In the late 2000s, hundreds of Chinese corporations entered US capital markets through a strategic option called a reverse merger. This wave of Chinese entrants in American equity markets proved to be, mostly fraudulent, and cost investors over $500 billion between 2009 and 2012.

A reverse merger, also known as reverse IPO, can be defined as a private company acquiring an existing, public company to list itself in public markets without having to go through the lengthy process of an initial public offering. While an IPO can take years to be implemented, a reverse merger is much quicker, and may take only a few months. Additionally, corporations that become public through a reverse merger avoid the underwriting fees that are typical of IPOs.

In the wake of the Great Recession that rocked global markets in 2008 following the US housing bubble, the Chinese government substantially increased subsidies targeting large-scale manufacturing projects owned by private Chinese companies to counter the losses incurred by reduced exports. However, these companies all had a common goal: to be listed on US stock markets. Access to such markets meant more investors, more money, and more credibility. And thus it began - one of the largest frauds in the history of free markets. In the Netflix documentary which covers this story, "The China Hustle", Dan David, CEO of GEO Investing, describes the Chinese reverse mergers as "packaging garbage as gold".

Despite the crisis, China's economy was growing rapidly, at a rate of 9.5% in 2009 according to the World Bank. That same year, the US's growth rate in GDP was - 2.6%. With improving relations between the United States and China, both countries sought to open up their markets to one another. China seemed like an extremely attractive market to US investors, and luckily for them (or not), they did not have to go to China - China came to them. In the months that followed, around three-hundred China-based companies listed themselves on major US exchanges such as NYSE and NASDAQ through reverse IPOs. The Chinese government prohibited the Securities and Exchange Commission (SEC) from overseeing their operations, which meant that the reverse merger companies could easily commit securities fraud; as such, that is precisely what ensued. For some companies, revenues were overstated tenfold and balance sheets were inflated at a time when corporations all over the world were still struggling to reach pre-crisis levels. The Chinese affiliates of Big Four accounting firms allegedly signed off audit reports for these companies without proper diligence.

Eventually, investors grew suspicious of the reverse merger corporations' figures, which were consistently high, outperforming the largest American companies. Some even traveled to China to visit the plants and factories of these companies. What they found was vastly different from what was shared with investors; operations were either limited or non-existent. Upon their return to the US, the "whistleblowers" sounded the alarm on the Chinese reverse mergers. Newsspread and eventually led to a wave of short-selling and huge losses for long investors, ultimately amounting to a $500 billion loss in market capitalization. In the years that followed, the SEC delisted hundreds of Chinese companies from US markets.

In the end, no China-based company was held accountable and American investors were never compensated for the losses. It is unclear what the role of the Chinese Communist Party was in the reverse IPO fraud, but what is clear is the audit failure and lack of transparency among the affiliates of large accounting firms in China. Shortly after the untangling of the fraud, the SEC tightened its rules regarding Chinese companies opting for reverse IPOs in US equity markets.

PostedOctober 27, 2020 BySarah "Poppy" Alexander

The hot retro design trend these days is not only slip dresses and tie-dye, but an once-obscure investment vehicle called a Special Purpose Acquisition Company orSPAC. SPACs (aka "blank check" companies) aresweepingthe nation as the darling of investors who wish to take a company public without the scrutiny of an IPO.

So what is a SPAC?

With due apologies toSeinfield, SPACs are companies about nothing. At their formation, they raise money in an IPO with only the mandate to buy another as-yet-undefined company. They are fundamentally investment vehicles, although they are structured like corporations.

The object of their fancy, once purchased, gets merged with the SPAC (sometimes called a "reverse merger") and is thus "taken public" without ever going through the rigorous vetting associated with an IPO. In theory, the investors in the SPAC reap the benefits from the purchased company's goods or services, and everyone's off to the races. Tech companiesin particular have embraced this new way to take themselves public.

The growth of this investment vehicle is astonishing. In 2020 so far,161 SPACshave gone public. In 2019, the number was 59. In 2009, 1.

Why is this trend concerning?

To ask this question a different way, why would anyone prefer a SPAC to a traditional IPO process? Its main advantage is avoiding regulatory scrutinywhich should make anyone concerned with investment fraud nervous. Companies that lack proper accounting controls or compliance processes could theoretically become public companies after only having to convince a small number of private investors that they are worthwhile investment risks. The general investing public, who lack insight into the behind-the-scenes process, could then invest in the not thoroughly vetted company via the SPAC's public offering.

The most visible symbol of these risks isNikolathe electric car company that quickly became an investor darling, merged with a SPAC, and then promptly collapsed amid allegations that it faked evidence of its product working.

What is the SEC doing about it?

The SEC hastaken noticeof this trend. Jay Clayton, the SEC's Chief Commissioner, recentlycommentedthat while SPACs could in theory be reasonable IPO alternatives, "It comes down to a question about disclosure and transparency and whether investors are getting all the information they need."It is not clear that investors are getting the information they need, as the Nikola collapse illustrated. With the ever-increasing number of SPACs out there, it is sadly very likely we're going to see another Nikola, and probably soon."

SPACs: Be Careful

Nikola is not the first 'SPAC' to emerge in an explosion of 'strategic' IPOs in 2020. Here's what investors need to know.

Ruth Saldanha

Sep 30, 2020

Mentioned:Tesla Inc(TSLA),General Motors Co(GM),PayPal Holdings Inc(PYPL),Nikola Corp(NKLA)

If you've been following IPO news, or stock market news, or any investment news over the past six months, you will have heard references toblank-check companies--special purpose acquisition companies, orSPACs. Most recently, you might have heard about them in the context of General Motors(GM)and Nikola(NKLA).

• What Is an Initial Public Offering?

Here's the backstory. General Motors made an announcement in September 2020 that it was getting into a "strategic partnership" with Nikola, an electric vehicle company that had not yet manufactured a product. According to the terms of the agreement, GM would receive an 11% equity stake in Nikola in exchange for manufacturing the Nikola Badger pickup truck using GM's own hydrogen fuel cell and battery technologies.

A couple of days after the deal was announced, Hindenburg Research published a report called'Nikola: How to Parlay an Ocean of Lies Into a Partnership With the Largest Auto OEM in America'.The report claimed the authors had evidence of fraud perpetrated by Nikola.

Since then, the founder and chairman of Nikola has stepped down, the SEC and the Department of Justice are looking into the claims made in the report, and the stock has fallen over 20%. Stephen Girsky, a former vice chairman of GM and a member of Nikola's board, has taken over as chairman.

Nikola Not the First Girsky founded an investment company called VectoIQ that then created a special company, which was publicly listed but had no business operations. VectoIQ was created specifically to take Nikola public via a so-calledreverse merger: The SPAC merged with Nikola in June of this year, and Nikola became a publicly traded company as a result.

Companies that go public via reverse mergers circumvent some of the stringent requirements of the SEC. To understand how and why, you need to know what SPACs are and how they work.

What Are SPACs? A special purpose acquisition company is a company with no real business operations. It exists only to raise capital via an initial public offering, or an IPO, and then use that capital to buy existing private companies.

"This atypical pathway to the public markets was once a niche strategy for small investment firms," Morningstar Pitchbook analyst Cameron Stanfill explains.

These companies own and manage nothing except the cash that they raise. Because of this, they are calledblank-check companies. They are generally formed by investors, also called sponsors. Sponsors usually have experience and expertise in a particular sector, and it is assumed that the acquisition targets will be companies in that sector. Many sponsors are seasoned private equity investors.

"These early embracers saw SPACs as a way to extract fees from adding structure to a reverse merger," notes Stanfill. "The strategy has now become the hottest financial topic of 2020 after a massive uptick in the volume of these blank-check vehicles and as the stature of the investment professionals involved legitimized the space."

How Do They Work? Stanfill describes the process like this: "At first, the SPAC follows the traditional IPO process, registering with the SEC, filing prospectuses, and running investor road shows. This entity then prices the IPO and raises the funds that will subsequently be deployed to acquire the target business. At this point, the SPAC is a publicly traded shell company and has assumed much of the cost and time commitments usually borne by the target company."

Once the SPAC raises capital, it usually has two years to completing a deal. If it does not, it faces liquidation. In the meantime, the capital is placed in a trust account, which earns interest at market rates.

What's interesting is that, when these companies have an IPO, they do not have to identity the companies that they want to acquire. Put another way, if you buy into a SPAC, you will have no idea what company you might end up owning. You don't even knowifyou will end up owning an acquired company.

The concept of a SPAC itself can be boiled down to a presold IPO for the private company that it acquires--without many of the stringent requirements, checks, and balances that go into a traditional listing.

Red Flags Investors should remember that the long (and indeed, tedious) IPO process is in place to protect investors. When a company goes public via a traditional IPO, there is careful institutional and regulatory vetting, which ultimately benefits the investor by bringing issues to light.

Take, for example, the Nikola case. If Nikola was to have gone the traditional IPO route, there would have been a much more stringent due diligence and audit process than with the SPAC reverse-listing. It is important to note that, at present, the allegations of fraud are just that--allegations. The SEC is in the process of investigating the claims. But nevertheless, there are questions around whether the claims would have gotten as far as they have if the firm had gone through the traditional IPO route.

But let's go back to SPACs.

Why 2020? SPACs have been around for at least 30 years. Why all the interest now?

Stanfill points out that direct listings were all the rage in 2019. "Then came the pandemic, which plagued markets with economic uncertainty, especially in public markets. The sustained volatility and the distinct price declines earlier in 2020 made IPOs and direct listings impractical options for the majority of private companies, which is where SPACs have found an opportunity. Unlike SPACs, direct listings do not allow private companies to raise any new capital during their transition to the public markets, which presents a problem for many startups, given the elongated economic ambiguity driven by the pandemic."

Essentially, he describes SPACs as large "boxes of money--that necessitate a much lower level of diligence than a similarly sized IPO of an operating entity since there are no financial statements to scrutinize."

Now that traditional IPOs are relatively fewer, investors have flocked to SPACs in the hopes of hitting upon the next Tesla(TSLA)or PayPal(PYPL). With this increased demand, existing sponsors have raised higher amounts. For example, Chamath Palihapitiya's Social Capital Hedosophia's first two SPACs acquired Virgin Galactic and Opendoor. He has since launched three more SPACs.

The true value of SPACs rests in the companies they acquire, and that's the main draw for retail investors. But you need to weigh this potential against the costs and risks associated with the convenience of SPACs afforded to other people.

"Despite the benefits SPACs offer, they are not a cure-all. From a cost perspective, a merger with a SPAC nets out to essentially the same cost outlay to the company as a traditional IPO. The original IPO fees are paid initially by the SPAC itself--typically 5.5% of the amount raised in the SPAC," Stanfill says. He adds that the costs, along with the sponsor's profits and any investment banking fees, are implicitly passed on to the company.

Who Makes the Money? It's not always smooth sailing, however. "Despite the benefits SPACs offer, they are not a cure-all. From a cost perspective, a merger with a SPAC nets out to essentially the same cost outlay to the company as a traditional IPO. The original IPO fees are paid initially by the SPAC itself--typically 5.5% of the amount raised in the SPAC--but these costs are implicitly passed on to the company along with the sponsor's promote and any investment banking fees related to the acquisition itself," Stanfill says.

He explains it with this example: If a hypothetical SPAC raised a $400 million IPO by selling 40 million shares at $10, the vehicle would pay $22 million in fees to the investment banks, leaving $378 million for the transaction. At the SPAC's founding in this scenario, the sponsors bought 10 million shares for a nominal fee rather than buying them for $100 million, therefore implicitly taking away capital that could have been raised by the company. In this simplified version, the company is implicitly paying $122 million to raise $500 million, leaving the company with $378 million, or a 22.4% cost of capital, without even factoring in warrants. This is relative to a traditional IPO raising $500 million, which at a 7% fee would cost the company $35 million, with the proceeds to the company totaling $465 million.

Should You Buy A SPAC? Still want to go for an SPAC? As always, we guide caution.

• You do not know in advance the acquisition target, so you're taking a bet on the founder of the SPAC. Retail investors rarely have insight into the minds of founders and can only make bets based on public perception. This is a risk.
• Even if the founder has a target in mind, the SPAC might not be able to close the deal. If this is the case, and you get your money back a few years after the initial investment, that is an opportunity cost. Anopportunity costis what you lose in gains that could have potentially been made had you not invested in the SPAC.
• As Stanfill's note on fees to investment banks shows, there are a lot of people making a lot of money from SPACs--and those people don't seem to be retail investors.
• The success of the SPAC depends on the success of the company it acquires. As established, the research, due diligence, and checks behind these acquisitions may not be as stringent as they would have been in the case of a traditional IPO or public company acquisition. It again seems like the investor is the loser.

So, before you invest in an SPAC, ask yourself who is making the money, what they are making the money on, and if you have alternatives you could consider. And as always, invest based on your financial goals, risk appetite, and time horizon.

Read the following and answer the questions below:

chinese_reverse_merger_research_note.pdf Litigation_Related_to_Chinese_Reverse_Mergers.pdf reversemergers.pdf The Chinese Reverse Merger Companies (RMCs) Reassessed_ Promising.pdf

1.Why might investors fail to investigate potential investments?

2. Why did the reverse merger comapanies get away with this scheme for so long?

3.Go to your textbook. Chapter 1, 2, 3, 4 and 5 and apply all key terms that apply to the reverse merger issue - cite examples from the included resources for each key term and why you think it fits the term.

4. Apply all of the legal standards of Corporate Liability discussed in this module to reverse merger companies?