Nasdaq Proposes New Rules for Reverse Mergers

In a filing with the Securites and Exchange Commission last week, the NASDAQ Stock Market proposed additional requirements for Reverse Merger companies that want to apply for a Nasdaq listing. According to the filing, the purpose of this rule change is to enhance investor protection, as this group of companies has "raised regulatory concerns."

A previously unlisted private company that becomes a public company by merging with a public shell must file a Form 8-K with the SEC, within four days of completing this reverse merger. This filing must contain audited financial statements and most of the information that is usually provided in a Form 10. I am using SinoCoking (SCOK) as an example for this procedure: The operating business of this coal company merged into a shell company named "Ableauctions.com, Inc." (AAC) on February 5, 2010. The Form 8-K was filed three days later, and the new entity was quoted on the Over-the-Counter Bulletin Board under the new ticker "SCOK" on February 8, 2010. SinoCoking amended this 8-K filing on March 5, 2010 to include the required audited financial statements.

Nasdaq proposes now "to prohibit a company going public via a reverse merger from applying to list until six months after the combined entity submits audited financial statements to the SEC." In SinoCoking's case that would have meant that the company was not allowed to apply for a Nasdaq listing earlier than September 5, 2010. But Nasdaq was very eager to approve SCOK for an initial listing. The stock started trading on the NASDAQ Stock Market on February 18, 2010, or more than two weeks before the company even filed its first audited financials with the SEC.

The second proposed rule change calls for a company to maintain a bid price of $4 per share or higher on at least 30 of the 60 trading days immediately preceding the filing of the initial listing application, while trading in the over-the-counter market, on another national securities exchange, or on a listed foreign market. SinoCoking was trading on the OTC market for just eight sessions before it was allowed to move up to the big board.

An additional requirement for a reverse merger uplisting to NASDAQ should be the "timely filing" of at least two required periodic financial reports with the SEC for domestic issuers (10-Q or 10-K), or in the case of a Foreign Private Issuer, one or more reports including financial statements for a period not less than six months (6-K or 20-F). SinoCoking filed its second such report (10-K) on September 29, 2009, which - had the proposed new rules been already in place then - would have marked the day the company were allowed to apply for a Nasdaq listing. That is, if we interpret the requirement for "timely filing" only loosely. SCOK has submitted a Form NT-10, "Notification of inability to timely file Form 10-K or 10-Q", for three of the four reporting periods since it became a public company. With a strict interpretation of this rule, the company would still not be allowed to apply for a Nasdaq listing today, more than 14 months after the reverse merger completed.

Nasdaq elaborates in its SEC filing what prompted the proposed rule changes:

• extraordinary level of public attention to reverse merger companies
• financial press and short sellers raised allegations of widespread fraudulent behavior
• certain individuals who aggressively promote these transactions have significant regulatory histories
• RTO promoters have engaged in transactions that are disproportionately beneficial to them at the expense of public shareholders
• PCAOB identified issues with the audits of these companies
• the SEC recently took an enforcement action based on a firm's audit of a reverse merger company
• promoters manipulate prices higher to satisfy Nasdaq's initial listing bid price requirement
• companies have gifted stock to artificially satisfy the 300 round lot public holder requirement

Nasdaq believes the additional listing requirements would help "to discourage inappropriate behavior on the part of companies, promoters and others." Heightened review procedures for reverse merger applicants had already been adopted over the past year, but new rules would result in "significant investor protection benefits." We have seen only two reverse merger uplistings since September 2010, NFEC and KEYP (currently halted), and the only Chinese small cap stock that has been approved to move from the OTC market to Nasdaq this year is Asia Pacific Wire & Cable (AWRCF), but this is not a reverse merger company.

Nasdaq sees the following investor protection benefits:

• FINRA will have more time to view trading patterns and uncover potentially manipulative trading
• a more bona fide shareholder base
• assure that the $4 bid price was not satisfied through a quick manipulative scheme
• improve the reliability of the reported financial results
• auditors and the company's audit committee will have reviewed several quarters, at least, of the public company's operating results
• new internal controls, adopted at the time of the merger, will have been in place for a while

CHIO's Planned Reverse Merger

China INSOnline (CHIO) is currently trading at $0.13, down 81.42% for the year and down 82.66% from its April 19 high at $0.75. The Trading China Tracker Score is 0 (Sell).

CHIO posted details about their proposed reverse merger with a Chinese biodiesel producer on Friday. Let's have a look into the details of the agreement and find out the likely direction of CHIO common stock should the merger close.

The merging company, Fujian Zhangzhou Dingneng Bio-technology Co. through Ding Neng Holdings (Ding Neng), began operations in 2006 and all of its revenue are, and in the near-term will continue to be, derived from the sale of biodiesel produced at Ding Neng's production facility in Zhangzhou City, Fujian province.

After the acquisition is completed, CHIO's existing stockholders are expected to own approximately 10.5% of the outstanding shares of the company, Ding Neng shareholders will own 85.0%, and 4.5% will be issued to Maxim Group LLP for services provided to complete the acquisition:

- Common stock outstanding pre-merger: 46 million
- Common stock outstanding post-merger: 438 million

CHIO intends to apply to Nasdaq to retain its listing upon completion of the acquisition. Nasdaq's approval will require that the post-acquisition entity will meet the initial listing requirements of the Nasdaq Capital Market, most importantly a minimum bid price of $4.00 per share. To achieve that, CHIO and Ding Neng have agreed to effect a reverse stock split at a ratio of not less than 1:20 and not more than 1:40, immediately prior to closing of the acquisition.

As CHIO is currently considered a public shell company, the merged entity will have to meet all of the rather strict requirements for an initial Nasdaq listing. At this point its seems unlikely, even with a 1:40 reverse split and "new CHIO" being able to meet the $4 bid rule, that the Nasdaq listing can be saved. Investors should be prepared to find new CHIO being quoted on the OTC Bulletin Board.

The agreement contains certain conditions to closing set by Ding Neng, the deal might still fall apart at this point. The Company must have been continuously listed on the Nasdaq Capital Market through the date of closing. The proposed name change to China Bio-Energy Corporation must have been approved by the company's board and shareholders, Nasdaq and FINRA. And, most importantly, no litigation, proceeding, investigation or inquiry will be pending or, to the company's knowledge, have been threatened.

Financials

Ding Neng Holdings' total revenue increased from $9.04 million in FY 2008 to $15.3 million in FY 2009 and $14.8 million in the first six months of 2010. Net income increased as well - from $1.22 million (2008) to $2.06 million (2009), and reaching already $3.24 million for the six months ended June 30, 2010.

It should be noted that reported net margins of 21.8% for 2010 are staggeringly high for a biodiesel business. Ding Neng reported net margins of 13.5% for both FY 2008 and 2009, which is more in line with competitors like China Clean Energy (CCGY). China Clean achieved net margins of 12.0% and 11.3% for the June quarters of 2010 and 2009, respectively. I couldn't find an explanation for the margin explosion at Ding Neng in the filing.

If we project Ding Neng's six months results on the full year 2010, using a sort of best-case scenario where the explosive growth rates (213% net income growth year-over-year) can be sustained for the second half of the year, we get to these estimates for FY 2010: Total revenue of $32 million (up 109%) and net income of $7 million (assumed net margin of 21.5%).

Please note that there are some discrepancies in this calculation. Ding Neng said that the annual aggregate capacity of their Zhangzhou biodiesel facility is approximately 40,000 tons. China Clean has reported a most recent average selling price of $682 per ton for biodiesel (up from $569 in 2009), and if we use this number we get to a maximum revenue potential for Ding Neng of $27.3 million per annum with their facility sold out and running at full capacity. Or $13.64 million for the first six months compared to the $14.83 million the company has already reported. Ding Neng must achieve much higher prices for their biodiesel than China Clean to make those numbers all work out.

Valuation

Ding Neng reported trailing twelve months earnings of $4.26 million and my best-case projection for FY 2010 net income is $7.00 million. Competitors like CCGY and China Integrated Energy (CBEH) are currently trading at 7 times earnings. Given that 2011 growth projections for Ding Neng are uncertain as the company is currently running at full capacity, has a short operating history, and growth based on margins that are about 80% above industry average (CBEH's net margin is also in the 12% range), I would set the fair value for "new CHIO" at the 5x earnings level.

This leads me to believe that a fair market capitalization for the post-acquisition entity should be in the $25 million to $35 million range. However, at CHIO's November 12 closing price of $0.13, and using the terms of the reverse merger agreement, the market capitalization of the new entity is currently $57 million, valuing the company with a P/E ratio of 13.4 and forward ratio of 8.2.

Personally, I would not touch the stock above a price per share of $0.05, and even then investors should be prepared for a delisting of CHIO from Nasdaq, as the proposed reverse stock split at a ratio of max. 1:40 won't be sufficient to maintain Nasdaq's required minimum bid price. It seems unlikely at this point that Ding Feng's conditions for closing will be met, and I would not be surprised if the deal will fall apart completely.