Public Offering - An initial public offering (IPO) or stock market launch, is the first sale of stock by a company to the public. It can be used by either small or large companies to raise expansion capital and become publicly traded enterprises.

Definition Private Placement -(or non-public offering) is a funding round of securities

which are sold without an initial public offering, usually to a small number of chosen private investors.[1] In the United States, although these placements are subject to the Securities Act of 1933, the securities offered do not have to be registered with the Securities and Exchange Commission if the issuance of the securities conforms to an exemption from registrations as set forth in the Securities Act of 1933 and SEC rules promulgated thereunder. Most private placements are offered under the Rules known as Regulation D. Private placements may typically consist of stocks, shares of common stock or preferred stock or other forms of membership interests, warrants or promissory notes (including convertible promissory notes), bonds, and purchasers are often institutional investors such as banks, insurance companies or pension funds.