Since 2007, over 150 Chinese companies, with a $12.8 billion value, have become listed on U.S. exchanges through a technique called a reverse merger. This is a technique by which a private company is merged into a public company and the private company’s management team takes over the combined publicly traded company. The public company is typically a shell company with no operations that has gone through bankruptcy and is now dormant. The reverse merger has been used in the United States for decades as a faster and less expensive way to go public than an initial public offering. While it’s very convenient to help clients access China though companies listed on U.S. exchanges through reverse mergers, is it safe? Not by a long shot. According to Bloomberg, over 50 of the companies have been deregistered by the SEC, of which the SEC filed fraud charges on 40 of them. Still, one recent study found that Chinese reverse merger stocks outperformed their U.S. peers. The study determined that Chinese companies were better capitalized than U.S. stocks going through reverse mergers. What’s unclear is how the U.S. reverse merger companies did versus the small cap peers that went public via the old fashioned way. Should you consider buying some of these for your clients? To me, the answer is an unequivocal “no.” U.S. companies going through reverse mergers often end up being listed on the OTC bulletin board with little liquidity. They wind up being bonanzas for attorneys as they offer fertile ground for law suits. There is no evidence as to why these companies should outperform on a risk adjusted basis. Even if there were some evidence, do you want to be explaining to your client why their statement shows some of their companies as having no value and being the subject of fraud law suits? While the reverse merger is one of the few products the U.S. has exported to China, this is this a product that is developing. Access to foreign markets is better gained through broader ETFs and mutual funds.
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