Friendly Fire from the SEC

In November of 2011, the SEC approved new rules imposing additional listing and disclosure requirements for companies seeking to go public through a reverse merger transaction. In a reverse merger, a private company merges into an existing exchange-traded public shell company with the public company surviving the merger.

The new SEC rules prohibit a reverse merger company from listing its shares on any of the three major U.S. stock exchanges until the company (1) has completed a pre-listing “seasoning” period by trading its shares in the U.S. over-the-counter market or on another regulated U.S. or foreign exchange for at least one year following the reverse merger, and (2) has timely filed all required reports with the SEC (at least one full fiscal year of periodic reports, including a Form 10-K with audited historical financial statements).

The SEC approved these rules in response to widespread allegations of fraud by foreign reverse merger companies, leading to concerns that such companies’ financial statements cannot be relied upon. In fact, more than 25 percent of all securities fraud class action lawsuits filed during the first half of 2011 involved Chinese reverse merger companies.

At minimum, according to the authors, the new rules are too broad. If certain foreign issuers present the greatest threat to investors due to shoddy accounting practices and meager financial disclosures, the SEC should have tailored the rules to apply only to foreign issuers seeking to consummate reverse merger transactions.