The U.S. Securities and Exchange Commission has issued an Investor Bulletin urging caution and advising extra due diligence when investing in companies that enter U.S. capital markets through "reverse mergers." The Bulletin comes in the wake of accounting abnormalities and investor losses at Chinese companies that have used the reverse merger to list on U.S. exchanges.

Reverse mergers enable private companies, including those domiciled outside North America, to access U.S. markets by merging with an existing, publicly traded shell company. In the past year, the SEC and both NYSE and NASDAQ have halted trading in more than a dozen reverse merger companies, citing a lack of current, accurate information about the firms and their finances. In addition, the Public Company Accounting Oversight Board has put pressure on U.S. audit firms doing business in China to raise their standards.

Despite the instances of fraud, China is one of the fastest-growing economies in the world and investors are eager to participate in that market. Investors would be wise to take heed of the SEC Bulletin and bolster their due diligence when considering investments in Chinese reverse merger companies. Questions to ask when deciding to make such an investment include:

  • Does the company have assets in the United States?  
  • Do members of the board of directors reside in the United States?
  • Does the company hold directors and officers insurance and provide entity coverage, and what are the policy limits and retention amounts?  
  • Who are the accountants? Preferably, they should be one of the Big Four and not an affiliate.