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.
Less than 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 money.”
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 prepare accordingly:
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, the lawyers/auditors, local government officials who are paid to look the other way/grease the “wheels of commerce,” “investment bankers” (not pointing fingers, but check out shops like Rodman & Renshaw), the Exchanges on which these firms’ shares trade, 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)!
Investment/brokerage 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.
Basically, the 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.
That 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?
I doubt 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).
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!
We 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…
Financial 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 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 legally profit. Thus, with careful consideration and more patience than is exercised by most, we will 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.