Chinese Companies, Reverse Mergers and auditor litigation risk

• In Event: Breakfast with Research Roundtable Session

Abstract

Beginning in 2008, and accelerating in the subsequent several years, there have been many private securities class action lawsuits, Securities and Exchange Commission enforcement actions, and Public Company Accounting Oversight Board (PCAOB 2011) enforcement actions targeting financial reporting fraud and securities fraud allegedly perpetrated by People’s Republic of China (PRC) companies and their management, against investors who bought these companies’ securities in the US, Canada, and other countries. There also have been many newspaper and magazine articles written by short sellers and others alleging fraud on the part of these PRC companies. Most of these PRC companies went public, not via an initial public offering, but via a reverse merger transaction. In a reverse merger transaction, a privately held company merges with a publicly held company and the surviving entity is immediately a publicly held company, albeit not terribly liquid. PCAOB (2011) is concerned about whether the audits of these PRC reverse merger firms are compliant with the PCAOB standards and calls for more research on the audits of the PRC reverse merger companies. Thoughtful observers noted that it could be xenophobic to tar PRC companies with a brush of negativity, as it could be that the large amount of financial reporting fraud associated with PRC companies could possibly be attributed to the fact that they are reverse merger companies, rather than the fact that they are PRC companies. Indeed, subsequent research seems to suggest that reverse merger companies – regardless of nationality – seem to be associated with relatively poor financial reporting quality and results for investors (Chen and Soileau 2014). Also, when comparing PRC reverse merger companies to US reverse merger companies, the research seems to show that PRC reverse merger companies in the aggregate have substantially worse financial reporting quality but a portfolio of PRC reverse merger companies provides substantially superior results for investors, compared to US reverse merger companies (Ang et al. 2014; Lee et al 2014). PCAOB (2011) has expressed their concerns about whether the audits of the PRC reverse merger companies are compliant with PCAOB standards. Yet, there has never been done an empirical investigation of the experience of auditors in the financial reporting litigation associated with PRC companies. There also has never been done an empirical investigation of the experience of auditors in the financial reporting litigation associated with reverse merger companies.

Authors

• Ross D Fuerman, Suffolk University

• Nancy Chun Feng, Suffolk University