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Study Challenges Effect of China-Based Reverse Mergers

Tammy Whitehouse | September 10, 2013

A recent academic study presented to the American Accounting Association says China-based reverse merger companies listed on U.S. stock exchanges have dished out no more harm to U.S. investors than similar U.S.-based companies from 2001 to 2010, and in fact have outperformed them.

The study says China-based reverse mergers, or CRMs, outperformed their peer group through the end of 2011, even after taking into account most of the companies that were accused of accounting fraud. The Securities and Exchange Commission has pursued fraud allegations against numerous China-based companies over the past few years, with many delisting. The SEC and the Public Company Accounting Oversight Board continue to seek access to companies and auditors based in China to investigate such allegations and to perform routine regulatory oversight, such as audit inspections. U.S. Treasury Secretary Jack Lew indicated this summer that the U.S. expected cooperation but nothing has developed since.

“Despite negative publicity (some from short sellers), we find little evidence that U.S. capital markets have been harmed by the admission of CRMs,” the authors wrote. The study, titled Shell Games: Have U.S. Capital Markets been harmed by Chinese companies entering via Reverse Mergers? is authored by Charles M. C. Lee of Stanford University, Kevin K. Li at the University of Toronto, and Ran Zhang of Peking University. 

The authors say they examined the overall financial health and performance of reverse mergers that became active in the U.S. stock markets from 2001 to 2010, with reverse mergers from China representing about 85 percent of foreign reverse merger listings during that period. The study's objective was to distinguish between problems that are common to all reverse mergers and those specific to China-based entities.

After identifying a control group that closely matched the risk attributes of the China reverse mergers, the authors say they have found new evidence to suggest reverse mergers across U.S. capital markets were more problematic for investors than China-based reverse mergers specifically. The study affirmed that reverse mergers in general tend to be small, financially constrained, illiquid stocks that are highly susceptible to default or bankruptcy.

The authors say when they split the sample of U.S. and China-based reverse mergers, they find U.S.-based entities generally underperformed and China-based entities outperformed. “CRMs are healthier than U.S. RMs on Day 1,” the authors wrote. “They are larger, less levered, more profitable, less likely to have a qualified audit opinion, and more likely to be at the growth or mature stage of the business life cycle.” The authors say their study helps refute widely held believes that China-based reverse mergers are exploiting a loophole in U.S. listing regulations.