Some Sun Is Shining in Reverse-merger Land

eurozoneIn spite of the continued hiccups due to the systemic risks posed by the European debt crisis, equities have just completed a three-year bull market and are entering the fourth year. The movement of the price and volumes illustrate that once again the markets are in a hope phase for a self-sustaining recovery in the U.S., a soft landing in China, stability in Greece, and improvement in the eurozone situation, because of the European Central Bank (ECB) liquidity measures. With regards to the eurozone, the recent policy measures to support the banking system and provide Greece with further fiscal assistance have alleviated part of the near-term systematic risks, but I believe the risks in the region remain high.

However, while the overall stock market is edging higher with 70% of U.S. stocks above their respective 200-day moving average (MA), reverse-merger stocks continue to face a tough climate based on mistrust.

The Bloomberg Chinese Reverse Mergers Index (CHINARTO) has witnessed a significant decline due to the numerous allegations related to accounting frauds.

Cornerstone Research recently published the Securities Class Action Fillings report for 2011. According to the report, the Class Action Fillings (CAF) Index reported 188 fillings in 2011, compared to 176 fillings during 2010, up 6.8% year-over-year. The average number of filings from 1997 to 2010 was 194, so the numbers are not unreasonable compared to the average.


The litigation against Chinese stocks listed on U.S. exchanges through reverse mergers accounted for a major component of filings activity during 2011. Out of the reported 188 filings, 33 were related to the Chinese stocks via reverse mergers, compared to nine in 2010, an increase of 267%. And since 2010, there have been 42 class-action filings with Chinese stocks that listed through the reverse-merger route.

Most of the filings for the Chinese stocks via reverse mergers (24 out of 33) materialized during the first half of 2011, so the situation has improved, with much fewer Chinese stocks listing via reverse mergers. There are reports that four Chinese stocks are set to be listed in the U.S., but none are via the reverse-merger route and instead are via the normal and tougher listing route. What this is doing is making Chinese stocks that list here meet the strict listing requirements, so we could see only the better Chinese stocks list here.

It has been evident from the data that Chinese fraudsters have been taking advantage of easy loopholes in the reverse-merger process, which has cost investors billions of dollars. In light of this, the Securities and Exchange Commission and exchanges have adopted strict rules for reverse-merger listing that will it difficult to cheat. The end result will be a better flow of reverse-merger and Chinese stocks to the market, which should help to add some lost confidence to the reverse-merger process.

A good strategy to use in searching for investment ideas is to follow the institutional money flow, which I discussed in Making the Best Investments: Should You Follow the Pro Money?