NEW YORK/HONG KONG (Reuters) - A wave of Chinese companies is washing up on U.S. stock exchanges, using transactions called reverse mergers in order to tap lucrative U.S. financing markets while bypassing normal procedures for initial public offerings.
With reverse mergers, the companies can get listed on U.S. stock markets without going through the more drawn out and expensive process of an IPO.
Charges of fraud and other legal issues in the past have tarnished the reputation of reverse mergers, but the improving quality of the companies, tighter disclosure restrictions and savvier investors, have eased some of those doubts.
"In the past, people did reverse mergers of some nanotech company that had no revenue and six employees. Now many of these Chinese companies are very profitable, extremely well run and growing very fast," said John Borer, head of investment banking at Rodman & Renshaw, which advised Chinese companies on about 25 reverse mergers last year.
A reverse merger generally happens when a smaller company takes over a larger one. In the Chinese deals, a small U.S. shell company that is usually listed on a stock exchange takes over a larger, privately held Chinese company. The Chinese company merges with the shell company, but, more importantly, controls it.
The process lets the Chinese company, in effect, "go public" through a merger rather than an IPO.
Chinese companies became top candidates for the deals over the past 10 years, but attracted the attention of U.S. regulators aware of China's looser corporate governance laws.
The transactions became more scarce toward the middle of the last decade -- there were only 27 in 2004 -- as evidence would emerge that some companies using the mergers had flaws and very little profit.
But Chinese reverse mergers are back in style. After only 45 of the transactions went through in 2009, 24 were completed through April 2 of this year. At that rate, 2010 could produce nearly 100 deals, which would make it the best year ever in terms of volume, according to PrivateRaise, a data service of DealFlow Media.
This time, more mature companies are showing up.
Last September, a small, Jiangsu-based wire maker priced a public offering on the Nasdaq thanks to a reverse merger. Shares of Lihua International LIWA.O soon tripled in price.
Even with a surge in Hong Kong's and Shanghai's stock market last year and the recent opening of ChiNext, an exchange aimed at small Chinese companies, many mainland companies still look to America's listing boards.
That is because reverse mergers present an easier path to financing than an IPO.
"Because of the impediments to capital markets in China, U.S. investors get the benefit of seeing (Chinese companies) here on these exchanges," said Omer Ozden, a private equity investor and former partner at a U.S. law firm that does reverse mergers.
U.S. regulators tightened the rules for reverse mergers in 2005, forcing companies to disclose more information after merging into shell companies. Some thought that this would slow the deals pace. It did the opposite.
"All of those steps and all of these regulations are there to protect the investors," said Marat Rosenberg, managing director at Halter Financial Group. "But they also bring the best companies here to the U.S., because these are the types of companies that can undergo this scrutiny."
The SEC declined to comment on the recent pick-up in reverse mergers. A former SEC official who helped push the 2005 rules through told Reuters Insider transparency was the main goal.
"It's really in the United States a 'buyer beware' issue from a U.S. investor perspective," said David Lynn, former SEC chief counsel at the Corporation Finance Division.
More companies are doing the deals without listing on the over-the-counter bulletin board. By casting themselves as "Form 10" shell companies, they are getting the equivalent of training wheels for public companies.
They have all the requirements of listing, but without a publicly traded stock. Using the structure, companies can skip the bulletin board, making their first trade on a larger board like the Nasdaq or the NYSE Amex.
When a Chinese company completes a reverse merger in the United States, it is generally done with a private investment in public equity (PIPE) fundraising. That lets investors, mostly hedge funds and private investment firms, take shares in the business at a negotiated price before trading begins.
The deals require investors to conduct due diligence, which ideally limits the likelihood of "pump and dump" schemes that reverse merger companies became known for. That could make them more attractive to big investors.
Lihua's investors, for example, include BlackRock, State Street and Pennsylvania's public school employee retirement fund -- backers not known for diving in without looking first.
Still, investors might want to take the "buyer beware" message to heart.
"A reverse merger is just a financial technique, like a PIPE or an IPO. There's nothing inherently bad with it. If bad people or bad companies use this technique, then it gives the technique a bad name," said Tom Shoesmith, head of U.S. law firm Pillsbury Winthrop's Shanghai office.
(Reporting by Michael Erman in New York and Michael Flaherty in Hong Kong. Additional reporting by Ronnie Koo in Hong Kong and Jui Chakravorty and Richard Lee in New York)
Reporting by Michael Erman. Editing by Robert MacMillan