Chinese Merger Tactics Show Importance of Incorporation Transparency

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Reuters recently released the second feature in Shell Games, a series “exploring the extent and impact of corporate secrecy in the United States.” The first special report in the series, “A little house of secrets on the Great Plains” dealt with shell companies established in Wyoming, generally recognized as a secrecy jurisdiction, and how some have been used to hide illict assets .

The newest report, “China’s shortcut to Wall Street” details how the reverse-merger process has allowed many Chinese companies to become publicly traded in the U.S., while bypassing many regulatory controls. The article details the process:

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.

These issues are further complicated as many Chinese companies are actually incorporated in the British Virgin Islands or other secrecy jurisdictions, making tracing the details of financial transactions and taking action against companies more difficult.

Reverse-mergers are not a recent development, but have taken off dramatically of late, especially as Chinese corporations began adopting the practice, with over 400 doing so in recent years. With well over 1,000 publicly traded shell companies—generally with little or no actual assets in existence—the potential opportunities to exploit this unregulated backdoor to public trading abound, though it has become far less frequent since the process became well publicized. Since then, stock values have fallen, as accounting irregularities have become apparent and as short-sellers set these companies in their sights.

The bi-partisan Incorporation Transparency and Law Enforcement Act of 2011, introduced yesterday by Senators Carl Levin (D-MI) and Chuck Grassley (R-IA), would aim to improve transparency in the incorporation process. Among its provisions is an element requiring states to determine and report the beneficial owners of corporations incorporated in their states. Federal agencies will then be able to obtain that information for investigations with subpoenas, uncovering some of the layers of secrecy used to hide illicit enterprises.

GFI’s Heather Lowe spoke about the important role increased information about shell companies will play for law enforcement and financial oversight agencies:

The U.S. financial system is a playground for corrupt, criminal, tax evading individuals from other countries,” said Ms. Lowe. “It is far too easy to gain access to financial services in the U.S. through anonymous U.S. corporations, while it is far too difficult for law enforcement groups to figure out who is really behind those corporations.

You can read Senator Levin’s release on the bill here, and find out more about beneficial ownership issues from the Task Force.