More U.S. Lawsuits Target Chinese Reverse Mergers

By | July 26, 2011

Accounting debacles at U.S.-listed Chinese companies have prompted a surge of securities fraud lawsuits, but investors might have trouble recouping their losses even if they win.

More than one-fourth of the 94 U.S. securities fraud lawsuits seeking class-action status and filed from January to June related to so-called Chinese reverse mergers, according to a study released Tuesday by the Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research in Boston.

This reflects a shift away from more traditional lawsuits accusing U.S. companies of inflating balance sheets or stock prices, or entering into bad mergers.

According to the study, the number of these cases is on pace in 2011 to be the fewest since federal law on class-action litigation was overhauled in 1995.

In a typical reverse merger, a Chinese company buys a U.S. “shell” company and takes over its stock ticker. That effectively lets it raise money without going through the regulatory reviews typical of companies going public.

Since March, more than two dozen U.S.-listed Chinese companies that underwent reverse mergers announced auditor resignations or other accounting problems.

Last month, the U.S. Securities and Exchange Commission issued a bulletin urging investors to “thoroughly research” such companies before investing.

According to the Stanford study, 24 securities fraud class-action lawsuits targeted Chinese reverse mergers in the first half of the year, compared with nine for all of 2010.

But Joseph Grundfest, a Stanford law professor and former SEC commissioner, said investors might have trouble recovering losses, citing the “very little” historic success in enforcing federal court judgments to recover assets of Chinese citizens living in China.

“There is a big difference between winning a lawsuit and collecting money because you won a lawsuit,” Grundfest said in an interview.

The United States has no extradition treaty with China and state secrets laws make it difficult to gather evidence about alleged wrongdoing that originates there.

That limits the effectiveness of the 2002 Sarbanes-Oxley reforms developed to root out accounting fraud following Enron Corp’s collapse the prior year.

Grundfest said investors might still have recourse against the auditors of Chinese companies or other intermediaries, but it still could be an uphill fight.

“The way many insurance policies are written, they won’t cover situations involving fraud,” he said. “It makes it entirely possible that at the end of the day, there may be very little effective recovery.”

The 94 lawsuits allege $48.3 billion of market value was lost between the trading day immediately preceding the end of a class period and the trading day immediately after the end.

Among the other 70 lawsuits in the first half, 21 targeted mergers. Just two related to the credit and financial crises, compared with 13 in 2010, 54 in 2009 and 80 in 2008.

(Reporting by Jonathan Stempel; editing by Andre Grenon)

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