According to the U.S. Securities and Exchange Commission's website, there are currently 144 domestic Chinese companies registered with the Commission. This number is deceiving, however, since more and more Chinese companies are entering the U.S. through business combinations with U.S. domestic listed companies or through off-shore holding companies, utilizing the WOFE, or wholly-owned foreign enterprise, structure. For the U.S. acquiror or partner, conducting due diligence on the Chinese company poses several unique challenges. Further, the decision to "domesticate" in the United States or remain a "foreign private issuer" can have significant ramifications for the company's ongoing regulatory compliance obligations. Foreign private issuers continue to enjoy certain levels of relief from the U.S. compliance regime by virtue of the fact that they are also required to comply with their local, or "home country," reporting requirements.
Paths To The U.S. Public Markets
The current favored strategy for many Chinese companies is to consummate a reverse merger with an existing SEC reporting company, preferably one that is listed on NASDAQ or the AMEX. A long-standing M&A vehicle, this structure has been revitalized by the dynamics of today's capital markets into a quick and easy route to the U.S. public markets. The reverse merger is no longer driven principally by tax or other structural considerations; rather, it offers a public liquidity option for private investors, while providing a broadened institutional and retail investor base. Today's reverse merger is considered preferable to a traditional IPO since it allows the company a gentler, more predictable foray into the continuing volatile U.S. public markets. In August of 2006 alone, generally a "quiet" month for market activity, 11 reverse mergers were completed and five more were announced, with activity showing no signs of weakening.
The reverse merger continues to garner market favor over a traditional IPO for several reasons. The capitalization structure is negotiated in advance, including the ability to adjust the existing public float and allocation of control to desired post-transaction levels. Similarly, the pricing framework is negotiated as part of the merger agreement, leaving little opportunity for the transaction to stall as a result of valuation concerns. With an existing public shareholder base provided by the target listed company, the transaction is far less susceptible to IPO market cycles. The once-private company, post-merger, now has "acquisition currency" through its publicly-traded stock, which has become increasingly in demand in recent years.
Typically, the surviving corporation will be a controlled U.S. corporation, with the original investors in the Chinese company maintaining upwards of 90% of the outstanding share capital. This puts obvious pressure on the trading market, and a strategy to address liquidity issues should be developed prior to the close of the transaction.
To tackle this issue, most Chinese-U.S. reverse mergers will include a concurrent fundraising exercise, known as a PIPE financing or "private investment in a public entity," coupled with registration rights. This is often designed to increase or diversify further the public investor base, and can include shares from current private investors seeking to sell-down their holdings. In addition, the PIPE provides a valuable opportunity for the Chinese company to embark on an institutional roadshow to raise investor awareness and, ultimately, to support the after-market trading of the stock.
Over the course of the past 18 months, PIPEs conducted in connection with a reverse merger have raised amounts equal to over half of the company's pre-money market capitalization. This has created concerns at the SEC, where certain staff members may view the resale registration as, in fact, a primary offering by the company. Recent deals have been structured to account for this concern in order to avoid any delays by the Commission in declaring the registration statement effective.
The majority of reverse mergers are effected with OTC Bulletin Board companies, although reverses have been done as well with AMEX, NASDAQ and even AIM listed companies. Two reasons are evident for the popularity of Bulletin Board companies. First, the acquisition price of the target listed company can be significantly less than that of an AMEX or Nasdaq company. Prices for Bulletin Board companies have increased over 100% in the past 18 months and average in the $500,000-plus range. A "clean" Nasdaq Capital Market company can cost over $1 million. This price inflation has caused a number of "service providers" to register Form 10 shell companies with the SEC, solely to meet the demand of the burgeoning reverse merger market.
Another reason to favor a Bulletin Board company over a Nasdaq or AMEX target is to avoid the more stringent listing requirements imposed by those exchanges. The Bulletin Board requires that a company remain current in its SEC filings, but does not impose the more demanding corporate governance controls of the main exchanges. This enables the Chinese company to ease itself into the U.S. reporting and compliance regime, develop its cost and support infrastructure on a more measured basis and then "graduate" to a main exchange.
If, however, the Chinese company sets its sights on a main exchange, it must be certain that it can meet the demanding quarterly reporting schedule imposed by the SEC. The reporting and compliance regimen for U.S. domestic issuers is a principal reason that many Chinese companies choose to remain foreign private issuers and list their shares in the U.S. through an off-shore holding company, typically located in the British Virgin Islands, Hong Kong, or the Cayman Islands.
SPACs Offer Alternative Route
In recent months, there has been a developing twist on the reverse merger strategy, and that is to utilize a merger with a SPAC, or Special Purpose Acquisition Company, as a path to the public markets. The end result is the same: the privately held Chinese company becomes a public listed U.S. company. Most SPACs are listed on AMEX or the OTC Bulletin Board, as Nasdaq has taken a policy decision to exclude these entities from listing on its exchange. SPACs can also be listed on AIM and, notably, without the U.S. regulatory burden or structural restrictions.
Recent SPACs have been formed solely with the intent of locating a suitable merger partner in China. For example, Great Wall Acquisition Corporation was formed in March 2004 with the intent of acquiring or merging with a China-based technology, media or telecommunications company. It eventually merged with ChinaCast Communication Corporation. Shanghai Century Acquisition Corporation, formed in April 2006, is not focused on any specific industry in China, whereas others, such as China Mineral Acquisition Corporation, are sector-specific. This trend in country-specific SPACs is expected to continue as the markets in China and other countries, such as India, present very attractive opportunities for institutional investors.
Due Diligence Poses Significant Challenge
As with any business combination, a successful due diligence exercise often holds the key to whether the transaction ultimately closes. There are particular challenges when conducting due diligence on a Chinese company, not the least of which is the translation of documents into English. This is not merely an issue of understanding the substance of various agreements and other company materials - certain of these documents will be required to be filed with the SEC prior to or upon closing of the transaction, typically as material contracts which must be disclosed. The translation from Chinese can be time-consuming and costly in order to ensure the terms of the agreement are not subtly misinterpreted given the tonal nature of the Chinese language.
Performing financial or accounting due diligence on a Chinese company can be critical. A good understanding of the differences between Chinese accounting principles and U.S. GAAP is required, of course. However, the U.S. partner must be certain to inquire as to the company's status under the various Chinese "tax holidays" that have been statutorily granted. The extent to which these tax holidays apply can have a significant impact on the company's net income, particularly going forward when the tax holidays no longer apply and the company must make appropriate provisions on its books for future liabilities.
Other key diligence will center on the company's organizational structure - such as, whether it is a wholly-owned foreign enterprise, or WOFE. Are the proper licensing and operating arrangements in place with the offshore holding company? The company's structure may well impact the ability of the company to pay dividends to shareholders and to repatriate offshore income. Similarly, special governmental regulations may apply to the company's particular industry or sector, thereby impeding or enhancing the company's ability to transfer assets or income offshore.
Differing U.S. Compliance Regimes
The obligations and timetable for ongoing compliance with the U.S. federal securities laws as a U.S. domestic issuer can be onerous for many Chinese companies that may not initially have an adequate U.S.-style infrastructure in place. Notably, a less burdensome regime exists for foreign private issuers, thus providing a significant incentive for Chinese companies to remain "offshore." Foreign private issuers are required to submit audited financial statements with respect to the year-end numbers within six months of the fiscal year-end in an Annual Report on Form 20-F. Rather than quarterly reporting requirements, interim financial statements must be provided to the SEC at least semi-annually on a Form 6-K. The Form 6-K is akin to the Form 8-K report for U.S. domestic issuers and does not require the detailed disclosure of a quarterly report on Form 10-Q. In addition, the offshore Chinese company is not subject to U.S. proxy rules or Section 16 reporting on the theory that it will comply with its home country requirements regarding shareholder meetings, director and officer shareholding disclosures and the like.
Another issue which should not be overlooked by Chinese companies is with respect to the ability to "deregister" from the U.S. reporting regime. The SEC proposed new rules in December 2005 for foreign private issuers seeking to deregister and final rules are expected before the end of 2006. In essence, the U.S. reporting and compliance regime under the Securities Exchange Act of 1934 precludes a company from truly exiting from the SEC's requirements once its securities have been registered. This is colloquially referred to as the "roach motel" - once you get in, you can never leave. A company can "delist" from an exchange easy enough, but its obligations under the Exchange Act are merely "suspended" until and unless it exceeds certain thresholds in terms of shareholders and assets, at which point it is again subject to full reporting.
Opportunities for Chinese companies to access U.S. investors have increased dramatically in recent years through a variety of business combination vehicles that avoid the uncertainty of a traditional IPO. Due diligence on the Chinese company can be complex and requires scrutiny of many Chinese regulations applicable to the target and its ultimate shareholders. In addition, the domicile of the surviving entity can have a significant impact on which set of SEC reporting rules it must adhere to. These transactions have many facets and will typically take more than four months to complete.
Barbara A. Jones is a Partner with the international law firm of Kirkpatrick & Lockhart Nicholson Graham LLP and practices from its Boston and New York offices. Ms. Jones specializes in international business transactions, including M&A, private equity and public and private offerings.