Wang: The Role of the Director Social Networks in Spreading Misconduct – The Case of Reverse Mergers


After 2000, a growing number of foreign firms list in the United States through reverse merger, a non-IPO listing technique that requires less information disclosure. Are the US regulations rigorous enough to deter the listing attempts of weak foreign firms? Using a unique data set, this paper presents the widespread misconduct of Chinese firms that are listed on US exchanges. The firms tend to be US-incorporated reverse mergers that are headquartered in small cities, are audited by small firms, and that change their auditors frequently. Using a social network analysis, I find that the firms are assisted by Western professionals to help them circumvent the US regulations, and they commit fraud and benefit from fast stock sales after listing. Further, I find that the social network of the linked directors facilitates the spread of their misconduct. During the wrongdoers’ listings, the investors in these firms lost at least $811 million. However, the penalties charged to the wrongdoers only accounted for 4.19% of this loss. I also find that the US-listed Chinese firms have a lower average Tobin’s q compared to the China-listed firms, in contrast to the prior research’s findings. These findings contradict the concurrent research that uses the reverse mergers’ financial data, which proves to be unreliable.


Available for download here.