The prospects for Chinese companies going public on the U.S. stock markets via reverse mergers appear to be improving, despite the worries about accounting fraud that derailed several Chinese stocks in recent years.
There were signs last month of improved cooperation between the Securities and Exchange Commission and China's Securities Regulatory Commission and a rare decision by the SEC to overrule Nasdaq’s delisting of a Chinese reverse-merger company.
New research may further improve the appetite for Chinese securities. A paper presented in August at the annual meeting of the American Accounting Association in Anaheim, Calif., found that “the current Sino-phobic reaction to Chinese reverse mergers may be overblown.”
In an effort to assess the performance of these often maligned companies, the study concluded that “as an asset class, Chinese reverse-merger firms (CRMs) have performed as well as or better than comparable firms already listed in the same exchanges in the United States. CRMs also perform much better than U.S. RMs on multiple dimensions, even after many CRMs were delisted or demoted due to recent scandals. The emerging picture is that, despite a higher incidence of accounting problems, the CRMs are more mature and less speculative than their U.S. counterparts.”
Noting that “recent regulatory actions by the SEC have effectively frozen the flow of Chinese listings into U.S. markets,” the paper’s authors wrote that “while these policies might improve credibility, they have also clearly been costly in terms of U.S. investor access to a high-growth region.”
Accounting professor Charles M. C. Lee of Stanford University, who carried out the research with Kevin K. Li of the University of Toronto and Ran Zhang of Peking University, said, “Admittedly, there has been a rash of accounting frauds among Chinese firms that entered the U.S. market via reverse mergers. Still, in the end, investors lose out if they let themselves be driven by stereotypes.”
Over the past decade, hundreds of foreign firms, the great majority of them Chinese, have gone public on U.S. equity markets through mergers with shell companies whose stock is publicly traded but have gone bankrupt and no longer maintain active operations. Such reverse mergers (also known as reverse takeovers or backdoor listings) are considerably less onerous and expensive than gaining entry through initial public offerings. Firms that go the reverse merger route tend to be much more cash strapped and speculative in nature than those choosing the IPO process.
In June 2011 the SEC issued a general warning about investing in reverse-merger companies. That year more than 20 CRMs were delisted or prevented from trading, while others had auditor changes or were targeted by high-profile short-sellers. As the new study noted, “The general perception, fueled by multiple media reports, is that CRMs are inherently toxic.”
To test this proposition, the researchers went to considerable lengths to assess how CRMs stack up to comparable groups of companies. A problem in some past research, they contended, has been to portray the IPO and reverse merger as alternate ways for private companies to go public, even though “a majority of RM firms were never IPO-eligible, and their owners/managers never had the luxury of this choice...Therefore, IPO firms are a particularly poor benchmark by which to evaluate the aftermarket performance of RM firms.”
“While legitimate issues remain with the structural integrity of corporate governance in Chinese firms...our findings suggest the problems identified in the press are more appropriately attributed to risks endemic to the markets in which RMs reside, rather than to issues specific to China per se,” they added.
Avoiding comparisons with IPOs, the authors instead focused on three groups of firms over the period 2001 through 2011—including 146 Chinese reverse-merger companies, 278 other reverse-merger companies (251 from the U.S. and 27 from abroad), and a control group of 424 non-RM firms matched to the RM companies on the basis of industry, market value of equity, and venue where traded. To ensure that the CRM sample did not underestimate the hazards of investing in those firms, the researchers included 42 companies that were cited for fraud, either by the SEC, U.S. media, security class-action litigation, or short-seller reports.
The professors reported that the reverse-merger companies in their sample outperformed their control firms over the three years after the RMs’ first annual report to the SEC in terms of survival rate, increased market liquidity, and ability to move up in exchange tiers (for example, from Pink Sheet to Over the Counter Bulletin Board or from OTCBB to NYSE/AMEX or Nasdaq).
This superior performance was largely driven by the Chinese contingent. In the words of the study, “At the beginning of their public life, CRMs have higher market capitalization, lower leverage, higher profitability, and more positive operating cash flows than U.S. RMs,” the researchers wrote. “Over the next three years, CRMs continue to fare better than either their U.S. counterparts or a group of exchange-industry-date-size matched firms. The CRM advantage is multi-dimensional, and is evident in terms of profitability, current ratio, book leverage, operating cash flows, upward mobility in exchange tiers, percentage of firms with qualified audit opinions, survival rate, market liquidity, as well as stock returns.”
The researchers found that three years after their reverse mergers, 56 percent of the CRMs, compared to 26 percent of U.S. RMs, traded on national market system exchanges, namely the NYSE/AMEX and Nasdaq, in contrast to the OCTBB or Pink Sheet. As the study pointed out, “These firms are the crown jewels of the RM population in the sense that they not only survive but also pass the strict listing requirements of the national market system exchanges.”
What accounted for the reverse-merger companies’ superior performance? The study explained that “rapid development of China’s economy has given rise to many promising start-ups” and that “over the past decade, IPO-eligible firms in China have far outnumbered the actual firms allowed to IPO each year.” Prof. Lee added, “900 firms are lined up for IPOs in China. You don’t have that deep a pool over here of companies waiting to go public.”
In the end, the researchers did not offer any specific proposals for regulatory changes to unfreeze the flow of Chinese firms into the U.S. market and to encourage those already in the U.S. market to remain public and not join the current parade to go private. They believe the study goes a long way toward refuting the widely held view “that CRMs are collectively exploiting a significant loophole in U.S. listing regulations,” and see their findings as “helpful to market regulators as they pursue the challenge of balancing access and credibility.”
The paper, entitled “Shell Games: Have U.S. Capital Markets Been Harmed by Chinese Companies Entering via Reverse Mergers?” was among hundreds of scholarly presentations at the American Accounting Association meeting, which drew more than 3,000 scholars and practitioners to Anaheim, Calif., from August 3 to 7.
