The Market for “Lemons”: A Study of Quality Uncertainty and the Market Mechanism for Chinese Firms Listed in the U.S.

• In Event: Financial Markets with Incomplete Information

Abstract

Akerlof’s (1970) seminal work provides a framework for market failure as a consequence of quality uncertainty. We hypothesize and find that a classic “Lemons” market occurred in recent Chinese firms listed in the US. Our study provides empirical evidence of a rarely documented market failure - Chinese firm US IPOs almost became extinct in 2012. Our tests reveal that there is little difference in ex ante observable characteristics of non-fraudulent versus fraudulent firms when the Chinese firms were listed while entrepreneurs know their type, consistent with their ex post privatizations. Our evidence indicates the existence of severe information asymmetry and substantial costs of dishonesty. We find little evidence that traditional market mechanisms such as short selling behavior, auditor quality or underwriter reputation provide credible signals of firm quality. We further find that factors capturing potential ex post settling up costs such as North America sales and CEO’s US education reduce the probability of financial fraud. Our findings support efforts by Chinese and U.S. regulators to improve the quality of Chinese firm financial reporting and audit quality. Finally, our results highlight the importance of the ability to enforce legal sanctions for financial fraud in contemporary capital markets.

Authors

• Randolph Paul Beatty, University of Southern California

• Hai Lu, University of Toronto

• Wei Luo, Peking University