News + Events
China Reverse Merger Companies at Risk
April 25, 2011
China reverse merger companies (CRMs) are under increased scrutiny by U.S. regulators and could face loss of market value, investor lawsuits, criminal charges, substantial costs, and management changes. CRMs are companies with operations in China that merged into shell companies with S.E.C.-registered shares. We recently reported on plans by the Public Company Accounting Oversight Board to focus on CRMs and their accounting firms for failure to follow proper audit standards. In addition, the SEC has established a task force to investigate CRMs for compliance with U.S. securities laws generally, and the Department of Justice could become involved if evidence of criminal wrongdoing is found. CRMs that violate securities laws can experience significant consequences including:
Loss of Market Value. Noncompliance with law can damage investor confidence in management, leading to lower share values as investors perceive greater risk. For some companies, significant declines in market values occurred after the posting of anonymous internet blogs alleging management wrongdoing, which were followed by investor class action lawsuits.
Civil Lawsuits. Companies involved in controversies that result in substantial losses of share value are often targets of class action lawsuits. Certain law firms in the U.S. focus on bringing these cases and often do so very soon after a controversy becomes public. These cases are expensive to defend, and can result in settlements or damage awards in the millions of dollars.
Criminal Charges. The U.S. Department of Justice prosecutes criminal violations of securities laws. Criminal penalties can be severe: For example, a person convicted of willful violations of securities laws can be fined up to $5,000,000 and imprisoned up to 20 years.
Increased Costs. Companies often pay substantial fees to attorneys and accountants in responding to investigations, defending investor lawsuits or criminal charges, replacing auditors or restating financial statements.
Management Changes. The SEC can bar persons responsible for wrongdoing from affiliation with a public company. Thus, the CEO and founder of a CRM could be permanently barred from being a director or officer of the company.
Reduced Access to Capital Markets. Investors and financial advisors are reluctant to consider or recommend investments in companies with high risk. With fewer interested investors, companies must sell shares at a lower price.
Clawback of Management Compensation. In certain cases, officers of a public company must repay incentive compensation based on financial results that are later restated.
CRMs should discuss with legal counsel how to address the risks described above.