Fraud investigations in reverse mergers



FW moderates a discussion on fraud investigations in reverse mergers between Jean Roux at PricewaterhouseCoopers and Frances Kao at Skadden, Arps, Slate, Meagher & Flom LLP.

FW: As an overview, how would you describe recent market activity involving reverse mergers and IPOs in general?

Roux: The US Securities and Exchange Commission (SEC) approved new rules for IPOs of reverse merger firms on its three listing markets – Nasdaq, NYSE, and NYSE Amex. The impact of the new rules remains to be seen, but the move will further slow the pace of PRC companies going public in the US. Recent statistics indicated that only 71 PRC companies went for IPO in the US up to the end of October this year, raising finances in a total amount of $14.012bn. This represents only 47.97 percent of the number of IPOs and 27.62 percent of the value raised via IPOs for last year. More telling is that from August to October, there was only one successful IPO by a PRC company in the US. It is difficult to say how much of the decrease in IPO activity can be attributed to the fraud allegations, but it is without doubt a contributory factor.

Kao: Questions have been surfacing for some time and, while the reverse merger procedure has been used in the US by both domestic and international entities, attention has most frequently been focused on reverse merger companies from the PRC. Broadly speaking, the market has punished many PRC-listed companies due to a general negative perception of the companies’ integrity and transparency.

FW: Has the public perception of reverse mergers, and even IPOs to an extent, been damaged by allegations of fraud at some of the companies recently involved in reverse mergers or IPOs?

Kao: It is too broad to say that the public perception of reverse mergers and IPOs has been damaged given that companies of all types and from all around the world use reverse mergers as a means to US listing. Rather, given the extensive coverage of the problems uncovered at some of the PRC reverse merger companies, along with the very public statements about these companies by short sellers, negative attention has been broadly focused on PRC listed companies. This is, of course, quite inequitable because large numbers of PRC listed companies are reputable, legitimate business enterprises, committed to sound business practices and fair reporting.

Roux: The recent allegations of fraud at PRC companies have hurt the public perception of China Inc. The high profile that some of the frauds have been exposed to in the media – for example Sino-Forest and Longtop Financial – has affected the public perception of publicly listed PRC companies and a lot more questions are being asked by potential investors. This is compounded by a lack of reliable publicly accessible information. Investors are feeling less secure about investing in PRC companies listed via both reverse mergers and IPOs. We have also seen the valuations of PRC companies listed by reverse mergers being affected negatively and this is probably due to a lack of trust and credibility in PRC companies. PRC RTOs have as a result become an easy target for short-sellers.

FW: How have regulatory agencies responded to these suspicions of fraud?

Roux: It will not be as easy as it once was for Chinese companies to list on the major US exchanges, as the US has set new rules to tighten standards for firms going public by reverse mergers. Regulators have taken a hard-line approach against the companies suspected of fraud. Regulators have responded aggressively with regards to trading halts and have been very demanding on the Companies to cure any filing deficiencies very promptly. However, regulators are facing certain problematic issues themselves. The PCAOB is having difficulties gaining access to auditor’s work papers to review and the SEC is lacking the power to compel compliance with subpoenas in China. The SEC has set up a task force to conduct a wide scale investigation of PRC RTO companies and is also focusing on stock promoters, investment bankers, auditors and law firms who actively recruited PRC companies to US stock exchanges. 

Kao: The regulatory authorities have stepped up measures to address the perceived risks presented by publicly-listed reverse merger companies. Among other things, the PCAOB has issued Staff Audit Practice Alert No. 6 and Staff Research Note 2011-P1 to ensure that US accounting firms are appropriately addressing particular audit risks in emerging international markets, including the PRC, in accordance with PCAOB standards. NASDAQ and the NYSE have proposed new rules governing the conditions under which reverse merger companies would be eligible for public listing. The exchanges have also been extremely vigilant in suspending trading upon public disclosures of potential wrongdoing and, ultimately, initiating the delisting process for those companies that are unable to successfully navigate an internal investigative process and, where initiated, an SEC investigative process.

FW: In your opinion, will these cases lead to increased efforts to combat fraud, protect investors and restore confidence in the markets?

Kao: There will be an effort to address the issues that have been raised regarding reverse merger companies. Restoring investor confidence is something else altogether. Given the limited extent of regulatory and civil legal jurisdiction, there are relatively few effective remedies for investors who have experienced losses due to wrongdoing or fraud where the companies involved in such activities are located in the PRC and otherwise have no connection to the US.

Until there is some agreement of active cooperation between US and PRC regulatory authorities in these matters, there can be little visible punishment for wrongdoers, thus limiting recovery of public confidence.

Roux: These cases have already led to increased efforts by regulators, exchange operators, and investors to combat financial statement fraud and rebuild confidence. The SEC recently enacted new rules making foreign companies wishing to enter the US market via reverse merger much harder. Senators from the US have also intensified pressure on the PCAOB and SEC to tighten oversight of PRC accounting firms auditing US listed companies. There have also been a plethora of guidance and warnings from the SEC, PCAOB, and exchange operators to investors regarding reverse merger companies. We have also seen an increase from clients and potential investors requesting us to perform fraud specific due-diligence services on potential clients. Investors are now looking to dig deeper and wider in scrutinising a company’s financial records before committing their money. 

FW: What steps can be taken to identify financial discrepancies and red flags at companies associated with a reverse merger or IPO? What forensic accounting techniques can be applied to detect fraud?

Roux: There is no ‘one size fits all’ type of approach. Different techniques need to be applied to companies of different sizes and in different industries. However, as a general rule of thumb, investors should evaluate the ‘quality’ of the target company’s management team, its core business, and its business partners. They should gain a deep understanding of the business including its market, customers, and suppliers, including but not limited to income level, which cities, provinces and towns they are operating in, and their relationship with local government. A thorough understanding of the target’s business operating models and internal processes is very important, including benchmarking to their closest competitors. When conducting due diligence, look out for unusual transactions. Obtain as much independent evidence from third parties like bankers, suppliers and customers as possible as such confirmations often provide more reliable information than information provided by the target. 

Kao: The proposed listing rules from the NYSE and NASDAQ require a seasoning period to allow financial irregularities to come to the fore and otherwise be detected by auditors. That would appear to be a sound policy judgment. Auditing and forensic accounting are separate disciplines but the large accounting firms have sophisticated and highly experienced resources on both the auditing and forensic sides. The forensic accounting sides of the large accounting firms have been routinely retained to assist in the investigations, internal and regulatory, of various reverse merger companies in which accounting and other issues have arisen. These forensic accounting resources may very well in the future be brought to bear on refining and enhancing auditing procedures. So, for example, particular attention may be paid to items such as cash flow, liquidity, use of funds, intercompany transfers, vendor payments, and revenue booking through round-trip transactions. The forensic accountants may also have insights into the actions taken to conceal financial problems or to inflate revenue and cash flow that may be helpful to auditors.

FW: Going forward, do you expect to see greater emphasis placed on due diligence when assessing reverse mergers and IPOs? What implications will this have for companies considering a public listing?

Kao: Greater emphasis will be placed on due diligence. Currently there are limited remedies for investors who may experience losses in the market due to alleged fraud by reverse merger entities – this results in the need to find a deep-pocket recovery source. Third parties such as PE or fund investors, accounting firms and underwriters are almost certain to be viewed as potential sources. Given this risk, third parties have already enhanced their diligence procedures and are likely to continue doing so. 

Roux: We have already seen a significant increase in investor concerns on the accuracy of listed PRC companies’ financial statements. Potential investors are also more cautious and are seeking additional assurance on merger and acquisition projects. During the last six months we have seen an increase in potential investors requesting additional due diligence procedures to be performed. Overall, the general awareness has increased and investors are more willing to engage reputable accounting firms to provide due diligence services. The increased due diligence will eliminate any tolerance for under-investment in adequate accounting systems, controls and staff. The SEC has also tightened the rules on reverse merger listing requirements and the number of reverse mergers will probably continue to decrease. The majority of PRC companies are however good business prospects and we believe the effect on PRC companies will not be a long term issue, and that investors’ confidence will eventually be restored.


Jean Roux is a Forensic Services partner at PricewaterhouseCoopers Hong Kong/China. Based in Shanghai, he leads PricewaterhouseCoopers Forensic Services for Central China. Mr Roux has over 25 years of forensic accounting and consulting experience. He has extensive experience in assisting boards of directors of companies and special committees with independent criminal and regulatory investigations of potential violations of securities laws. He can be contacted on +86 (21) 2323 3988 or by email:

Frances Kao is a partner at Skadden, Arps, Slate, Meagher & Flom LLP, based in the firm’s Hong Kong office. Ms Kao has a US and international dispute resolution practice in which she represents public and private companies, as well as their officers, directors and employees, in commercial litigation, arbitration, and both internal and civil and criminal government investigations. She is a native Mandarin speaker. Her areas of practice include international arbitration and litigation, regulatory investigations including FCPA, regulatory enforcement work, internal and regulatory investigations, and securities litigation. Ms Kao can be contacted on +852 3740 4827 or by email:

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Jean Roux



Frances Kao

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