This case concerns a "reverse merger" by which a Chinese corporation obtains publicly traded status in the United States. The objective is to familiarize students with this alternative to an initial public offering, the more widely known method by which a company can become publicly traded, and to sharpen their analytical and research capabilities as they access the SEC website and EDGAR database as well as websites that provide other financial information for the answers to specific questions.
This case is appropriate for use in an advanced corporate finance class, an entrepreneurship or new business formation class, or an international finance class. Some aspects of the case may also be of interest to a business law or securities class. The case has a difficulty level of four, and should take from one to two hours of class discussion. Students will require three to four hours of preparation time.
The "reverse merger" is an alternative to the initial public offering (IPO) method of "going public". This back-door SEC registration technique is relatively common in practice, but is entirely ignored in finance textbooks as well as the academic literature.
The case considers China Automotive Systems, Inc., formed when Visions-In-Glass, Inc., a US non-operating, public "shell" company, acquires Great Genesis Holdings Limited, a closely held Hong Kong company that indirectly owns joint venture interests in mainland China. After the merger, Great Genesis stockholders own most of the stock of Visions-In-Glass, Inc., thus controlling the corporation and Visions-In-Glass retains its publicly trading status. The privately traded Hong Kong company becomes a publicly traded U.S. company.
In addition to focusing on the process of the reverse merger and the financial returns to various investor groups, this case examines how recent SEC actions may affect future reverse mergers. These actions include the suspension of trading in 26 shell companies for delinquent reporting, and the promulgation of regulations adding reporting requirements for shell companies or reverse mergers. These actions may reduce the advantages of a reverse merger in the future. Students gather information and render an opinion as to whether the China Automotive reverse merger presents evidence of a fraudulent "pump and dump" scheme, as well as whether reverse mergers remain advisable in the future. A further unique aspect of this case involves restrictions on investment and/or currency exchange that a foreign country may impose on its residents. The case demonstrates how transactions may avoid or circumvent such restrictions. Finally, the case illustrates the layering of funding common in a start-up business, and how firms use exemptions from SEC registration (for private placements and the Reg S exemption) in connection with funding.
CHINA AUTOMOTIVE SYSTEMS, INC.--THE CASE FOR REVERSE MERGERS
Visions-In-Glass, Inc. was incorporated in Delaware in June 1999 for the purpose of designing, manufacturing and marketing art stained glass with themes that memorialize the holocaust. The company had only minimal funding, $1000 from its founder and $2300 from seven other shareholders. Eight months later, the company raised an additional $6300 from 48 non-U.S. investors. Table 1 details the company's stock issues.
None of the shares issued were registered with the SEC. The initial issue relied on the section 4(2) exemption and the later shares were issued under Regulation S. To obtain publicly traded status, the company registered its common stock with the SEC in August 2001. The company wanted the stock to be listed for public trading on the over-the-counter Electronic Bulletin Board. In August 2002, Yarek Bartosz acquired the founder's 5 million shares for $100,000 and became the company's sole officer and director. At that time, the company had no assets and had never had any substantial operations. Aggregate revenues from the date of its incorporation were less than $7,000; the cumulative net operating loss exceeded $10,500. A copy of the Stock Purchase Agreement of August 23, 2002 pursuant to which Yarek Bartosz acquired control of the company is attached to the Form 8-K filed by Visions-In-Glass, Inc. with the SEC on September 3, 2003 in connection with this transaction. It can be viewed in the SEC's EDGAR database at http://www.sec.gov/Archives/edgar/data/1157762/000095014702001142/ex99-1.txt. Information about the assets, liabilities and operations of Visions-In-Glass, Inc. from its inception through yearend 2002 is reported on the FORM 10-KSB filed by the company with the SEC in March 2003. This is available in the SEC's EDGAR databaseat http:// www.sec.gov/Archives/edgar/data/1157762/000100201403000096/vig10k2002.htm.
Great Genesis Holdings Limited
Great Genesis Holdings Limited is a Hong Kong limited liability company incorporated on January 3, 2003. Great Genesis Holdings Limited acquired all the shares of Ji Long Enterprise Investment Limited on March 4, 2003 by issuing Great Genesis stock to Ji Long stockholders in exchange for their Ji Long stock.
Ji Long Enterprise Investment Limited, a Hong Kong limited liability company incorporated in October 1992, owns joint venture interests in the Sino-foreign joint ventures identified in table 2. The combined sales of these joint ventures ranks second in their industry sector in 2003; their market share is 18%. (The industry rank and market share comes from the China National Information Center).
The owners of Great Genesis Holdings Limited are residents of China. As a result, they are subject to investment restrictions and foreign exchange restrictions imposed by the government of China. They are permitted to invest in both "A" and "B" shares of Chinese companies. "A" shares are issued by companies incorporated in China. These stocks are priced in Chinese renminbi. "B" shares are issued by companies incorporated in China but are denominated in currencies other than the renminbi. (Until March 2001, only foreign investors could own "B" shares. After that date, Chinese investors can invest in "B" shares but must have foreign currency accounts in order to do so. Investors without an external source of foreign currency are subject to foreign exchange regulation.) Chinese investors (even institutional investors prior to March 2003) can not invest in foreign securities. See, e.g., http://chinese-school.netfirms.com/China-shares.html and http://www.southcn.com/english/news/money/200303100395.htm.
In addition, foreign exchange restrictions make it nearly impossible for individuals in China to obtain foreign currency for foreign investment purposes. As of November 2003, the restrictions were alleviated somewhat for Chinese businesses seeking to invest offshore, but they remain in place for individuals. See, e.g., http://www.tdctrade.com/alert/cba-e0312news1.htm and http://www.friedlnet.com/news/03012403.html.
THE REVERSE MERGER PROPOSAL
Great Genesis Holdings Limited proposes to enter into a "reverse merger" with Visions-In-Glass, Inc. This will provide Great Genesis and its direct and indirect subsidiaries a presence in the US capital markets. The owners of Great Genesis have rejected other approaches to secure exposure to the US capital markets, including an initial public offering in the United States, a private placement or Rule 144a private placement in the United States, or an offering in China coupled with a sponsored ADR in the United States.
The Great Genesis merger proposal features three elements. The first affects the shares outstanding and the shareholdings of Yarek Bartosz. Under the proposal, Visions-In-Glass will split its stock 3.5 to 1 and cancel 17,424,750 of Bartosz's post-split shares in exchange for which Great Genesis will pay Bartosz $200,000 (or $250,000 if Visions-In-Glass, Inc. has 400 round lot shareholders as of the date of the merger) with an additional $70,000 pending commencement of trading of the company's stock on NASDAQ.
The second aspect of the merger proposal is the actual acquisition of Great Genesis Holdings Limited. Visions-In-Glass will acquire all of the outstanding stock of Great Genesis Holdings Limited. In exchange for that stock, it will issue 20,914,250 new shares to Great Genesis stockholders and warrants to purchase 550,735 shares for $1.36 per share to individuals designated by the Great Genesis stockholders.
The final element of the reverse merger proposal concerns control of the company after the acquisition. Bartosz will resign as the sole officer and director of Visions-In-Glass, Inc. The shareholders of Great Genesis and their associates will become the corporation's new directors and officers.
After the merger, the stockholders of Great Genesis will own 95% of the outstanding shares of Visions-In-Glass, Inc. The transaction is termed a "reverse merger" because a non-operating "shell" company with minimal assets and publicly trading stock acquires a private company with substantial assets and active operations. While the "shell" company survives the merger and the publicly trading status is retained, control passes to the owners of the acquired company.
OUTCOME OF THE REVERSE MERGER PROPOSAL
The parties agreed on the terms of the reverse merger and completed it on March 5, 2003. A copy of the reverse merger agreement (the Share Exchange Agreement) was attached to an amended Form 8-K filed with the SEC by Visions-In-Glass, Inc. on March 21, 2003. A copy can be viewed at http://www.sec.gov/Archives/edgar/data/1157762/000101054903000128/ visions8kaex41030503.txt.
On April 8, 2003, the company filed a Form 14-C with the SEC advising that a majority of the shareholders had approved a resolution changing the name of Visions-In-Glass, Inc. to China Automotive Systems, Inc. and that change would be effect on filing appropriate documentations in Delaware (the state of incorporation) about May 15, 2003.
Prior to the merger, the stock of Visions-In-Glass, Inc. was listed on the OTC Electronic Bulletin Board and was quoted at $0.01 per share but was essentially inactive. Five days after the merger, 300 shares of Visions-In-Glass, Inc. stock traded at $3.10 per share. In the year after the merger, the company's stock price varied between $2.90 (during the first two weeks of April 2003) and $18.50 (on December 26, 2003), averaging $7.66. During the summer of 2004, the stock price declined to about $4.00 per share. Trading in the stock reached a maximum of 425,800 shares (market value of $3,491,560) on October 23, 2003 and averaged 22,300 shares per day in the year after the merger. On November 17, 2003, China Automotive Systems, Inc. filed an application for listing on the NASDAQ small cap market.
Additional information about China Automotive Systems, Inc. is available from the company's internet site, www.chinaautomotivesystems.com/index.asp, and in reports filed with the SEC which can be accessed from the SEC's EDGAR database at www.sec.gov/cgi-bin/browseedgar? company=visions+in+glass&CIK=&filenum=&State=&SIC=&owner=include&action=ge tcompany.
SEC REGULATION OF REVERSE MERGERS AND SHELL COMPANIES
As noted, Visions-In-Glass, Inc. gave notice of the reverse merger with Great Genesis Holding Limited by filing Form 8-K. This provided potential investors with information about changes in the company that might affect their valuation of its stock. In 2004, the SEC promulgated regulations that increase the number of events that require Form 8-K disclosure Disclosure is now required if a reporting company acquires a significant amount of assets and when there are changes in control of a company. The new regulation also accelerates the filing deadline. A copy of this regulation is available at http://www.sec.gov/rules/final/33-8400.htm.
This concern that investors have adequate information to value companies is also reflected in SEC action in June 2004 suspending trading in 26 "shell companies" that had not filed timely reports with the SEC. The concern over delinquent reporting was heightened by the fact that the stock of shell companies typically trades at very low prices and is considered more susceptible to manipulation or fraud, particularly if required disclosures are not current. See, "SEC Cracks Down on Late Filers, Halts Trading in 26 Shell Firms," Wall Street Journal, June 9, 2004.
In addition, the SEC has proposed further regulations affecting "shell companies". Noting that these companies are frequently used in "pump and dump" schemes, the proposed regulation would prohibit "shell companies" from raising capital using Form 8-S. It would also require a company that ceases to be a "shell company" because of a reverse merger to include in its Form 8-K filing the same information that would be required to register securities with the SEC. The proposed regulation is available for review at http://www.sec.gov/rules/proposed/33-8407.htm.
1. Briefly describe the purposes and process of a reverse merger. Compare and contrast a reverse merger with an IPO, a private placement and an ADR. What are some advantages and disadvantages of each?
2. Why did Yarek Bartosz pay $100,000 to acquire 94.5% ownership of a firm with no assets and no apparent business prospects?
3.a. What return (total and annualized) did the founder of Visions-In-Glass, Inc. realize on the sale of stock to Bartosz?
b. What return (total and annualized) did Bartosz realize on the investment in Visions-In-Glass stock?
c. What return (total and annualized) did the seven private placement shareholders realize on their investment in Visions-In-Glass, Inc.?
d. What return (total and annualized) did the 48 Reg S offering shareholders realize on their investment in Visions-In-Glass?
4. Why did Great Genesis Holdings Limited select a reverse merger rather than an IPO, a US private placement, or a China offering together with a sponsored ADR to enter the US capital markets?
5. What proportion of Great Genesis did each of the 5 Chinese investors in the Ji Long Holding Company own before the merger? What proportion did each receive of the shares issued by Visions-in-Glass to acquire Great Genesis? Comment on your findings.
6. Were the warrants issued at the time of the reverse merger ever exercised? If so, on what terms? Who exercised them? Comment on the function of the warrants in this transaction.
7.a. Describe the "pump and dump" scheme and the concerns of the SEC regarding shell corporations and their role in the reverse merger process.
b. Is there any evidence of "pump and dump" in the reverse merger which resulted in the formation of China Automotive Systems?
c. Given the negative view the SEC appears to hold of reverse mergers, what would you advise a private corporation today which is considering the use of a reverse merger in order to "go public"?
Vaughn S. Armstrong, Utah Valley State College
Norman D. Gardner, Utah Valley State College
Table 1: Visions-In-Glass, Inc. Stock Issues Amount Issue date Shareholder raised June 1999 Founder $1,000 June 1999 Private placement 2,300 February 2000 Regulation S offering 6,300 Total shares outstanding as of 12/2002 9,300 Percent Shareholder Shares of total Founder 5,000,000 94.5% Private placement 230,000 4.4% Regulation S offering 63,000 1.2% Total shares outstanding as of 12/2002 5,293,000 Registration Shareholder status Founder Exempt-- Section 4(2) Private placement Exempt-- Section 4(2) Regulation S offering Exempt-- Regulation S Total shares outstanding as of 12/2002 Table 2: Holdings of Ji Long Enterprise Investment Limited (as of 2003) Company Founded Business Jingzhou Henglong Automotive Automotive Parts Co. Limited 1997 Parts Shashi Jiulong Power Steering 1993 Power Steering Co. Limited Shenyang Jinbei Henglong Automotive Automotive Steering System 2002 Steering Co. Limited Zhejiang Henglong & Vie Pump 2002 Pumps Manufacturing Co. Limited Jingzhou Henglong Fulida 2003 Textiles Textile Co., Limited 2002 Net Ji Long's Company Sales ownership Jingzhou Henglong Automotive 26,007,000 42% Parts Co. Limited Shashi Jiulong Power Steering 10,789,000 81% Co. Limited Shenyang Jinbei Henglong 4,022,000 55% Automotive Steering System Co. Limited Zhejiang Henglong & Vie Pump 66,000 51% Manufacturing Co. Limited Jingzhou Henglong Fulida - 51% Textile Co., Limited Company histories for Jingzhou Henglong Automotive Parts Co. Limited and Shashi Jiulong Power Steering Co. Limited are available at the internet sites for those companies: http://www.henglongcn.com/hlls.asp and http://www.henglongcn.com/jlls.asp.…