Failed PRC Reverse Mergers: Strategies to Maximize Stakeholder Recoveries

Reverse Mergers Boom and Bust

The past two years have seen the boom and bust of so-called “Chinese reverse merger” transactions.  In a typical reverse merger transaction, a company operating in the People's Republic of China merges into a defunct (or nearly defunct) company that is listed on a public exchange in the US or elsewhere in order to more quickly access capital markets that would otherwise present a lengthy or unwieldy process.  By merging into an existing listed entity, the Chinese operating companies avoided lengthy delays, and heightened scrutiny, associated with raising capital through initial public offerings.  Unfortunately, a number of these companies have failed, resulting in billions of dollars in losses to creditors and investors, and prompting governmental investigations, regulatory rule revisions, and creditor and shareholder lawsuits.  Indeed, one fourth of all securities actions filed in the United States in the first half of 2011 involved Chinese reverse merger companies.(1) Since then, many of these companies have gone private to cash out the original investors and shield them from regulations applicable to public companies.

The Aftermath 

In 2011, the SEC began suspending trading of securities in certain of these companies created via reverse mergers and issued investor advice and new rules amid allegations of fraud and mismanagement at the companies.  Though news reports have devoted much attention to the downfall of these companies and the resulting shareholder losses, there has been little discussion of the options available to preserve and maximize the value of the underlying operating assets after the debt or equity security prices have plunged.  This is no easy matter: the Chinese operating subsidiaries are usually indirectly owned by the publicly listed holding company, typically controlled by a board of directors comprised of at least some independent directors, and may be unwilling to cooperate with their ultimate parent.  In the worst cases, the management of the operating entities in China may be complicit in actual fraud.  Due to differences in the manner in which corporations are regulated and corporate governance is viewed in China, it may be difficult to force action at the Chinese subsidiary level.

Gaining Control

When a product of a reverse merger goes south, both shareholders and investigators may demand to see what assets are still available to the defunct parent corporation.  This is often a multi-step process, involving several foreign legal systems.

First, if financial discrepancies appear, immediate steps should be taken to form a special committee of independent directors to investigate and safeguard assets from depletion through a special resolution of the board of directors.  The special committee should be empowered to take all action necessary to investigate financial discrepancies and preserve assets of the estate including, if warranted, commencing chapter 11 or similar proceedings to safeguard assets and insure transparency of the process.

If the special committee is obstructed from fulfilling its duties by management, other board members, or a controlling shareholder that may be engaged in wrongdoing, the special committee can then use its mandate to assume formal control of the company through institution of bankruptcy or insolvency proceedings.  An insolvency proceeding authorized by the special committee as part of its directive to protect assets, accompanied with a request that the court recognize the special committee as the controlling entity in the proceeding, can effectively permit the special committee to fulfill its mandate under the auspices of a transparent court-supervised process that is open to all stakeholders, including creditors and investors.  In addition, a bankruptcy court or similar tribunal can use its equitable power to enjoin a controlling shareholder from interfering with the conduct of the insolvency proceeding by appointing new directors or firing existing ones.

The case of ShengdaTech, Inc. is illustrative.  ShengdaTech was formed through a reverse merger of a British Virgin Islands company that owned five PRC subsidiaries into a US holding company that was listed on NASDAQ.  An ongoing internal investigation spearheaded by a special committee of independent board members led to evidence highly suggestive of fraud.  Faced with these developments, in early August, the Chinese controlling shareholder implicated in the wrongdoing sought to add directors to the full board to obtain a majority of votes and, presumably, dissolve the special committee before it could complete its investigation.

The resolution creating the Special Committee conferred broad power upon the Special Committee to complete the internal investigation and safeguard assets.  To fulfill its duties, the Special Committee filed a chapter 11 petition in the United States Bankruptcy Court in Reno, Nevada on behalf of the company to safeguard assets and to enjoin the previous owner from obstructing in the special committee's performance of its mandate.  The bankruptcy court agreed and issued an injunction to prevent the controlling shareholder from altering the composition of the board or otherwise interfering in the management of the company.

Reaching Down the Chain

Once control of the listed company is secured, the special committee can take steps to secured control of intermediate companies in the corporate family that actually own the PRC operating companies under the auspices of the insolvent estate.  For example, many PRC operating companies are owned by companies in the British Virgin Islands or the Cayman Islands, which then become intermediate subsidiaries following the reverse merger transaction with the listed company.  The first step is thus to replace the management of the intermediate subsidiary in accordance with the corporate law of the host country.  It is important to anticipate roadblocks in this process as often-times, the registered agents of the intermediate subsidiaries are operating under written instructions from the PRC controlling shareholder who is often also an officer or director of the intermediate subsidiary.  Accordingly, if the registered agent refuses to recognize a duly passed resolution, litigation may be necessary at this stage for the registered agent to recognize the resolution and to alter the company registry accordingly.

Though replacing board members at the intermediate level may pose difficulties, it is in fact relatively simple compared to gaining control effective control of the PRC operating entities.  Chinese corporate law still relies heavily on formalities that have been replaced in Western law by principles of agency law.  In particular, Chinese companies are required to have both a legal representative and a company seal – or “chop.”  The legal representative must sign official corporate registration documents in order for many corporate actions may be effective.

Problems thus arise when the legal representative is complicit in fraud or mismanagement or is otherwise uncooperative due to cultural differences or local relationships.  Until a legal representative is replaced by the special committee's designee, the special committee will be powerless to exercise effective control over the PRC operating companies.  The process to replace a legal representative can be costly and involve time consuming litigation.  Complaints filed in Chinese civil courts must meet rigorous procedural requirements, must be filed in the province where the assets are located, and may even be rejected by courts outright as not sufficiently stating a case.  Careful oversight and coordination with local PRC counsel is absolutely critical to achieve a successful and expeditious outcome. 

Takeaways

Creditors, investors and independent directors of "reverse merger" companies must exercise a heightened degree of care in insuring that accurate financial reporting and operational control are in place.  In addition to standard auditing controls and procedures, it is critical that independent PRC legal representatives be chosen to insure that the PRC operating companies will adhere to the direction of the operating company's ultimate legal owners if the original owner is legitimately displaced.  If financial discrepancies arise, immediate action to appoint a special committee led by independent directors should be taken.  Once appointed, a special committee must move swiftly to complete its investigation and, if warranted, take decisive steps to safeguard assets, including the commencement of a bankruptcy or insolvency proceeding.  The process of ultimately wresting control of PRC operating assets from a wrongdoer is a highly complicated process that must be swiftly navigated with great care and cultural sensitivity in order to maximize recoveries to stakeholders.

John Lyons represents corporations in complex business reorganizations, acquisitions and divestitures, typically in distressed situations, and also has represented clients in connection with asset recovery proceedings.

For example, Mr. Lyons represented the special committee of the board of directors of ShengdaTech, Inc. in its Chapter 11 case to complete the committee’s investigation of ShengdaTech and to safeguard assets.  His other representations include the official committee of unsecured creditors in the American Airlines Chapter 11 cases, Delphi Corporation, Verasun Energy, Einstein/Noah Bagel Corp., Exodus Communications, Interstate Bakeries Corporation, Montgomery Ward and US Airways.

Mr. Lyons has been consistently recognized as a leading lawyer in Chambers USA and the Leading Lawyers Network. In addition, he was named by Turnarounds & Workouts as one of the nation’s top dozen “Outstanding Young Bankruptcy Lawyers.”  Mr. Lyons can be contacted on +1 312 407 0860 or by email at john.lyons@skadden.com.

Frances Kao has an international dispute resolution practice in which she represents public and private companies, as well as their officers, directors and employees, in commercial litigation, arbitration, and both internal and civil and criminal government investigations before the DOJ, the SEC, the FTC, state attorneys general and local district attorneys.

Ms. Kao’s representative clients include BP China, China National Offshore Oil Company, China Petroleum and Chemical Corp. (Sinopec), China Sunergy Limited, JA Solar Limited, KFC Corporation, KUFPEC (China) Inc., Merrill Lynch Capital Services, Inc. and The Sports Authority, Inc. She also served as chief investigator for the special committee of the board of directors of ShengdaTech, Inc.

She is a native Mandarin speaker and was selected as a leading lawyer in Chambers Asia 2012 for dispute resolution.  Ms. Kao can be contacted at + 852 3740 4827 or by email at frances.kao@skadden.com.