In 2006, Zou Dejun began to look for opportunities to list his firm Dalian RINO Environment Engineering Science and Technology Co. Ltd. (Dalian RINO) on the US markets to access funding. Through a contact, Zou found a Nevada-based shell company, Jade Mountain Corporation, that was listed on the Over-the-Counter Bulletin Board (OTCBB) but which was largely inactive.

On 5 October 2007, the reverse merger between Dalian RINO and Jade Mountain Corporation took place through Innomind Group Ltd (Innomind), a single shareholder company. A share exchange transaction of 17,899,643 shares of common stock was issued to Innomind Trust, essentially giving Innomind control as the trust's beneficiaries were Zou and his wife, Qiu Jianping. When the reverse merger was completed, Jade Mountain changed its name to RINO International Corporation (see Figure 1 for the group structure).

RINO's only source of operating profits is through a contractual arrangement with the China-incorporated company Dalian RINO, which dictated that 100 per cent of Dalian RINO's profits was to be channelled into Innomind's wholly-owned subsidiary. The Chairman of RINO was

Qiu, while the CEO was Zou. Zou was also the CEO of Dalian RINO. Innomind's sole shareholder is a relative of Zou and Qiu.

Although trading on the OTCBB did bring in new capital, Zou had set his sights on a listing on NASDAQ. He took steps to ensure that RINO met NASDAQ's listing requirements. In 2008, Frazer Frost, a US-based audit firm and Rodman & Renshaw, an investment bank with experience in helping Chinese companies list on the NASDAQ, were hired. In July 2009,

RINO was successfully upgraded from the OTCBB to the mainboard of NASDAQ. In the first six months of its listing on NASDAQ, RINO raised about US$1 billion through share issues and stock warrants.

The Man Behind The Wheel

Zou is well-known in his home country and was viewed as a promising star in the environmental engineering industry. His background is a classic rags-to-riches story, having worked his way up from serving in the navy to a technician in a local machine repair shop, before obtaining a degree in Electronic Automation at Liaoning Broadcast University. He saw great potential in the waste water treatment industry and started his first venture, Dalian Yingkun Energy and Environmental Engineering soon after. In 2003, he founded Dalian RINO and became its CEO.

Board Composition

RINO's board comprised three independent directors - Professor Quan Xie, Kennith Johnson and Zhang Weiguo - and two non-independent directors, Zou and Qiu.

The husband-wife pair of Zou and Qiu had a large presence in RINO's management and board through their shareholdings and positions in RINO's subsidiaries. The three independent directors lacked industry experience although they were from diverse backgrounds. Professor Quan was an academic in the environmental and life sciences discipline, Johnson was a CPA and had extensive experience in public and corporate auditing, while Zhang was the Chief Operating Officer of the Chinese milk formula company, Synutra, and was responsible for its US operations and strategy.

Board Committees

The audit, nomination and compensation committees were made up of the same people: Johnson, Zhang and Professor Quan. This fulfilled NASDAQ's requirements of having at least 3 independent directors on the audit Committee. The directors each chaired a committee. Johnson was the chairman of the audit committee; Zhang chaired the nomination committee and Professor Quan the compensation committee.

Director Compensation

The independent directors were each paid cash retainers of US$2,000 per quarter and US$500 for each board or committee meeting attended. On top of this, Johnson received 2,000 shares in 2009 for his role as chairman of the audit committee but there were no additional fees or benefits for other directors. The non-independent directors did not receive director fees or benefits.

Although the 2009 annual report indicated that the board of directors met six times during the year, it reported that the fees paid to both Zhang and Professor Quan's to be only US$8,000 - which was only the guaranteed basic cash retainer amount for a year.

CFO Turnover

RINO had three different chief financial officers (CFO) in three years: Bruce Carlton Richardson served from October 2007 to September 2008, Qiu from October 2008 to April 2010, and Ben Wang from May 2010.

Trouble Looms in Muddy Waters

On 10 November 2010, Muddy Waters, a short-seller, issued a report which questioned RINO's actual financial situation. Among the allegations were accounting irregularities in RINO's 2009 revenues, which differed substantially between its results reported in the US (US$193 million) and its results in its Chinese regulatory filings (US$11 million). Muddy Waters estimated its actual 2009 revenues to be under US$15 million.

To make matters worse, none of this income was transferred from Dalian RINO to RINO as agreed. Instead, the capital raised by RINO was diverted to fund Dalian RINO's China operations. In addition, RINO's CEO, Zou, publicly confirmed that of its six major flue gas desulphurisation (FGD) contracts, two were non-existent and the remaining four had "issues".

Suspicions were heightened when RINO did not report any tangible assets as would be consistent with a manufacturing firm. RINO's tax disclosures to the SEC and RINO's reported zero tax in China, both of which did not match its reported revenues.

Questions About the Auditor's Role

The discovery of these irregularities by a short-seller firm, instead of an audit firm, begs the question as to the competency of RINO's auditor. First and foremost, Frazer Frost is a relatively small firm and did not have local operations or an office in China. Instead, employees travelled to China from their California headquarters to perform audits, which cast doubts on their capability in performing audits effectively.

The audit partner, Susan Woo, did not have significant experience in auditing listed companies in the US, much less overseas-based companies. She had 13 years of accounting experience specialising in international tax and finance. Moreover, checks revealed that almost all of Frazer Frost's listed clients were China-based companies.

The Fallout

One day after the release of the Muddy Waters' report, RINO stated that it had begun an internal review12 and five days later, RINO decided to postpone its Q3 2010 earnings conference call. After the confirmation of fraudulent accounting practices, RINO's audit committee issued a statement declaring that it will conduct a thorough investigation.

After the allegations by Muddy Waters, RINO's stock collapsed by 60 per cent from US$15.52 to US$6.07 over six days. On 11 April 2011, SEC suspended RINO from trading13. Compared to a year ago, RINO's stock had fallen almost 80 per cent.

Cross-Border Issues

The SEC and the China Securities Regulatory Committee (CSRC) had signed a memorandum of understanding to improve cross-border cooperation and collaboration in 1994. However, the SEC does not have any say on the reporting procedures of Chinese companies to China's

State Administration for Industry and Commerce (SAIC), which requires all local and foreign companies to submit their business operating reports (including annual financial statements) annually.

Before the new rules, NASDAQ did not require foreign companies to submit reports that were lodged in their home countries. This meant that RINO had needed to comply only with the Sarbanes-Oxley Act, NASDAQ listing rules and other applicable corporate laws in US.

Questions:

1. What are the key corporate governance issues with RINO? List at least two key issues and discuss.

2. What additional governance and informational issues could arise from a Chinese foreign listing through a reverse merger in the US? List at least one additional governance issue and one informational issue, respectively, and discuss.

3. From a corporate governance perspective, what are some of the key red flags that indicated fraud in RINO International? List at least three red flags and discuss.

4. Based on approaches to address issues arising from information asymmetries, especially moral hazard and adverse selection, what can such reverse takeover companies do to attract investors in the future?