Regulators Doing Not Much of Anything At All to Stem Reverse-Takeover Abuses
Thestreet.com had an article the other day that mentioned how NASDAQ officials are raising requirements for RTO (reverse-take-over) firms,
making them more stringent after a spate of fraud allegations against
ones that trade on their exchanges. I applaud the Exchange for finally
doing something - hell, anything - about what seems to be clear,
widepsread, and systemic market abuse, but unfortunately, they don't
seem to be doing nearly enough.
two short months ago, back when there was still some semblance of
debate over whether firms like China MediaExpress Holdings (CCME) were
frauds or not (I use the term "debate" losely, as almost anyone with
even fleeting knowledge of financial/accounting frauds saw the red/orange flags a few hundred miles away),
myself and several others wondered why the SEC and the Exchanges
appeared to have exercised little, if any care when allowing (especially
China) reverse-merger firms to list in the U.S. To many of us, it
seemed as if regulators had their heads firmly implanted in the
nether-regions of their digestive tracts. Fast forward a few weeks and
it doesn't like like much has changed. CCME itself epitomizes in
virtually every way the magnitude and scope of RTO fraud, and thus makes
for an interesting and appropriate example from which to learn.
The original firm, TM Entertainment & Media Inc., was a SPAC (Special Purpose Acquisition Company), otherwise known as a 'blank-check' company,
because the firm goes public/raises equity financing with the vague yet
somehow explicit purpose of using those funds to acquire an
as-yet-identified business. Investors associated with Bulldog funds
were actively pushing CCME's original/precursor firm to return capital,
yet "at the last minute," the SPAC managers found and executed a
reverse-merger with CCME and its subsidiaries, saving their butts (and
paychecks). The operating companies that comprised CCME would likely
have never passed muster had they tried to list themselves directly on
any U.S. exchange besides OTCBB, but through the magic of naive, lax
regulation and enforcement, they'd secured for themselves (and their
majority shareholders, the CEO and family) a coveted U.S. listing and
the perceived credibility that comes with it.
Why, you may ask, do
the Exchanges and the SEC (as well as other regulatory/enforcement
bodies) allow such blatant gaming of (the spirit, if not the letter of)
laws and regulations designed to prevent investors from fraudsters and
scam artists? Don Ohlmeyer is quoted (by Tony Kornheiser) as saying,
"If you ever have a question and can't think of the answer, its always
Allow me to peel back the curtain on how the game works
(and to do so while perhaps taking some liberties and painting some
possibly unfairly broad strokes). Those with uneasy stomachs should
In the case of RTO's, there are a
not-insignificant number of wallets being made fatter from the practice,
including those of (possibly disreputable) managers (often) in far-away
lands to their lawyers/auditors, to local government officials who are
paid to look the other way/grease the "wheels of commerce," to the
"investment bankers" (not pointing fingers, but check out shops like Rodman & Renshaw),
to the Exchanges on which these firms' shares trade, to the "research"
firms that get paid to pump-up the stock price... and that's just to
name a few! If you think the exchanges like NASDAQ have an incentive to
exercise extraordinary caution for (especially China, etc) RTO firms,
check out their listing standards & fee schedule. Each firm has the potential to generate hundreds of thousands if not millions of dollars in fees for the Exchange(s)!
firms, exchanges, SRO's (i.e. FINRA), etc. all spend significant
resources lobbying Congress to keep the SEC off their backs. Sure, they
do some less self-interested things, too, but that's neither
here-nor-there. Congress controls the SEC budget, and thus exerts undue
and self-defeating influence on what goes down at the SEC, when, how,
etc. In a report released last month, Boston Consulting Group
corroborated much of what I and many other critics have said for quite
some time: the SEC suffers from many organizational and
resource-constrained shortcomings, and Congress needs to increase the
budget and relax its control over the organization.
only way the SEC focuses its sights on a (potential) problem is if
there is pressure from Congress and/or not doing so will result in
extraordinary damage to the perception of U.S. markets as the most
transparent and fair in the World. And if the SEC isn't pressuring
broker-dealers and exchanges to exercise more prudent
self-regulation/enforcement, you bet your ass they aren't going to do so
voluntarily, unless of course not doing so would hurt the bottom line.
being the case, are we really surprised that NASDAQ is doing jack shit
to tackle abuses by RTO firms? Are we really surprised the SEC isn't
putting the screws to the exchanges and B/D's who enable such abuses (if
they aren't actually complicit therein)? Why would they?
Congress is putting much if any pressure on them to Get It Done, since
Congress doesn't act unless someone is pressuring them to do so, either
by throwing money their way or threatening to withdraw or hold-off-on
future contributions. And where do we think that money comes from?
Institutional investors. The same institutional investors who have to
balance their desire to be protected from abuse (i.e. have their asses
covered for poor/lack-of diligence) with news of their ineptitude
impacting their ability to attract and retain assets, so when it comes
to a very small, relatively obscure corner of equity markets.
Retail investors in such securities are, well, retail,
and a even then, they constitute only a very, very tiny portion of the
retail market. Until Widows and Orphans start taking heavy losses,
given constrained resources, the SEC isn't really going to dedicate said
resources to investigating and prosecuting bad actors, at least not
with anything even approaching the zeal with which they pursued Bernard
Madoff (a decade after they should have).
This is From Stone Street Advisors
Thus, all signs indicate
that the SEC is off to an unfortunately late start in the RTO space, to
say the least. At this point, I fully expect any losses incurred will
result in little if any recovery for investors. Hopefully the
Commission will learn from the experience and respond quicker, and with
greater zeal in the future, although whether that will actually come to
pass is debatable, at best. CCME has been halted by the NASDAQ since 3/11,
during which time the firm has announced the resignation of its
auditor, and a board member appointed by its non-executive majority
shareholder, both amidst significant concerns that management was
engaged in fraudulent practices.
Yet the stock has still not been suspend from trading by the Exchange, despite likely being in violation of NASDAQ's listing regulations for corporate governance (and other) reasons. Nor has the stock been suspended by the SEC, despite the SEC's website suggests this is EXACTLY the kind of situation during which the Regulator imposes such sanctions!
must remember the SEC, by the very nature of its work does not
frequently update the public as to the ongoing nature of investigations,
and that these investigations can take years until they are able to
bring cases of fraud and/or other abuses of securities laws.
Unfortunately, even keeping the preceding in mind, so-far the SEC's
efforts - whatever they may be - have left much to be desired. CCME,
for example, completed its RTO process on 10/16/2009,
and potential orange/red flags hinting at (accounting) fraud have been
present ever since in SEC filings. Surely, the SEC cannot pour over
every statement of every registered filer, but when a firm goes through 3
different auditors in less than that number of years, combined with
questionable and/or easily-exploitable transactions like RTO's, that
should trigger an alarm or two...
Despite such shortcomings, markets in the U.S.
are still the most fair and transparent in the World, despite the
disturbing frequency and magnitude of wrongdoing. The correct response
to these facts is not avoidance and/or paranoia, but rather acceptance.
Most firms are managed in (mostly) good faith and as such, should be considered
potential investments. Even the ones that aren't - whether we know so
for certain or have not-unreasonable suspicions - create opportunities
from which to profit. Thus, with careful consideration and more
patience than is exercised by most, we should not only be able to
identify these opportunities to earn substantial profits, but those
where we are asked to take-on entirely too much risk for the potential
reward, as well.
Several extremely successful investors have said
this in any number of ways over the years, but this is the mindset that
differentiates investors from speculators. Speculators chase trends in
pursuit of easy money. Investors conduct careful research and only
thereafter put their capital at risk. In situations like those
discussed above, speculators routinely get fleeced, whereas investors
are able to not only minimize losses, but potentially capitalize on
gains from share price declines.
True investors care just as much -
if not moreso - about minimizing losses as they do maximizing gains,
the practice of which requires one to constantly and consciously repeat a
simple, time-tested mantra:
This is especially true when it comes to chasing return via hot trends, many of which are little if anything more than fads and gimmicks incognito.
The sooner we recognize this, the sooner we can protect ourselves from
losses or, if the situation allows, position ourselves to profit from
share price declines once other market participants catch-up. The
longer we take to identify the situation for what it is - whether
because of fraud, blind optimism, or both - the less time we have to
react accordingly. Thus, we are well-served to err on the side of
caution, rather than letting our optimism and self-confidence get the
best of us.