SEC Cracking Down on Foreign Shell Cos.

The commission has "become increasingly proactive" on reverse mergers in the past year, says the chief accountant of its enforcement division.

While the Securities and Exchange Commission has recently stepped up its enforcement efforts against allegedly fraudulent U.S. shell companies in greater China, those efforts aren’t limited to that region, according to James Kroeker, the SEC’s chief accountant.

Speaking at last week’s Zicklin Center Financial Reporting Conference at Baruch College in New York City, Kroeker did not mention China by name. He said that “while there are a number of [reverse-merger stories] from a particular country that have grabbed headlines recently, the problems coming to the forefront are not limited to companies based in any geographic region.”

Still, it was clear that the headline-grabbing nation was China. In an April 27 letter to a House Oversight and Government Reform subcommittee, SEC chair Mary Schapiro reported that in the prior five weeks, the commission had suspended trading in at least three
China-based entities (Heli Electronics, China Changjiang Mining & Energy, and Rino International) that had become U.S. domestic issuers through reverse mergers. The SEC also revoked the U.S. registrations of at least eight other such companies “in the last several months alone,” she stated.

Broadly speaking, a reverse merger refers to a private operating company’s acquisition by a public shell company. Reverse mergers typically result in the owners and management of the private company having voting and operating control of the combined company. In effect, the private company becomes an SEC reporting company with registered securities without having to file a registration statement.

In a March 14 research note, the Public Company Accounting Oversight Board reported that 603 companies had accessed the U.S. capital markets from January 1, 2007, to March 31, 2010, via reverse mergers. (Of those, 159 came from the China region.) Citing the PCAOB report, Kroeker said that “U.S. auditors may be issuing audit opinions on financials, but not engaging in their own audit work. Instead, the U.S. firms may be issuing audit opinions based almost entirely on the work performed by other auditors based outside the [United States].”

During the past year, the SEC has “become increasingly proactive” in the area of reverse mergers, said Howard Scheck, chief accountant of the commission’s enforcement division. He noted that the SEC has been keeping close watch over 8-K filings involving auditor resignations at reverse-merger entities.

In the past few months, the issues the SEC has noticed in 8-Ks concern cash and accounts receivable, according to Scheck. In terms of cash, “the questions are whether the companies have the ability to confirm that the cash balances are right,” he said. “As far as the accounts receivable, there’s the possibility that the customers do not exist or are frauds.”

However, those are “only allegations reported in the 8-Ks,” said Scheck. “So we’re going to be monitoring that.”

In its research note, the PCAOB noted that its staff identified reverse-merger transactions based on Form 8-K filings that included Item 5.06, Change of Shell Company Status. Public shell companies that cease to be shell companies after reverse mergers are required to report that change in their status under that item.

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