In the late 2000s, hundreds of Chinese corporations entered US capital markets through a strategic option called a reverse merger. This wave of Chinese entrants in American equity markets proved to be, mostly fraudulent, and cost investors over $500 billion between 2009 and 2012.
A reverse merger, also known as reverse IPO, can be defined as a private company acquiring an existing, public company to list itself in public markets without having to go through the lengthy process of an initial public offering. While an IPO can take years to be implemented, a reverse merger is much quicker, and may take only a few months. Additionally, corporations that become public through a reverse merger avoid the underwriting fees that are typical of IPOs.
In the wake of the Great Recession that rocked global markets in 2008 following the US housing bubble, the Chinese government substantially increased subsidies targeting large-scale manufacturing projects owned by private Chinese companies to counter the losses incurred by reduced exports. However, these companies all had a common goal: to be listed on US stock markets. Access to such markets meant more investors, more money, and more credibility. And thus it began – one of the largest frauds in the history of free markets. In the Netflix documentary which covers this story, “The China Hustle”, Dan David, CEO of GEO Investing, describes the Chinese reverse mergers as “packaging garbage as gold”.
Despite the crisis, China’s economy was growing rapidly, at a rate of 9.5% in 2009 according to the World Bank. That same year, the US’s growth rate in GDP was – 2.6%. With improving relations between the United States and China, both countries sought to open up their markets to one another. China seemed like an extremely attractive market to US investors, and luckily for them (or not), they did not have to go to China – China came to them. In the months that followed, around three-hundred China-based companies listed themselves on major US exchanges such as NYSE and NASDAQ through reverse IPOs. The Chinese government prohibited the Securities and Exchange Commission (SEC) from overseeing their operations, which meant that the reverse merger companies could easily commit securities fraud; as such, that is precisely what ensued. For some companies, revenues were overstated tenfold and balance sheets were inflated at a time when corporations all over the world were still struggling to reach pre-crisis levels. The Chinese affiliates of Big Four accounting firms allegedly signed off audit reports for these companies without proper diligence.
Eventually, investors grew suspicious of the reverse merger corporations’ figures, which were consistently high, outperforming the largest American companies. Some even traveled to China to visit the plants and factories of these companies. What they found was vastly different from what was shared with investors; operations were either limited or non-existent. Upon their return to the US, the “whistleblowers” sounded the alarm on the Chinese reverse mergers. Newsspread and eventually led to a wave of short-selling and huge losses for long investors, ultimately amounting to a $500 billion loss in market capitalization. In the years that followed, the SEC delisted hundreds of Chinese companies from US markets.
In the end, no China-based company was held accountable and American investors were never compensated for the losses. It is unclear what the role of the Chinese Communist Party was in the reverse IPO fraud, but what is clear is the audit failure and lack of transparency among the affiliates of large accounting firms in China. Shortly after the untangling of the fraud, the SEC tightened its rules regarding Chinese companies opting for reverse IPOs in US equity markets. We are left with the following questions: Did banks on Wall Street know about the crime that was unfolding? Were they only interested in selling huge numbers of securities at the expense of investors, reminiscent of what transpired with the aggressive sale of mortgage-backed securities by banks just a few years prior?