June 29, 2011

Avoid Investing in Reverse Merger Companies

 Have you heard of a "reverse merger" company?  The SEC describes a reverse merger as : "In a reverse merger transaction, an existing public “shell company,” which is a public reporting company with few or no operations,1 acquires a private operating company—usually one that is seeking access to funding in the U.S. capital markets."  

I got that quote from an SEC investor warning about reverse merger companies.   On the same topic Forbes says in How to Spot a Pump and Dump of reverse mergers that " this variety of reorganization happens to be a common first step in penny stock scams."

There have been some recent problems with reverse mergers.   In that investor warning the SEC says they have suspended trading in several companies because of concerns over the accuracy and completeness of their financial filings.  The list is :
Heli Electronics Corp. (HELI);
China Changjiang Mining & New Energy Co (CHJI)
RINO International Corporation (RINO);
Advanced Refractive Technologies, Inc. (ARFR);
HiEnergy Technologies, Inc. (HIET); and
Digital Youth Network Corp. (DYOUF):

If you'd bought any of these you'd have lost all or virtually all of your money.

Recently there have been several Chinese companies that did reverse mergers with virtually dead US companies merely as a method of getting into the US stock market.   Several of these companies have had some major issues with their financial reporting.  Some people allege that there are Chinese companies perpetrating financial fraud and reporting false information to the SEC. This article claims: 1 in 10 reverse mergers of Chinese firms on US stock exchanges "fraudulent"    I'll leave it for the authorities to decide who is committing fraud and who isn't.   But there is sufficient reason for concern.  For these reasons I would be particularly careful of Chinese reverse merger companies.    Personally I think that buying stock in foreign companies should be left to the experts and that individuals are best to go with index funds if want to buy foreign stocks.

How do you spot reverse merger??  

An article on Chinese reverse mergers says that one way to tell is if they list a 5.06 item in their 8-k filings.   One such example is the 8-k from Rino International which was one of the companies the SEC stopped trading on.  In their 8-k it says:

Item. 5.06   Change in Shell Company Status.

As a result of its acquisition of all of the outstanding capital stock of Innomind and the Restructuring Agreements, as described in Item 2.01, which description is in its entirety incorporated by reference in this Item 5.06 of this Current Report, the Company ceased being a shell company as such term is defined in Rule 12b-2 under the Exchange Act.

THis is a clear sign of a reverse merger.   You may also tell by finding references to a reverse merger specifically in the companies filings.   THey should expose this as a risk element in their financial statements.   Spotting reverse mergers isn't always easy.   For that reason again, in general I'd recommend avoiding buying stock in foreign companies unless you've done good due diligence to investigate them and ensure they are legit.

This is not to say that all reverse mergers are bad.   Its just a financial mechanism.  Some well known names like Atari and US Airways went through reverse mergers.    Unless you're talking about a well known entity then I think that the risks involved in buying a reverse merger company are too high for us normal people and so we should avoid buying into reverse mergers.

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