Reverse Mergers:The Chinese ExperienceJan Jindra, Torben Voetmann, and Ralph A. Walkling

This document is Ohio State University Fisher College of BusinessWorking Paper no. 2012-03-018. It is also Ohio State University DiceCenter Working Paper no. 2012-18 (July 13, 2012).

Reverse Mergers: The Chinese Experience*

Jan Jindraa,

Ohio State University

Torben Voetmannb,

Cornerstone Research

Ralph A. Walklingc

Drexel University

Abstract:

Chinese reverse mergers (CRMs) claim to provide easy entry to the U.S. and international

markets. Recently, a large number of Chinese firms using reverse merger transactions have been

listed on the U.S. stock exchanges. We review the historical use and mechanics of these reverse

mergers, and contrast them with initial public offerings (IPOs). We also explore settlements of

securities class action lawsuits involving Chinese firms. Our analysis shows that larger, more

reputable Chinese firms are significantly less likely to pursue reverse mergers. We also find that

CRM firms are more likely to be subject to class action litigation in the U.S and that the

settlement amounts are smaller for CRM firms than for Chinese IPO firms. Our analysis further

indicates that CRM firms significantly underperform the Chinese IPO firms. Thus, the evidence

suggests that CRMs are not substitutes for Chinese IPOs.

Keywords: Reverse merger, IPO, cross-listing, China, securities class action lawsuit, lawsuit

settlement.

This Draft: July 13, 2012

* The views expressed in this article are solely those of the authors, who are responsible for the content, and do not

necessarily represent the views of Cornerstone Research. a Jan Jindra, Department of Finance, Fisher College of Business, Ohio State University, Columbus, OH 43210;

650-489-6807; jindra.2@osu.edu b Torben Voetmann, Cornerstone Research, San Francisco, CA 94111; 415-229-8172; tvoetmann@cornerstone.com

c Ralph A. Walkling, LeBow College of Business, Drexel University, 3141 Chestnut Street, Philadelphia, PA 19104;

215-895-4920; raw38@drexel.edu

1

Reverse Mergers: The Chinese Experience

Abstract:

Chinese reverse mergers (CRMs) claim to provide easy entry to the U.S. and international

markets. Recently, a large number of Chinese firms using reverse merger transactions have been

listed on the U.S. stock exchanges. We review the historical use and mechanics of these reverse

mergers, and contrast them with initial public offerings (IPOs). We also explore settlements of

securities class action lawsuits involving Chinese firms. Our analysis shows that larger, more

reputable Chinese firms are significantly less likely to pursue reverse mergers. We also find that

CRM firms are more likely to be subject to class action litigation in the U.S and that the

settlement amounts are smaller for CRM firms than for Chinese IPO firms. Our analysis further

indicates that CRM firms significantly underperform the Chinese IPO firms. Thus, the evidence

suggests that CRMs are not substitutes for Chinese IPOs.

2

I. Introduction

“[W]e [Muddy Waters] are confident that ONP [Orient Paper, Inc.] is a fraud. Its purpose is to raise and misappropriate tens of millions of dollars.” (Carson C. Block and Sean Regan, Muddy Waters Research report dated June 28, 2010, p. 1.) “[RINO International Corp.] reported 2009 revenue of $193 million. In reality its revenue is under $15 million, and its management has diverted tens of millions of dollars for its own use.” (Carson C. Block, Muddy Waters Research report dated November 10, 2010, p. 1.)

As a result of increasing negative media coverage, Chinese firms that have listed their

shares on U.S. exchanges via reverse mergers are now being scrutinized by investors, regulators,

and plaintiff law firms. Subsequently, the value of shares of Chinese reverse merger (CRM)

firms listed on U.S. exchanges fell by almost 50% in 2011.1 The Securities and Exchange

Commission (SEC) has issued an investor warning related to the accounting and disclosure

practices of CRMs, and the Public Company Accounting Oversight Board (PCAOB) has

published a research note identifying potential concerns in audits performed by U.S.-registered

accounting firms.2 Finally, numerous CRM firms are facing securities class action lawsuits. In

this research we provide a general overview of reverse merger transactions, detailed analyses of

CRMs, and comparison of CRMs with other Chinese firms that have listed their shares on U.S.

exchanges via initial public offerings (IPOs).

The recent increase in the use of reverse mergers by non-U.S. firms raises the question of

whether they in fact offer an easier method of gaining entry to the U.S. capital markets as

1 See, for example, Bloomberg’s Chinese Reverse Mergers Index (ticker symbol: CHINARTO). 2 SEC Investor Bulletin: Reverse Mergers, June 9, 2011. “Activity Summary and Implications for Reverse Mergers Involving Companies from the China Region: January 1, 2007 through March 31, 2010,” PCAOB, Research Note #2011-P1, March 14, 2011 (PCAOB Note 2011).

3

compared to traditional IPOs.3 In investigating this question, we would expect to observe

different characteristics of firms pursuing reverse mergers versus those pursuing IPOs. As such,

we analyze the characteristics of CRMs and compare them to the characteristics of Chinese firms

that have listed their shares in the U.S. via IPOs. However, reverse mergers are frequently

described as having lower up-front costs when compared to IPOs. To the extent that reverse

merger have lower up-front costs than IPOs, we should observe smaller and less profitable firms

pursuing reverse mergers in lieu of IPOs.

The recent negative publicity of CRMs also raises the possibility that reverse mergers

attract less reputable issuers. Table 1 show the CRM firms that are currently subject to SEC

investigations and have had the trading of their shares suspended. Many of these firms are also

subject to class action litigation. While the perceived high number of investigations and lawsuits

may be reflective of increased likelihood of fraud, it may also reflect the risk associated with

newly listed firms. We therefore compare CRMs with Chinese IPOs to study the characteristics

that are frequently used to certify the CRMs that have been included in class action litigation, the

likelihood that a particular firm becomes a defendant in a class action lawsuit, and the damages

and settlement amounts incurred by defendants in such lawsuits.

We analyze samples of CRM firms and Chinese IPO firms that have listed on at least one

major U.S. stock exchange. We find that the CRM firms are substantially smaller in terms of

assets, have higher leverage, have lower analyst and institutional following, and face a higher

probability of a class action lawsuit. The recent settlements of class action lawsuits suggest that

plaintiffs suing CRM firms settle for smaller amounts when compared to Chinese IPOs and U.S.

3 William K. Sjostrom, Jr., “The Truth about Reverse Mergers,” 2 Entrepreneurial Bus. L. J. 743 (2007–2008). (“Although [reverse mergers] are often pitched as IPO substitutes, they provide neither a large infusion of equity capital nor share liquidity, the two primary benefits of an IPO.”)

4

class action settlements. Moreover, CRMs have significantly underperformed Chinese IPOs.

Overall, we find that many Chinese firms in our sample may have treated reverse mergers and

IPOs as substitutes. Likely due to the supposedly easy entry to the capital market of reverse

mergers, such transactions also appear to attract more class action litigation once the stock lists

on a major stock exchange. While the increased incidence of litigation may increase the cost of

reverse mergers, the settlements of such cases indicate that the costs may be lower when

compared to other settlements of class action lawsuits involving Chinese IPO firms. As a result

of these costs, the entry to the U.S. capital market for CRMs is not as easy as it appears.

This paper is organized as follows. Section II describes the mechanics of reverse mergers,

including CRMs and allegations against CRMs. Section III describes the data on CRMs and

Chinese IPOs listed in the United States used in our analysis. Section IV presents empirical

results. Section V discusses class action lawsuits and settlements for CRMs. Finally, Section VI

concludes the paper with a discussion of the implications of the empirical findings.

II. Mechanics of Reverse Mergers

A. Reverse Mergers4

Prior to the recent CRM wave, reverse merger transactions existed for many years and

were used in a variety of settings.5 For example, in 1970, Ted Turner turned to a reverse merger

with Rice Broadcasting to create Turner Broadcasting, later known as Time Warner.6 A more

recent transaction involved a $10 billion reverse merger transaction that was completed between

4 For a detailed description of reverse mergers, see David N. Feldman, Reverse Mergers: Taking a Company Public Without an IPO (2006) and Reverse Mergers: And Other Alternatives to Traditional IPOs (2009). 5 William K. Sjostrom, Jr., “The Truth about Reverse Mergers,” 2 Entrepreneurial Bus. L. J. 743 (2007–2008). (“RMs have been around for years but have recently regained popularity.”) 6 Gariel Nahoum, “Small Cap Companies and the Diamond in the Rough Theory: Dispelling the IPO Myth and Following the Regulation A and Reverse Mergers Examples,” 35 Hofstra L. Rev. 1903 (2006–2007).

5

the publicly traded Archipelago and the privately held non-profit New York Stock Exchange

(NYSE) in March 2006.7 In the transaction, the NYSE’s member-owners acquired 70% of the

publicly traded Archipelago stock.8 Following the reverse merger transaction, NYSE became a

for-profit publicly traded firm.9 Yet another reverse merger example is the combination of drug

giants Merck and Schering-Plough for $41.1 billion in 2009.10 Therefore, reverse mergers are

neither new nor unusual transactions.

A reverse merger transaction (or reverse takeover) generally involves two firms, one

publicly listed firm and one private firm seeking public listing.11 The public firm is usually only

a “shell” companyi.e., it has no or only nominal assets, and is merely listed on an exchange.12

As a result of the transaction, the private firm is acquired by the public firm and merged into it.13

In exchange for contributing substantially all of the merged firm’s assets, the private company’s

shareholders are issued a majority stake in the merged firm, gaining a controlling stake.14 Hence,

following the transaction, the public firm contains the operating assets and liabilities of the

private company and retains its stock exchange listing.15 The private company effectively

7 Dean Starkman and Ben White, “NYSE Approves Archipelago Acquisition,” Washington Post, December 7, 2005. 8 David Weidner, “NYSE Blasts Foes of Merger,” MarketWatch, November 8, 2005. 9 Frank J. Fabozzi, Handbook of Finance: Financial Markets and Instruments, 2008, p. 140. 10 David Feldman, “Schering-Merck Plot Biggest Reverse Merger Ever,” Reverse Merger & SPAC Blog, March 10, 2009. 11 See, for example, SEC Investor Bulletin: Reverse Mergers, June 9, 2011 and SEC Release No. 33-8587, July 15, 2005. See also William K. Sjostrom, Jr., “The Truth about Reverse Mergers,” 2 Entrepreneurial Bus. L. J. 743 (2007–2008). (“The private operating company then merges with the shell company or a newly-formed subsidiary of the shell company.”) David N. Feldman, Reverse Mergers: Taking a Company Public Without an IPO (2006), p. 37. Reverse mergers are often structured as a reverse triangular merger where a shell company forms a new subsidiary and the private companies are merged with the newly formed subsidiary. In this paper, the terms “reverse merger” and “reverse triangular merger” are used interchangeably. 12 William K. Sjostrom, Jr., “The Truth about Reverse Mergers,” 2 Entrepreneurial Bus. L. J. 744 (2007–2008). (“A public shell company is a company that has a class of securities registered under the Securities Exchange Act of 1934”). ¶ 1, 15 U.S.C. ¶ 78a (2006 and ¶240.12b–2 (2007). 13 Aden R. Pavkov, “Ghouls and Godsends? A Critique of ‘Reverse Merger’ Policy,” 3 Berkeley Bus. L. J. 478 (2005–2006). 14 William K. Sjostrom, Jr., “The Truth about Reverse Mergers,” 2 Entrepreneurial Bus. L. J. 743 (2007–2008). 15 Kimberly C. Gleason, Ravi Jain, and Leonard Rosenthal, “Alternatives for Going Public: Evidence from Reverse Takeovers, Self-Underwritten IPOs, and Traditional IPOs,” Indian School of Business, Working Paper, December

6

becomes an SEC reporting entity with registered securities and with access to the capital

markets.16 This so-called “back door” entry to public markets provides an avenue for private

companies to readily access capital which may have been previously unavailable to them.17

An important characteristic of a reverse merger is that the transaction does not raise new

capital for either the public shell or the private firm.18 Frequently, however, reverse mergers are

structured to raise capital via a simultaneous private investment in public equity (PIPE) financing

option.19 A PIPE is a private sale of equity securities to a small group of investors. Because the

securities issued are not registered at the time of the offering, they cannot be sold in the public

market until a registration statement has been filed and declared effectivethat is, after the

completion of the reverse mergeror unless a valid exemption from registration is available.

The benefits of a reverse merger with simultaneous PIPE transaction compared to a registered

public offering are, among others, less time commitment (i.e., no road show or book building),

lower registration expenses, and fewer disclosure requirements.20 The most important frequently

cited benefit is the speed with which PIPEs can be arranged between the issuer and investors.21

2005, p. 4. (“Following the acquisition, the management of the privately held firm usually replaces the management of the vehicle, and the surviving entity is the newly public, previously private ‘target.’”) 16 William K. Sjostrom, Jr., “The Truth about Reverse Mergers,” 2 Entrepreneurial Bus. L. J. 743 (2007–2008). (“[T]he operating company’s business is still controlled by the same group of shareholders and managed by the same directors and officers, but it is now contained within a public company...the operating company has succeeded to the shell company’s public status and is therefore now public.”) 17 Thomas L. James, “Use of Reverse Mergers to Bypass IPOs: A New Trend for Nanotech Companies,” Nanotechnology Law & Business 95 (March 2007). (“The ‘back door’ method of becoming a public company is gaining popularity with many types of companies, including nanotech companies, which are capital intensive businesses that need access to greater and more readily available sources of capital that are traditionally only available for public companies.”) See also Aden R. Pavkov, “Ghouls and Godsends? A Critique of ‘Reverse Merger’ Policy,” 3 Berkeley Bus. L. J. 478 (2005–2006). (“A reverse merger, like an initial public offering, is a transaction whereby a private company may become a public corporation with full access to the public capital markets.”) 18 William K. Sjostrom, Jr., “The Truth about Reverse Mergers,” 2 Entrepreneurial Bus. L. J. 749 (2007–2008). (“[A]n RM is not a capital raising transaction. No shares are sold for cash in the transaction.”) 19 William K. Sjostrom, Jr., “The Truth about Reverse Mergers,” 2 Entrepreneurial Bus. L. J. 752 (2007–2008). 20 S. Chaplinsky and David Haushalter, “Financing under Extreme Risk: Contract Terms and Returns to Private Investments in Public Equity,” The Review of Financial Studies , Vol. 23, No. 7 (2010), p. 2793. 21 S. Chaplinsky and David Haushalter, “Financing under Extreme Risk: Contract Terms and Returns to Private Investments in Public Equity,” The Review of Financial Studies , Vol. 23, No. 7 (2010), p. 2793.

7

Compared to the IPO process, reverse mergers are associated with benefits such as lower

direct costs of issuance, shorter time to completion, and higher liquidity for shareholders.22

Empirical research suggests that an IPO can cost as much as 18% of the proceeds, covering

direct expenses such as underwriting costs, legal fees, and filing and listing costs.23 In contrast,

the cost of a reverse merger is typically less than $1 million.24 Completing an IPO is a lengthy

process that can take several months, while a reverse merger can be completed in as little as a

few days. This time comparison is somewhat misleading because, following a reverse merger,

the public company is expected to meet SEC filing requirements for which the preparation can

take substantial effort and time. Nevertheless, the reverse merger avoids the process of finding an

underwriter and completing the registration statement and prospectus.25 All that is required by

the company is a disclosure through an SEC Form 8-K. Another perceived benefit is that smaller

companies often have few options to enter the capital markets.26 As a result, reverse mergers

offer an alternative to an IPO, giving smaller firms access to capital that otherwise would be

unavailable. Finally, foreign firms listing in the U.S. gain increased visibility and credibility

among investors and customers.27

22 Thomas L. James, “Use of Reverse Mergers to Bypass IPOs: A New Trend for Nanotech Companies,” Nanotechnology Law & Business (March 2007). See also Philip Brown, Andrew Ferguson, and Peter Lam, “Choice Between Alternative Routes to Go Public: Backdoor Listing versus IPO,” July 2010, http://ssrn.com/abstract=1897816. (“Backdoor listing has often been touted as a cheaper, easier and faster way to go public. However, empirical evidence to support such claim is sparse and, at best, anecdotal.”) 23 See Jay R. Ritter, “Initial Public Offerings,” in Handbook of Modern Finance (1999). See also William K. Sjostrom, Jr., “The Truth about Reverse Mergers,” 2 Entrepreneurial Bus. L. J. 750 (2007–2008). 24 Gariel Nahoum, “Small Cap Companies and the Diamond in the Rough Theory: Dispelling the IPO Myth and Following the Regulation A and Reverse Mergers Examples,” 35 Hofstra L. Rev. 1904 (2006–2007). 25 See also SEC Commissioner Luis A. Aguilar, Speech at Council of Institutional Investors, Spring Meeting, Washington, D. C., April 4, 2011. (“[A] reverse merger, ‘gives the formerly private company the credibility and access to capital of being registered as a public company, without any of the vetting from underwriters and investors that companies undergo when they perform a traditional IPO.’”) 26 Gariel Nahoum, “Small Cap Companies and the Diamond in the Rough Theory: Dispelling the IPO Myth and Following the Regulation A and Reverse Mergers Examples,” 35 Hofstra L. Rev. 1897 (2006–2007). 27 Paul R. Bessette, Yusuf Bajwa, and R. Adam Swich, “The Rise of SEC Investigations and Shareholder Lawsuits Involving Chinese Companies Listed on U.S. Stock Exchanges,” Willamette Insight Autumn 2011, p. 49.

8

However, a major cost of engaging in a reverse merger is the cost associated with

performing due diligence of the shell and private firms. This cost has increased since the 1970s

and 1980s when “a general lack of regulation of both reverse mergers and the use of shell

companies” led to easy grounds for fraudulent activity.28 Furthermore, the foreign cross-listed

firms face higher costs related to defending themselves against class action litigation in the U.S.

when compared to their countries of origin. This is due to the more active litigation market in the

U.S. as well as the added cost of defending against a lawsuit in a country that may be far away

from its headquarters.

B. Chinese Reverse Mergers: Recent Developments

Chinese companies have increasingly turned to the use of reverse mergers in order to gain

listing on securities exchanges in the U.S.29 One study suggests that “Chinese firms further

regard reverse mergers as preferable to a traditional IPO since it allows the company a more

predictable foray into U.S. public markets.”30 A study by PCAOB identified 157 companies from

the China region that have used reverse mergers to access the capital markets in the United States

since 2007.31 (In contrast, only 56 Chinese companies have used IPOs.32) Roughly two-thirds of

these CRMs traded on the over-the-counter (OTC) Bulletin Board, and the others are listed on

NASDAQ or the NYSE.33

28 Gariel Nahoum, “Small Cap Companies and the Diamond in the Rough Theory: Dispelling the IPO Myth and Following the Regulation A and Reverse Mergers Examples,” 35 Hofstra L. Rev. 1904–5(2006–2007). 29 Gariel Nahoum, “Small Cap Companies and the Diamond in the Rough Theory: Dispelling the IPO Myth and Following the Regulation A and Reverse Mergers Examples,” 35 Hofstra L. Rev. 1907 (2006–2007). 30 Gariel Nahoum, “Small Cap Companies and the Diamond in the Rough Theory: Dispelling the IPO Myth and Following the Regulation A and Reverse Mergers Examples,” 35 Hofstra L. Rev. 1907 (2006–2007). 31 PCAOB Note 2011, p. 1. 32 PCAOB Note 2011, p. 1. 33 According to PCAOB Note 2011, 101 CRM companies traded on the OTC Bulletin Board and 49 were listed (as of the time of publication) on NASDAQ or the NYSE.

9

CRMs, as all other reverse merger firms, are required to file audited financial statements

with the SEC, and their auditors are required to be registered with the PCAOB.34 The audit

practices of these accounting firms in conducting CRM audits and the accuracy of the audited

financial statements issued by CRMs have been questioned by regulators and investors. For

example, the PCAOB issued “Staff Audit Practice Alert No. 6” in July 2010, which highlights

emerging trends in work performed for CRM clients by U.S.-registered accounting firms.35 The

alert noted that some accounting firms might not have been conducting audits of CRMs in

accordance with PCAOB standards.36 According to the PCAOB, these standards establish

requirements that apply when an auditor uses the work and reports of other independent auditors

or contractors. The problem of auditing can be illustrated with the SEC investigation in the

summer of 2010 of the audit practices of Moore Stephens Wurth Frazer & Torbett, LLP

(MSWFT), a U.S.-registered PCAOB accounting firm that had several CRM clients. Following

its investigation, the SEC issued a cease-and-desist order against MSWFT after finding the

company had failed to follow applicable professional standards, including PCAOB standards, in

reviewing the financial statements of China Energy Savings, Inc., a CRM.37

Following the SEC order, more than 24 CRMs announced auditor resignations, most of

which were U.S.-registered auditors.38 The SEC, NASDAQ, and NYSE have suspended trading,

halted trading, or delisted the securities of at least 29 CRMs, citing, among other reasons, public

34 According to PCAOB Note 2011, 74 percent of CRM companies hired U.S.-registered accounting firms to perform their audit work in association with SEC disclosure requirements. 35 See “Staff Audit Practice Alert No. 6: Auditor Considerations Regarding Using the Work of Other Auditors and Engaging Assistants from Outside the Firm,” PCAOB, July 12, 2010. 36 “Part of Audit Performed by Other Independent Auditors” (AU 543). 37 Order Instituting Public Administrative and Cease-and-Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933 and Section 4C of the Securities Exchange Act of 1934 and Rule 102(e) of the Commission’s Rules of Practice, Making Findings, and Imposing Remedial Sanctions and A Cease-and-Desist Order, In the Matter of Moore Stephens Wurth Frazer & Torbett LLP and K. Dean Yamagata, CPA, dated December 20, 2010. 38 “SEC Digs Deep in Long March to China,” Business Law Currents, June 1, 2011. In some cases, the CRM issuer is alleged to have “fired” the auditor over disagreements related to the quality of the audited financial statements.

10

interest concerns, removal of audit opinions, failure to respond to information requests, failure to

comply with SEC requirements, and failure to evidence compliance with initial listing standards

(see Table 1). On June 9, 2011, the SEC issued an Investor Bulletin warning investors of the

potential risks of investing in CRMs.39 Furthermore, NASDAQ has proposed that a reverse

merger company should meet certain listing requirements, including having: “(A) traded for at

least one year in the U.S. over-the-counter market, on another national securities exchange, or on

a regulated foreign exchange, following the filing with the Commission or Other Regulatory

Authority of all required information about the transaction, including audited financial

statements for the combined entity; and (B) maintained a closing price of $4 per share or higher

for a sustained period of time, but in no event for less than 30 of the most recent 60 trading

days.”40

C. Class Action Litigation: CRMs

With the increased scrutiny by the SEC and regulators, CRMs are also facing numerous

securities class action lawsuits. This trend is documented, for example, in a study by National

Economic Research Associates. The study suggests that about 12% of private class action cases

in U.S. federal courts during 2010 are against non-U.S. issuers. Moreover, 38% of those class

actions were brought against Chinese companies.41 Notwithstanding the increasing

investigations, securities class actions, and reports by short sellers like Muddy Waters, not all

39 SEC Investor Bulletin: Reverse Mergers, June 9, 2011. 40 NASDAQ, Change of Control, Bankruptcy and Liquidation, and Reverse Mergers, 5110. [“In addition to satisfying all of NASDAQ’s other initial listing requirements, a Reverse Merger Company will only be approved for listing if, at the time of approval, it has: (A) timely filed all required periodic financial reports with the Commission or Other Regulatory Authority (Forms 10-Q, 10-K or 20-F) for the prior year, including at least one annual report. The annual report must contain audited financial statements for a full fiscal year commencing after filing the information described in paragraph (1)(A) above; and (B) maintained a closing price of $4 per share or higher for a sustained period of time, but in no event for less than 30 of the most recent 60 trading days prior to approval.”] 41 Jordan Miles, Robert Patton, and Svetlana Starykh, “Trends 2010 Year-End Update: Securities Class Action Filings Accelerate in Second Half of 2010; Median Settlement Value at an All-Time High,” NERA, http://www nera.com/nera-files/PUB_Year_End_Trends_1210.pdf, p. 9.

11

U.S.-listed Chinese companies should be automatically labeled as fraudulent. It is important to

recognize that the information provided in short seller reports about companies are mostly one-

sided, since the short seller stands to gain substantial rewards when a company’s stock price

subsequently declines. As a result, short seller reports “should be taken with a grain of salt…

[since] the effect of short sellers on companies can be devastating.”42 In some cases, the

devastating information can destroy an otherwise viable company. For example, the Muddy

Waters report on Sino-Forest wiped out $3.25 billion in market capitalization in two trading days

upon its publication.43 Some commentators refer to such reports by Muddy Waters in unflattering

terms as “a pile of crap.”44

The majority of allegations against CRMs are centered around issuing false and/or

misleading statements and inflating revenues or earnings.45 In addition, the SEC has shown

interest in the investment bankers and auditors who have assisted CRMs.46 A number of class

action complaints list the investment banks as codefendants. According to the plaintiffs, these

investment banks knowingly permitted false and misleading statements to be made in offering-

related documents, including revised registration statements or prospectuses. Similarly, the

PCAOB has reported that, post-merger, the public company frequently dismisses the auditor of

the former shell company and retains the Chinese operating company’s auditor, often a U.S.

accounting firm.47 In some situations, the U.S. auditor will engage the services of another firm to

42 Paul R. Bessette, Yusuf Bajwa, and R. Adam Swich, “The Rise of SEC Investigations and Shareholder Lawsuits Involving Chinese Companies Listed on U. S. Stock Exchanges,” Willamette Insight, Autumn 2011, p. 53. 43 Paul R. Bessette, Yusuf Bajwa, and R. Adam Swich, “The Rise of SEC Investigations and Shareholder Lawsuits Involving Chinese Companies Listed on U. S. Stock Exchanges,” Willamette Insight, Autumn 2011, p. 53. 44 David Pett and John Shmuel, “Muddy Waters Sino-Forest Research ‘Pile of Crap,’” Dundee Financial Post, June 7, 2011. 45 James S. Ang, Zhiqian Jiang, and Chaopeng Wu, “Good Apples, Bad Apples: Sorting Among Chinese Companies Traded in the U.S.,” working paper 2012, http://ssrn.com/abstract=2024826. 46 Scott Eden, “SEC Probes China Stock Fraud Network,” The Street, December 21, 2010. 47 PCAOB Note 2011, p. 6.

12

perform part of the audit.48 However, a firm cannot serve as principal auditor and report as such

on the financial statements, unless the firm’s participation in the audit is sufficient.49

As part of its ongoing campaign to deter threats of fraudulent and manipulative activity,

the SEC proposed rule changes for reverse mergers in 2005. Prior to these SEC rule

amendments, reverse mergers required less time prior to going public because the primary tasks

only involved negotiating an agreement with a promoter and preparing a current report on a

Form 8-K to announce the event. Starting in 2005, the SEC circulated new rules intended to

protect investors by deterring fraud and abuse in the use of reporting shell companies in

transactions such as reverse mergers. Further, the requirement of CRMs to file audited financial

statements with the SEC was intended to deter abuse and further the goal of protecting

investors.50

III. Data and Sample Characteristics

We identify a sample of CRMs from public press searches using the following steps.

First, we select the five transactions from the Thomson Reuters SDC Mergers and Acquisitions

Database (SDC) which occurred prior to December 31, 2010 and which are classified as CRMs.

Second, we supplement this list with Chinese firms in the Bloomberg Reverse Merger Index

which were members as of December 31, 2010 and June 10, 2011. This yields a total of 80 firms.

Third, we perform a search of public press articles on Factiva using the search term “Chinese

reverse merger.” This search identifies an additional 34 Chinese firms.

48 AU 543 governs the degree of reliance U.S. auditors can place on the work and reports of other independent auditors. 49 AU 543, “Part of Audit Performed by Other Independent Auditor.” Like other SEC registrants, CRM companies are required to file audited financial statements with the SEC, and the auditors of those statements are required to certify that the statements are prepared in compliance with U.S. generally accepted accounting principles (GAAP). 50 Gariel Nahoum, “Small Cap Companies and the Diamond in the Rough Theory: Dispelling the IPO Myth and Following the Regulation A and Reverse Mergers Examples,” 35 Hofstra L. Rev. 1906 (2006–2007).

13

A review of the information on all 114 firms reveals that eight firms used an IPO to list

their shares in the U.S. These are deleted from our sample. Two more companies are deleted

from the sample because they did not involve a reverse merger transaction. For two additional

firms, we are unable to confirm whether or not their U.S. listings involved reverse mergers, and

thus we delete them as well.51 This results in a sample of 102 CRMs. Finally, we exclude the two

firms that cannot be matched to the databases provided by the Center for Research in Security

Prices (CRSP)52 and Capital IQ Compustat.53 This leaves a final sample of 100 CRMs.

While our search does not impose any time period limitations, the first CRM in our

sample occurred in the year 2000. From the public press search, we also collect the date each

company first listed its shares on a major U.S. exchange. For example, in 2009 a total of 37

companies uplisted their shares from OTC Bulletin Board to a major U.S. exchange.54

We also collect information on Chinese IPOs from 1990 to 2010 using the Thomson

Reuters SDC New Issue Database. We exclude all transactions not classified as IPOs by SDC.

We identify an initial sample of 130 Chinese IPOs in the U.S. Again, we exclude companies that

cannot be matched to the CRSP and Capital IQ Compustat databases. This leaves a final sample

of 111 Chinese IPOs.

Table 2, panel A, shows the year-by-year breakdown of our final sample as well as the

average total assets for the CRMs and Chinese IPOs. A total of 16 CRMs and 14 Chinese IPOs

51 The companies are Netsol Tech Inc. (NTWK) and SciClone Pharmaceuticals Inc. (SCLN). 52 CRSP is the standard data supplier of stock data used in academic research. According to CRSP, its database contains end-of-day and month-end prices on all listed NYSE, NYSE Amex, NASDAQ, and Arca common stocks along with basic market indices, and includes the most comprehensive distribution information available, with the most accurate total return calculations. See http://www.crsp.com/products/stocks htm (accessed on April 27, 2012). 53 Capital IQ provides historical accounting and market data. See https://www.capitaliq.com/home/what-we-offer/information-you-need/financials-valuation/compustat-financials.aspx (accessed on April 27, 2012). 54 The date of listing the shares on a major U.S. exchange does not necessarily coincide with the date of the reverse merger transaction. We rely on public press searches and CRSP data to determine the first date that a stock started to trade on NYSE, Amex, or NASDAQ.

14

were completed between 2000 and 2004, compared to 84 CRMs and 91 Chinese IPOs between

2005 and 2010. The average total assets for CRMs over both periods were $101.6 million,

compared to $1,439.9 million for Chinese IPOs. The size difference shows that the total assets of

CRMs are, on average, 14 times smaller than those of Chinese IPOs. However, the average total

assets of CRMs between 2005 and 2010 were three times smaller than the average assets for the

Chinese IPOs. While we observe a slowdown in Chinese IPOs during the financial crisis in the

U.S. in 2008 and 2009, the activity in the CRMs remained relatively unaffected by the crisis.

This suggests that reverse merger transactions are more resilient that IPO markets and appear to

offer a more stable option of cross-listing on U.S. exchanges.

Table 2, panel B, shows the breakdown of CRMs and Chinese IPOs by industry. The

manufacturing industry involved 21 CRMs, followed by the “Business Equipment: Computers,

Software, and Electronics” industry with 15 CRMs. The Chinese IPOs were concentrated in two

industries42 in Business Equipment: Computers, Software, and Electronics, and 35 in Mines,

Construction, Building Materials, Transportation, Hotels, Business Services, and Entertainment.

However, the majority of the assets of the Chinese IPOs were in oil, gas, and Coal Extraction and

Products and Telephone and Television Transmission. For example, two such Chinese IPOs had

average total assets of $26.3 billion.55

Table 2, panel C, shows the breakdown of CRMs and Chinese IPOs by state of

incorporation. Not surprisingly, the difference between CRMs and Chinese IPOs is that the

majority of Chinese IPOs are not incorporated in the U.S. Only four Chinese IPOs are

incorporated in Delaware. Out of the 100 CRMs, 27 are incorporated in Nevada, 18 in Delaware,

and 45 outside the U.S. (mostly in China and the Cayman Islands).

55 The two companies are Yanzhou Coal Mining Co., Ltd. and PetroChina Co., Ltd.

15

IV. Characteristics of CRMs and Chinese IPOs

We now examine whether firm characteristics explain the choice between reverse merger

and IPO. We would expect to observe similar firm characteristics for the two samples in Table 3.

For CRMs (Chinese IPOs), all variables are measured at the time of the fiscal year-end

immediately following the uplisting to a major exchange (the IPO). Since the fiscal year-end

does not coincide with the date of the uplisting or the date of the IPO, we are able to capture

firm’s pre-listing characteristics. Note that Compustat does not provide data for our firms prior to

their listing on a major U.S. stock exchange.

First, we consider size as measured by total assets. We find that the average and median

total assets of Chinese IPOs are significantly higher compared to CRMs. This size difference is

statistically significant and economically meaningful. The average size of Chinese IPOs exceeds

the average size of CRMs by a factor of 14. This suggests that CRMs are typically smaller in size

than Chinese companies raising funds in the U.S. via IPOs, and indicates that an IPO may not be

an option for all firms seeking cross-listing in the U.S.

Second we examine growth opportunities, measured by Tobin’s Q. As is customary, Q is

calculated as the sum of book value of debt and market value of common stock divided by book

value of total assets. The median Q is significantly lower for CRMs, which indicates that the

typical Chinese IPO has higher growth options. However, the average Q is similar between the

two samples. Therefore, we find mixed evidence that growth opportunities are related to the

choice between a reverse merger and an IPO.

Surprisingly, we find that the financial leverage of CRMs, measured as total debt divided

by total assets, is significantly higher than that of Chinese IPOs by a factor of approximately two.

Despite their smaller size, the CRMs are significantly more leveraged than Chinese IPOs firms.

16

The higher leverage of CRMs indicates that they were able to raise capital in form of debt.

Despite the size and leverage differences, the operating performance [cash flows relative to total

assets and return on assets (ROA)] is similar for CRMs and Chinese IPOs. Therefore, CRMs are

able to raise substantial amounts of capital via debt offerings prior to cross-listing in the U.S. and

their operating performance is comparable to Chinese IPOs.

Finally, we examine the spending on R&D and capital expenditures. Chinese IPOs spend

a statistically significantly higher amount on R&D per dollar of total assets. At the same time,

their average amount spent on Capital Expenditures (Capex) is marginally lower than for CRMs.

The results suggest that firms with higher R&D expenditures are more likely to pursue an IPO,

and are thus likely to fund future growth opportunities. However, other capital expenditures do

not affect the choice between reverse merger and IPO.

Table 4 presents multivariate logistic regressions estimating the probability that Chinese

firms will list in the U.S. via a reverse merger versus an IPO. In regression 1, we analyze the

effect of size, growth opportunities, and leverage. The results indicate that larger Chinese firms

are significantly less likely to pursue reverse mergers. Chinese firms with higher leverage are

significantly more likely to pursue reverse mergers. Growth opportunities do not significantly

affect the choice between a reverse merger and an IPO. In regression 2, we include measures of

operating performance. While both operating cash flows and return on assets have positive

coefficients, neither is significantly different from zero, indicating that operating performance

does not affect the reverse merger/IPO choice. Finally, in regression 3, we include R&D and

capital expenditures. We note that neither variable has a significant coefficient, suggesting that

the levels of these expenditures are not related to the choice between a reverse merger and an

IPO. The significance of size and leverage is not affected by the inclusion of other variables.

17

Overall, we conclude that only firm size and leverage are significantly related to Chinese

firms’ choice between a reverse merger and an IPO, while growth prospects, operating

performance, and expenditures are not. Therefore, our results are consistent with the assertion

that smaller Chinese firms pursue reverse mergers and larger Chinese firms pursue IPOs.

V. Class Action Lawsuits and Settlements

A. Class Action Lawsuits

We now analyze the factors affecting the probability that Chinese firms become

defendants in class action lawsuits and whether, based on the recent public press, CRM firms

face a significantly higher likelihood of a lawsuit. We analyze factors related to stock price

performance, the Cammer factors, and the firm characteristics studied in the prior section.

Figure 1 shows the cumulative average total return of CRMs, Chinese IPOs, and S&P

500 firms between June 30, 2008 and June 30, 2011. CRM and Chinese IPO performance

metrics moved in tandem until early 2011, after which the CRMs underperformed the Chinese

IPOs. Figure 1 shows that had an investor purchased the basket of CRMs in June 2008, the

investor would have lost 49% compared to a gain of 3% on the S&P 500. The problem with the

performance in Figure 1 is that it includes a survivorship bias. To examine the performance

without the survivorship bias, we calculate the cumulative performance using an event study.

An event study is a standard methodology used by financial economists to measure the

performance of common stocks following an event such as a CRM. This methodology is

commonly used in the academic literature to determine whether the disclosure of new

18

information is associated with statistically significant changes in securities prices.56 We calculate

the monthly abnormal returns in excess of the market portfolio and cumulate the abnormal

returns over one, two, and three years. The cumulative abnormal returns (CARs) begin the month

after the date of the uplisting for the CRMs, and begin the calendar month after the date of the

IPO for the Chinese IPO firms. Table 5 shows the average CARs for CRMs and Chinese IPOs

through the first three years. Both types of firms experience negative CARs over horizons

spanning one to three years; i.e., on average, an average firm significantly underperforms the

market. For each time period, CRMs show worse performance than Chinese IPOs. However, the

average CAR of CRMs is not statistical significantly different than the performance of Chinese

IPOs for any of the periods studied. These results are not driven by outliersthe percentage of

positive CARs during the three-year period is 25.3% for CRMs and 32.4% for Chinese IPOs.

This suggests that only one in four CRMs experience positive performance after three years. In

comparison, one in three Chinese IPO firms experience positive CARs for three years after

listing, a result that suggests that Chinese IPOs show a stronger long-term stock performance.

Overall, based on stock price performance, CRMs perform worse than Chinese IPOs. Poor stock

performance is frequently associated with increased incidents of securities class action litigation;

therefore, based on these results, we would expect that CRMs are more likely to become subject

to securities class action litigation.

56 See, for example, Stephen J. Brown and Jerold B. Warner, “Using Daily Stock Returns: The Case of Event Studies,” Journal of Financial Economics, Vol. 14, 1985, pp. 3–31 and A. Craig MacKinlay, “Event Studies in Economics and Finance,” Journal of Economic Literature, Vol. 35, 1997, pp. 13–39. Since the methodology’s inception about forty years ago, more than 500 articles in peer-reviewed academic journals have used it. See S.P. Kothari and Jerold B. Warner, “Econometrics of Event Studies,” in Handbook of Corporate Finance: Empirical Corporate Finance, 2004, pp. 5–8.

19

We now investigate the likelihood of class action litigation and some of the

characteristics used to certify such a class, namely the Cammer factors.57 In Section 10(b)

claims, plaintiffs typically allege class-wide reliance through a fraud-on-the-market claim. This

claim requires that the security subject to litigation trades in an efficient market. Whether the

market is efficient is a rebuttable presumption that is frequently investigated by the Courts. We

therefore analyze whether CRMs differ from Chinese IPOs along the following dimensions:

trading volume, filing of SEC form S-3, analyst following58, and institutional ownership.

For the period of January 2001 through April 2012, Figure 2 shows an increased

frequency of securities class action activity after 2010 involving CRMs relative to Chinese IPOs.

Table 6 shows that CRMs face a 32% likelihood of becoming subject to class action lawsuits,

which is higher than the 23.4% likelihood for Chinese IPOs. However, the difference is not

statistically different from zero. Surprisingly, Chinese IPOs become subject to litigation sooner

after listing than CRMs; however, this difference is not statistically significant.

With respect to the characteristics of CRMs and Chinese IPOs, the average weekly

trading volume to shares outstanding is similar in magnitude between the two groups. Very few

CRM or Chinese IPO firms file S-3s. Furthermore, 52% of the CRMs and 62.2% of the Chinese

IPOs are covered by equity analysts, figures that are not significantly different from each other.

However, significantly fewer analysts follow CRMs as compared to the number of analysts 57 See Cammer v. Bloom, 711 F. Supp. 1264 (D.N.J 1989). 58 Bradford Cornell, “Market Efficiency and Securities Litigation: Implications of the Appellate Decision in Thane,” Virginia Law & Business Review, Vol. 2, No. 2, Fall 2011, p. 246. (“[W]hen a company is followed by a significant number of securities analysts, it can be inferred that financial information and other relevant news items are reviewed by sophisticated investment professionals who make purchase or sale recommendations to their clients. Therefore, the security’s market price reflects the new information, as interpreted by the securities analysts and acted upon by their clients.”). See also Cammer v. Bloom, 711 F. Supp. 1264 (D.N.J 1989). (“[I]t would be persuasive to allege a significant number of securities analysts followed and reported on a company’s stock during the class period. The existence of such analysts would imply, for example, the [company] reports were closely reviewed by investment professionals, who would in turn make buy/sell recommendations to client investors. In this way the market price of the stock would be bid up or down to reflect the financial information contained in the [company] reports, as interpreted by the securities analysts.”)

20

following Chinese IPOs. Moreover, both the institutional ownership and the number of

institutional owners of CRM firms are statistically significantly lower when compared to the

institutional following of Chinese IPOs.59

In summary, the company characteristics show that CRMs are typically small companies

followed by few analysts and institutions. However, despite the lower following, the CRMs in

our sample have a comparable share liquidity to that of Chinese IPOs.60 We note that CRMs

frequently face class certification challenges by defendants who point to company-specific

circumstances and characteristics. For example, in the litigation involving China Agritech, Inc.,

the Court did not certify the class.61 Specifically, the Court stated that the plaintiffs satisfied

three of the five Cammer factors.62 However, according to the Court, the plaintiffs did not satisfy

two other factors: sufficient analyst coverage, and establishment of a cause-and-effect

relationship between the new information and the stock price reaction.63 The Court stated that

59 Bradford Cornell, “Market Efficiency and Securities Litigation: Implications of the Appellate Decision in Thane,” Virginia Law & Business Review, Vol. 2, No. 2, Fall 2011, p. 246. (“[T]he existence of market makers and arbitrageurs, indicates that the subject company’s securities react quickly to new information because market makers and arbitrageurs trade in ways that ensure the incorporation of new information into the securities’ market prices.”) 60 William K. Sjostrom, Jr., “The Truth about Reverse Mergers,” 2 Entrepreneurial Bus. L. J. 749 (2007–2008). (“Undoubtedly, however, its shares will be thinly traded, if at all, and therefore will be relatively illiquid. This is because there will be no post-deal underwriter support to help develop an active secondary market because no underwriter was involved in the deal.”) 61 Theodore E. Dean, et al. v. China Agritech, Inc., et al. (“According to a press release dated February 12, 2011, the Complaint alleges China Agritech issued materially false and misleading financial statements. Particularly, the Complaint alleges that on or about February 3, 2011, analyst firm LM Research issued a report (the ‘Report’) alleging, among other things, that the Company’s statement of revenue and earnings for the fiscal year 2009 are materially false and misleading. The Report, citing sources, claims that China Agritech’s U.S. financial statements were materially different than the financial statements filed with Chinese authorities by a number of the Company’s subsidiaries. The report claims that the revenue reported in the Company’s SEC filings for 2009 is ten times larger than what the Chinese regulatory reports show. The LM Research report also noted a number of potential badges of fraud within the Company. The Complaint alleges that when these disclosures of potential fraud concerning China Agritech were revealed to the market, the price of China Agritech stock dropped, damaging investors.”) 62 Cammer v. Bloom, 711 F. Supp. 1264 (D.N.J 1989). 63 http://www.dandodiary.com/2012/05/articles/securities-litigation/class-certification-denied-in-securities-suit-against-uslisted-chinese-company/. (“In order to determine whether or not China Agritech’s shares trade in an efficient market, the Court consider five factors: (1) the average weekly trading volume of the company’s securities; (2) the number of securities analysts following the company; (3) the extent to which market makers trade in the security; (4) the company’s eligibility to file an SEC Form S-3 (the short form registration statement for the sale of

21

“the more securities analysts following and reporting on a company’s stock, the greater the

likelihood that the stock trading public is relying on the information the company

disseminates.”64 Regarding the cause-and-effect relationship, the Court stated that the plaintiffs

were unable to show sufficient evidence in support of a finding of market efficiency.65 Based on

the result in Table 6, other CRMs may be similarly situated to China Agritech in that some key

factors such as analyst and institutional following are significantly lower as compared to the

following of Chinese IPOs.66 Finally, we note that if plaintiff law firms target firms with

characteristics conducive to certifying the class, our results suggest that CRMs would be less

likely to be subject to class action litigation. Next, we investigate the probability of securities

class action litigation in a multivariate setting. new shares); and (5 )the existence of a cause-effect relationship between unexpected corporate news and a change in the price. As Judge Klausner noted, ‘several courts have recognized that the fifth factor is the most important.’”) 64 Order Re: Plaintiff’s Motion for Class Certification (DE 94) and Defendant’s Motion to Exclude the Expert Declaration of Adam Werner (DE 100). 65 Order Re: Plaintiff’s Motion for Class Certification (DE 94) and Defendant’s Motion to Exclude the Expert Declaration of Adam Werner (DE 100). (“‘One of the most convincing ways to demonstrate efficiency [is] to illustrate over time, a cause and effect relationship between company disclosures and resulting movements in stock price.’ Cammer, 711 F. Supp. at 1291. The most common way to test a causal connection is through conducting event studies, which attempt to determine whether new information correlates with price movement. Countrywide, 273 F.R.D. at 614. Causation may be inferred if there is a correlation. Id. This inference is stronger under certain circumstances, such as ‘(1) the more statistically significant the correlation; (2) the more objectively defined the event is;(3) the better the study controls for nonfraud factors; and (4) the larger and more representative the sample.’ Id. Experts on both sides agree that the correlation is statistically significant at a 95% confidence level. Even after acknowledging this, Dr. Werner found market efficiency after conducting an event study where he found correlation at a statistically significant level for only one of four events. Dr. Feinstein conducted two event studies, one using the same four events as Dr. Werner and the other using those four events in addition to three others. Dr. Feinstein’s studies found that, in the aggregate, there was a statistically significant level of correlation between Agritech’s disclosures and movement in the price of its stock. However, it is unclear how meaningful this finding is, as the level of correlation was measured in the aggregate. Even if the Court weighed evidence from Dr. Feinstein equally to that of Dr. Werner, Plaintiffs’ own experts differ in their conclusions. This fact, alone, leads the Court to find that Plaintiffs have not satisfied their burden to show conclusive evidence of a causal relationship between Agritech’s disclosures and movement in the price of its stock. Therefore, the Court finds that the fifth factor does not support a finding of market efficiency.”) 66 http://www.dandodiary.com/2012/05/articles/securities-litigation/class-certification-denied-in-securities-suit-against-uslisted-chinese-company/. (“Many of the U.S.-listed Chinese companies that have been the subject of securities class action litigation may be able to raise similar questions of whether or not their shares trade or traded in an efficient market. To the extent the companies can show that their shares did not trade in an efficient market, they may be able to overcome the fraud-on-the-market presumption of reliance, and the value of the claims against them may be substantially diminished. And as [Kevin M. LaCroix] noted at the outset, there are a host of other potential difficulties that may also impede the plaintiffs’ efforts to pursue these claims. Many of these cases were filed, but not all of them will prove to be valuable for the plaintiffs and their counsel.”)

22

Table 7 presents the results of estimating the probability that CRMs and Chinese IPOs

would be subject to securities class action litigation. All regressions include the following

firm-specific control variables: size, growth opportunities, leverage, operating performance, and

expenditures. To determine whether CRMs face a higher likelihood of litigation, we include a

Chinese Reverse Merger indicator variable set equal to one if the firm is a CRM firm and to zero

otherwise. Regression 1 reports the base model estimating the probability of litigation. The CRM

indicator is positive but is not significant. Only leverage enters with a significant coefficient. The

negative sign of the coefficient indicates that higher level of debt is associated with lower

likelihood of litigation. In regression 2, we include the characteristics related to class

certification arguments. The CRM indicator becomes significant at the 0.10 level, suggesting that

CRM firms are more likely to be subject to class action litigation. The significance of leverage is

not affected. Share liquidity enters with a positive coefficient, significant at the 0.01 level.

Finally, in regression 3, we explore the sensitivity of measuring analyst and institutional

following. The CRM indicator is now significant at the 0.05 level, a result consistent with higher

probability of litigation for CRM firms. The number of institutions owning a firm’s stock enters

with a positive and significant coefficient, suggesting that higher institutional following leads to

higher likelihood of class action litigation. Overall, the logistic regression indicates that CRM

firms are more likely to be subject to class action litigation in the U.S., lending support to the

argument that more risky and less reputable companies pursue reverse merger transactions.

Hence, even if a reputable firm pursues a reverse merger, it may be facing a “lemon” problem

and consequently facing higher indirect costs of public listing than if it had pursued an IPO

instead.

23

B. CRM Settlements

Only a few securities class action lawsuits involving CRMs and Chinese IPOs have

settled so far.67 We collect the data on the settlements and report the results in Table 8. Three

CRMs and six Chinese IPOs settled class action lawsuits in 2010 and 2011. The average

settlement is $4.7 million; however, the average settlement for the three CRMs is $1.5 million.

As a percentage of total assets and market value, the average settlement for all firms is 1.25%

and 7.54%, respectively. Reflecting the larger average size of Chinese IPO firms, the

corresponding settlement averages for CRM firms are higher. As a percentage of maximum loss

and disclosure loss, the settlements are on average 2.03% and 6.29%, respectively.68 For the two

CRM settlements, the average maximum dollar loss is 1.03% while the average disclosure dollar

loss is 183.32%. Although little empirical settlement data exists on CRMs to date, the observed

sizes of settlements involve small dollar amounts when compared to Chinese IPOs subject to

10b-5 class action lawsuits in the U.S. Furthermore, the average settlement amount for 65 court-

approved settlements in 2011 was $21 million, which is a substantial decrease from the historical

average settlement amount of $39.9 million between 1996 and 2010.69 Finally, only 12.7% of all

historical settlements were below $2 million.70 Therefore, while the incidence of litigation

67 In Section 10(b) and Section 11 claims, causation plays a central role in assessing alleged damages. Typically, an analysis of loss causation in a fraud-on-the-market claim under Section 10(b) examines the price change when the alleged truth is revealed to the market. Alternatively, an analysis of negative causation under Section 11 begins with an examination of any price decline occurring prior to the alleged truth being revealed to the market. 68 http://securities.stanford.edu/Settlements/REVIEW_1995-2011/Settlements_Through_12_2011.pdf. Disclosure Dollar Loss (DDL) is another simplified measure of shareholder losses. DDL is calculated as the decline in the market capitalization of the defendant firm from the trading day immediately preceding the end of the class period to the trading day immediately following the end of the class period. DDL is calculated for the class-ending disclosure that resulted in the first filed complaint. Maximum dollar loss is based on the difference between the maximum stock price during the alleged class period and the closing price after the end of the class period. 69 Securities Class Action Settlements, 2011 Review and Analysis, Cornerstone Research (http://securities.stanford.edu/Settlements/REVIEW_1995-2011/Settlements_Through_12_2011.pdf). 70 Securities Class Action Settlements, 2011 Review and Analysis, Cornerstone Research (http://securities.stanford.edu/Settlements/REVIEW_1995-2011/Settlements_Through_12_2011.pdf).

24

appears higher for CRM firms, the cost of litigation as measured by dollar settlement amounts

does not appear large, especially when compared to other settlements.

VI. Conclusion

We provide an overview of CRMs and contrast their characteristics with characteristics

of other newly cross-listed firms in the U.S., Chinese IPOs. We also analyze the probability of

class action litigation and settlement of such cases.

Our results indicate that the CRM firms are substantially smaller in terms of assets, have

higher leverage, have lower analyst and institutional following, and face a higher probability of a

class action lawsuit. The recent settlements of class action lawsuits suggest that plaintiffs suing

CRM firms settle for smaller amounts as compared to Chinese IPOs and U.S. class action

settlements. Moreover, CRMs have significantly underperformed Chinese IPOs.

Overall, our results should be interpreted with caution as new data is likely to become

available and may affect our results. We find that CRMs and IPOs have many characteristics in

common. CRMs, nevertheless, seems to offer an easy entry to the U.S. capital market. However,

and despite the lower up-front cost of reverse mergers, CRMs also appear to attract more class

action litigation once their stocks uplist to one or more major stock exchanges, and they

experience significant underperformance after such uplisting. As a result, the cost of entry for

CRMs is not immediately comparable to the cost of a traditional IPO. While the increased

incidence of litigation may increase the cost of Chinese reverse mergers, the settlements of such

cases indicate that the costs may be lower when compared to other settlements of class action

lawsuits. Still, we suggest that an added unobservable cost of CRM transactions may be related

25

to a “lemon” problem, wherein even reputable firms face higher costs of doing business as a

result of being pooled together with less reputable firms.

Table 1

SEC

Investigation

SEC

Suspended Trading

Nasdaq

Halted Trading

NYSE/Amex

Halted Trading

1. Advanced Refractive Technologies X

2. China 9D Construction Group X

3. China Agritech, Inc. X

4. China Century Dragon Media, Inc. X X

5. China Changjang Mining & New Energy Co. X

6. China Continental, Inc. X

7. China Digital Media Corporation X

8. China Electric Motor, Inc. X

9. China Energy Savings Technology, Inc. X

10. China Expert Technology, Inc. X

11. China Green Agriculture X

12. China Integrated Energy, Inc. X

13. China Intelligent Lighting & Electronics X X

14. China Media1 Corp. X

15. China Media Express Holdings, Inc. X

16. China Mineral Acquisition Corp. X

17. China Ritar Power X

18. China Sky One Medical X

19. China Technology Global Corp. X

20. China Yuchai International Limited X

21. China-Biotics, Inc. X

22. Digital Youth Network Corp. X

23. Duoyuan Global Water Inc. X

24. Duoyuan Printing, Inc. X X

25. Fuqi International X X

26. Greater China Corp. X

27. Harbin Electric Inc. X

28. Heli Electronics Corp. X

29. HiEnergy Technologies, Inc. X

30. HQ Sustainable Maritime Industries, Inc. X

31. Jiangbo Pharmaceuticals, Inc. X

32. Keyuan Petrochemicals X

33. New Oriental Energy & Chemical Corp. X

34. NIVS IntelliMedia Technology Group, Inc. X

35. Puda Coal, Inc. X

36. Rino International Corporation X X

37. ShengdaTech, Inc. X

38. Subaye, Inc. X

39. Universal Travel Group X

40. Wonder Auto Technology, Inc. X

41. Yuhe International, Inc. X

Total 17 6 15 8

Name

28

Table 2

Panel A: Year

NumberAverage

Total AssetsNumber

Average

Total Assets

1994-1999 6 $1,437.3

2000-2004 16 $59.7 14 $8,778.9

2005-2010 84 $109.6 91 $311.0

2005 12 $95.5 8 $202.9

2006 20 $68.7 6 $276.7

2007 20 $101.8 30 $388.2

2008 18 $148.3 5 $70.7

2009 13 $143.7 11 $298.5

2010 1 $114.2 31 $314.1

Total 100 $101.6 111 $1,439.9

Chinese

Reverse Mergers

Chinese

IPOs

29

Table 2, continued

Panel B: Fama-French 12 Industries

NumberAverage

Total AssetsNumber

Average

Total Assets

1. Consumer NonDurables 12 $69.9 1 $32.6

2. Consumer Durables 5 $78.4 1 $122.7

3. Manufacturing 21 $115.9 3 $735.0

4. Oil, Gas, and Coal Extraction and Products 3 $125.3 2 $26,289.0

5. Chemicals and Allied Products 6 $82.8 1 $230.8

6. Business Equipment: Computers, Software, and Electronics 15 $63.5 42 $407.3

7. Telephone and Television Transmission 1 $86.0 4 $6,448.7

8. Utilities 2 $1,578.4

9. Wholesale, Retail, and Services 8 $111.6 7 $257.2

10. Healthcare, Medical Equipment, and Drugs 13 $83.2 6 $158.2

11. Finance 2 $71.0 7 $5,950.6

12. Other: Mines, Constr, BldMt, Trans, Hotels, Bus Serv, Entertainment 14 $176.5 35 $405.8

Chinese

Reverse Mergers

Chinese

IPOs

30

Table 2, continued

NumberAverage

Total AssetsNumber

Average

Total Assets

Non-US Incorporation 45 $90.7 107 $1,491.0

Delaware 18 $105.0 4 $72.7

Florida 8 $96.0

Nebraska 1 $697.9

Nevada 27 $98.1

North Carolina 1 $77.6

Chinese

Reverse Mergers

Chinese

IPOsPanel C: State of Incorporation

31

Chinese

Reverse Mergers

Chinese

IPOs

Total Assets Ave 101.62 1,439.93 1,338.31 **

Med 80.16 230.78 150.62 ***

Q Ave 3.34 3.37 0.03

Med 2.02 2.63 0.60 **

Leverage Ave 14.30% 7.98% -6.32% ***

Med 7.12% 0.96% -6.17% ***

Operating CF / Total Assets Ave 7.22% 7.06% -0.16%

Med 8.55% 9.32% 0.77%

ROA Ave 11.15% 6.89% -4.26%

Med 13.31% 8.33% -4.98% ***

R&D / Total Assets Ave 0.79% 1.63% 0.84% **

Med 0.00% 0.31% 0.31% **

Capex / Total Assets Ave 7.54% 5.51% -2.03% *

Med 3.32% 2.77% -0.56%

Table 3 - Sample Firm Characteristics 1 Year After Listing

Numbers in parentheses show p-values associated with individual coefficients. ***, **, and * indicate statistical significance

at 1%, 5%, and 10%, respectively.

Difference

(CIPO - CRM)

32

1 2 3

Total Assets -0.01*** -0.01*** -0.01***

(0.000) (0.000) (0.000)

Q -0.01 -0.02 -0.02

(0.727) (0.449) (0.488)

Leverage 7.57*** 8.09*** 7.45***

(0.000) (0.000) (0.000)

Operating CF / Total Assets 1.31 1.10

(0.280) (0.443)

ROA 1.33 1.32

(0.162) (0.273)

R&D / Total Assets -11.43

(0.204)

Capex / Total Assets 3.00

(0.281)

Pseudo R-Squared 0.496 0.513 0.528

Pr(Likelihood Ratio) 0.000 0.000 0.000

N 203 203 203

Table 4 - Logistic Regression: Probability of Reverse Merger vs. IPO

Numbers in parentheses show p-values associated with individual coefficients. ***, **, and * indicate statistical

significance at 1%, 5%, and 10%, respectively.

33

Difference

(CIPO - CRM)

Event WindowAverage

CAR

Percent

Positive CAR

Average

CAR

Percent

Positive CAR

Average

CAR

1-12 months -18.84% 38.4% -12.12% 30.6% 6.72%

(0.011) (0.008) (0.233)

1-24 months -55.90% 28.3% -35.31% 30.6% 20.59%

(0.000) (0.000) (0.140)

1-36 months -69.75% 25.3% -30.55% 32.4% 39.20%

(0.000) (0.000) (0.029)

Table 5 - Cumulative Abnormal Returns

Chinese IPOsChinese Reverse Mergers

34

Chinese

Reverse Mergers

Chinese

IPOs

Subject to Class Action Litigation Ave 32.0% 23.4% -8.6%

Time from IPO/Uplisting to Litigation Ave 888.5 776.3 -112.3

Med 637.0 525.0 -112.0

Ave Weekly Volume / Sh. Out. Ave 4.9% 4.8% -0.1%

Med 2.3% 3.2% 0.8%

Filed S-3 Ave 1.0% 0.0% -1.0%

Followed by Analyst(s) Ave 52.0% 62.2% 10.2%

Number of Analysts Ave 0.8 2.3 1.5 ***

Med 1.0 2.0 1.0 ***

Institutional Ownership Ave 6.5% 14.9% 8.4% ***

Med 1.0% 13.3% 12.3% ***

Number of Institutional Owners Ave 9.3 26.1 16.8 ***

Med 4.0 25.0 21.0 ***

Table 6 - Company Characteristics

***, ** and * are for the tests of differences in means and meadians for the two samples and indicate statistical significance at

1%, 5%, and 10%, respectively.

Difference

(CIPO - CRM)

35

1 2 3

Chinese Reverse Merger 0.50 0.67* 0.87**

(0.144) (0.083) (0.036)

Total Assets 0.01 0.03 0.02

(0.675) (0.335) (0.466)

Q -0.02 -0.04 -0.07

(0.553) (0.498) (0.405)

Leverage -2.34* -2.56* -2.44*

(0.070) (0.082) (0.099)

Operating CF / Total Assets -0.08 0.42 0.48

(0.945) (0.746) (0.721)

ROA 0.63 0.69 0.74

(0.568) (0.588) (0.544)

R&D / Total Assets -1.48 -0.39 1.40

(0.811) (0.950) (0.838)

Capex / Total Assets 0.18 -0.15 -0.23

(0.933) (0.947) (0.919)

Ave Weekly Volume / Sh. Out. 11.38*** 10.20***

(0.000) (0.001)

Filed S-3 -13.33 -13.51

(0.992) (0.992)

Followed by Analyst(s) 0.40

(0.287)

Number of Analysts -0.03

(0.784)

Institutional Ownership 1.00

(0.527)

Number of Institutional Owners 0.02**

(0.043)

Pseudo R-Squared 0.045 0.177 0.195

Pr(Likelihood Ratio) 0.594 0.010 0.004

N 203 202 202

Numbers in parentheses show p-values associated with individual coefficients. ***, **, and *

indicate statistical significance at 1%, 5%, and 10%, respectively.

Table 7 - Logistic Regression: Probability of Class Action Litigation

36

Company Type Settlement DateSettlement

Amount

Total Assets Prior to

Settlement

Market Value Prior to

SettlementMaximum

LossDisclosure

Loss Plaintiff Counsel

LDK Solar Co., Ltd. IPO 6/17/2010 $16,000,000 0.36% 5.81% 2.44% 5.27% Cohen Milstein Sellers & Toll

Agria Corp. IPO 6/7/2011 $3,750,000 1.28% 12.15% 2.69% 1.50% Robbins Geller Rudman & Dowd

Fuwei Films (Holdings) Co., Ltd. IPO 4/27/2011 $2,150,000 2.00% 4.03% 1.55% 19.94% Rosen Law Firm

Noah Education Holdings, Ltd. IPO 5/27/2011 $1,750,000 0.86% 1.83% 1.02% 3.23% Robbins Geller Rudman & Dowd

Giant Interactive Group, Inc. IPO 10/26/2011 $13,000,000 2.55% 3.22% 2.99% 4.38% Abraham, Fruchter & Twersky, Robbins Geller Rudman & Dowd

China Sunergy Co., Ltd. IPO 5/12/2011 $1,050,000 0.18% 0.79% 1.47% 3.42% Kahn Swick & Foti

Average - Chinese IPOs $6,283,333 1.20% 4.64% 2.03% 6.29%Median - Chinese IPOs $2,950,000 1.07% 3.63% 2.00% 3.90%

China Organic Agriculture, Inc. CRM 9/16/2010 $600,000 0.35% 1.67% 0.31% 105.81% Sarraf Gentile, Vianale & Vianale

China Shenghuo Pharmaceutical Holdings, Inc.

CRM 3/18/2011 $800,000 1.76% 5.02% 0.31% 9.24% Cohen Milstein Sellers & Toll

Tongxin International, Ltd. CRM 5/3/2012 $3,000,000 1.90% 33.33% 2.48% 434.91% Robbins Geller Rudman & Dowd

Average - Chinese IPOs $1,466,667 1.34% 13.34% 1.03% 183.32%Median - Chinese IPOs $800,000 1.76% 5.02% 0.31% 105.81%

Average - ALL $4,677,778 1.25% 7.54% 1.70% 65.30%Median - ALL $2,150,000 1.28% 4.03% 1.55% 5.27%

Table 8 - Summary of Class Action Settlements in 2010 and 2011

Settlement Amount as a Percent of:

37