Chinese Reverse Mergers Spawned U.S. Class Actions, Report Says

The deals, involving shell companies, were “significantly more likely to involve restatements of financial statements,” according to the study.
David KatzMay 22, 2012

Driven in part by abundant reverse-merger filings by firms in China resulting in listings on U.S. exchanges, the number of securities class-action filings involving accounting allegations rose in 2011 over 2010, according to a new report by Cornerstone Research.

Of the 188 securities class-action lawsuits filed in 2011, 70 included accounting allegations. That compares with 46 in 2010, the lowest number of accounting case filings in recent years, according to the report, “Accounting Class Action Filings and Settlements—2011 Review and Analysis.”

The reverse mergers were “significantly more likely to involve restatements of financial statements and, as a result, include alleged violations of generally accepted accounting principles,” according to a statement by Cornerstone.

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Indeed, the accounting world paid a good deal of attention last year to the incidence of Chinese companies using reverse mergers of shell companies to list on U.S. stock exchanges. Further, the Securities and Exchange Commission stepped up its enforcement efforts against allegedly fraudulent U.S. shell companies in greater China.

In a letter to the U.S. House Oversight and Government Reform subcommittee in April 2011, SEC chair Mary Schapiro reported that in the prior five weeks, the commission had suspended trading in at least three China-based entities (Heli Electronics, China Changjiang Mining & Energy, and Rino International) that had become U.S. domestic issuers through reverse mergers. The SEC also revoked the U.S. registrations of at least eight other such companies “in the last several months alone,” she stated.

Broadly speaking, a reverse merger refers to a private operating company’s acquisition by a public shell company. Reverse mergers typically result in the owners and management of the private company having voting and operating control of the combined company. In effect, the private company becomes an SEC reporting company — with registered securities but without having to file a registration statement.

Overall, the number of accounting case filings involving financial-statement restatements also increased last year, reversing a four-year trend of declines, according to the Cornerstone report.

In 2011, 20 accounting case filings included restatements, compared with 12 case filings in 2010. “Declines in the number of financial statement restatements had been widely attributed to improved corporate governance practices as a result of the Sarbanes-Oxley Act,” according to the Cornerstone statement.

In 2010, however, the number of restatements by public companies rose, which may have contributed to the increase in case filings involving restatements, according to the research firm.

“As we approach the tenth anniversary of the passage of Sarbanes-Oxley, it is interesting to observe the increase in allegations related to SOX 404 reporting in recent years,” Cornerstone added. (Under Section 404 of Sarbox, public companies and their independent auditors are each required to report to the public on the effectiveness of the companies’ internal controls over financial reporting.)