Volume 102 - Issue 4 Georgetown Law Journal

Breaking Down a Great Wall: Chinese Reverse Mergers and Regulatory Efforts to Increase Accounting Transparency

This Note argues that because procedural hurdles limit the likelihood that class action lawsuits and SEC enforcement cases will deter wrongdoers or provide adequate recourse to defrauded investors, regulators should seek to prevent companies from listing on U.S. exchanges unless these issuers make adequate disclosure of their auditing arrangements. This disclosure should include information about the division of labor between U.S. and non-U.S. auditors, as well as the degree of access PCAOB inspectors are granted to any non-U.S. audit firm’s records and procedures. By focusing disclosure require- ments on auditing structure instead of Chinese reverse merger companies specifically, legitimate Chinese or small-cap companies will not necessarily be disadvantaged when entering U.S. markets. In addition, this disclosure may provide an incentive for countries such as China, where PCAOB inspectors are largely precluded from ensuring compliance with auditing standards, to be more transparent in their auditing practices, thereby benefiting investors and markets generally.

This Note proceeds in four Parts, the first three of which describe and evaluate affected entities’ responses to the increase in fraudulent conduct by Chinese reverse merger companies. Part I outlines shareholders’ response to the phenomenon—class action lawsuits—and argues that this option is unlikely to be an effective avenue for redress. Part II evaluates the SEC’s three-part approach to fraudulent reverse mergers, which has involved filing enforcement actions, educating investors, and approving more robust listing standards for U.S. exchanges. Part III describes the important role of the PCAOB and its rules regarding U.S. auditing firms’ collaboration with non-U.S. firms, as well as the reasons Chinese companies have been able to avoid this regime. Building on the most successful aspects of this regulatory response and seeking to improve on its weaknesses, Part IV provides recommendations for how to make existing regulations more robust.

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