Reverse takeovers - or RTOs - are a common way for small companies to list on U.S. exchanges using existing publicly listed shell companies. Unlike a traditional initial public offering (IPO), reverse takeovers don't involve the initial sale of any stock, but rather the transfer of stock from a non-operating shell company to a (formerly) private operating company.
For example, suppose that a Chinese manufacturing firm wishes to list its shares on a U.S. stock exchange like the OTCBB or OTC Markets exchanges. Instead of going through the costly IPO process, they could instead purchase the outstanding shares of a publicly traded shell company, assume trading under that name, and then formally change the name to their own.
How Reverse Takeovers Work
Reverse takeovers can be relatively complex transactions, particularly in the context of foreign ownership, which is the most commonly seen form for international investors. But as mentioned in the example above, reverse mergers involve a private company merging with a publicly listed company with no assets or liabilities - e.g. a shell corporation.
Once a controlling stake in the company is purchased (usually 90%), the operating company takes control of the board of directors in a process that can take only a few weeks. Most shell corporations are registered with the SEC, which eliminates time consuming reviews, but reporting companies must file their audited financial statements and disclosures via an 8-K.
Private companies undergo reverse mergers for a number of different reasons, including increased liquidity in share ownership, greater access to capital markets via future stock offerings, the ability to easily use equity as a currency and as part of compensation plans, and even as a retirement strategy for a business owner.
Reverse Takeover Controversy
Reverse takeovers entered the limelight in 2008 and 2009, when several Chinese RTOs turned out to be fraudulent operations. Since these operating companies were located overseas, investors, regulators and auditors often found it difficult to obtain reliable information, setting the scene for the fraudulent activities that followed.
In the summer of 2010, the U.S. Securities and Exchange Commission launched an initiative to determine whether these companies were accurately reporting their financial results and to assess the quality of the audits being done by the auditors. The subsequent investigation halted trading in more than 35 companies based overseas.
In November of 2011, the SEC announced a new set of rules designed to help curb this fraud in NASDAQ, NYSE, and NYSE Amex listed companies. The new rules forbid a reverse takeover company from applying to these exchanges until:
- The company completed a one-year "seasoning period" by trading in the U.S. OTC market or another regulated U.S. or foreign exchange following a reverse takeover, and filed all required reports with the SEC, including audited financial statements.
- The company maintains the required minimum share price for a sustained period, and for at least 30 of the 60 trading days prior to its listing application and the exchange's decision to list.
Protection from RTO Fraud
There are many different ways that fraud can occur with reverse takeovers. While many of these instances are easy to spot for investors, some involve complex financial transactions that fool even the experts. For instance, China MediaExpress Holdings Inc. convinced former AIG Chief Executive Maurice "Hank" Greenberg to invest in the company.
That said, here are some tips to keep in mind:
- If it's too good to be true... Many RTO frauds involve extravagant revenue and net income gains, rising margins, and other very bullish indications, often in the face of a market downturn to poor peer performance.
- Watch inventories on the balance sheet. Some RTO frauds fail to properly commit the fraud itself, by showing no changes in inventories on the balance sheet, despite rapidly improving revenues on the income statement.
- Listen to the short sellers. It's easy for many investors to write off short sellers, but sometimes they bring up valuable points that should be considered on websites like SeekingAlpha and other financial websites.