30 Mar Foreign RTOs: Separating the Wheat from the Chaff
Yes it is possible to have a non U.S.-based entity go public in the United States. It’s long been a way for private, foreign companies to gain access to the lucrative U.S. capital markets without having to pay the large underwriting fees of going public through a well-known investment bank. It can also be the means of raising capital through a public offering and providing some liquidity for expansion or shareholder exit–just like it can for any other American entity. The struggle is that many foreign-based reverse mergers often have nefarious motives in their desire to enter the public market. When this is the case, outright fraud is often present and the SEC eventually clamps down on the facilitators of such deals and the news of their crimes generally shows up on the news section of the SEC website. If a firm or player makes the SEC news, it’s always for law-breaking reasons. When we receive any type of request from a foreign individual or entity, we not only put them through audit and compliance boot camp, but we also put them through an internal “smell test” to ensure they’re the real deal. We’ve found that when someone has an intent to defraud or break the rules, there are a few red flags that make that evident from the outset. The larger and more complex frauds are more difficult to spot, but are equally if not more important to bring to the surface before havoc is wrought on unsuspecting and eventually duped investors.
Initial Red Flags
In discussing deal opportunities with potential clients, there are a few features of any given deal that immediately cause us to put up the caution wall. Here are just a few:
- It’s a foreign deal. While not all foreign deals are bad deals or evil deals, they all require more vetting. Distance, language, accounting and cultural barriers can impact any successful due diligence. We do less foreign deals than domestic deals, but the foreign deals always come in at a higher volume. It stands to reason that we’ve got a higher B.S. filter at the outset.
- They want 99% to 100% of the stock of the public shell deliverable. This has pump-and-dump written all over it. With more control over the largest share of the trading stock, pump and dump schemes are much more easily perpetrated.
- Pink or gray sheets only. Because pink or gray sheets require little to no disclosure to the SEC, they’re easier to reverse merge with something that is either nothing or completely fraudulent. This is one of the reasons the SEC has warned against so many marijuana reverse takeovers. Nothing is really merged in except maybe an idea.
- No profits, no revenue. Worse than no profits is no revenue, especially when it comes to foreign firms. This goes right along with the pink/gray sheet concern. Without a real business, especially with a foreign firm, the red lights usually start blinking.
If we’re successfully able to get through the initial red flag items, then we’ll work through other more stringent and anal due diligence to determine whether the opportunity represents too great of a risk for investors.
Our Threshold Foreign Companies Entering the U.S. Markets
When it comes to foreign firms, we typically require a higher barrier to entry. We won’t work with firms in startup mode and we prefer not to work with those that are running regular losses. Ideally, the companies will already have a few years of GAAP compliant and PCAOB audited financials. We’ll also include extensive background checks and interviews on the operators themselves. And unlike background checks in the United States where the process is pretty easily performed with a Social Security Number, background checks on foreign companies operators is a bit more tricky. Much of the work is manual and performed by checking and rechecking with various references. In addition, it will also be ideal to have on-site meetings with the potential company in question along with a financial professional with language skills in that market. While not possible with each deal, the aforementioned ideals for a foreign RTO or reverse merger are helpful in filtering through the garbage deals that many a company in this market sees.
Not all foreign-to-U.S. RTOs are bad news for investors. Some are, in fact, very good and recent reports indicate that some Chinese reverse mergers greatly outperformed their U.S. counterparts. This is likely due to the increased scrutiny and due diligence performed on the front-end of the deal–something which many APO/RTO and direct offering facilitators doing U.S. deals could learn from. In assessing various deals that come across our desks, we like to take a more cautious stance, particularly when it comes to working directly with foreign-based firms that want to monkey with the U.S. financial markets.