CHINA AUTOMOTIVE SYSTEMS, INC.: THE CASE FOR REVERSE MERGERS

Journal of the International Academy for Case Studies, 2005 by Armstrong, Vaughn S, Gardner, Norman D

CASE DESCRIPTION

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.

CASE SYNOPSIS

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.

INSTRUCTORS' NOTES

RECOMMENDATIONS FOR TEACHING APPROACH

Students should be encouraged to read the case, access the SECs EDGAR database to obtain additional information about the companies and the reverse merger transaction, and respond to the questions listed in the case.

DISCUSSION OF CASE QUESTIONS

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?

Initial Public Offering

In an Initial Public Offering (IPO) a corporation sells or issues shares of its common stock to the public. In order for a corporation to legally sell stock to the public, it must first register the stock issue with the Securities and Exchange Commission (SEC). Registration requires full disclosure to potential investors of all relevant information about the stock issue as well as the company's management, the nature of its business, and its financial condition.

Companies meet the disclosure requirement by preparing a legal document called a prospectus, which contains all relevant information about the company. A prospectus must be filed with and approved by the SEC before the securities may be sold to the public.

When the proposed public offering has been approved by the SEC, the process of selling the securities to the public may begin. This process, called underwriting, is normally carried out by an investment bank, which contacts its clients to see if they may have interest in purchasing the securities. In each case the potential purchaser of the securities must be given a copy of the prospectus prior to the completion of a sale.

The initial sale of securities to investors is referred to as the primary market. Once securities have been sold by the corporation to the public, secondary market trading in these securities may begin. The issuing corporation is not a party to transactions in the secondary market. Investors that previously purchased securities from a corporation in the primary market, may enter the secondary market and sell to another investor. Such trades are normally facilitated by securities brokerage firms and may be executed on an exchange or other organized market.