Spillover Effects of Fraud Allegations and Investor Sentiment

Abstract

We examine whether a stock price spillover effect spreads through the method of listing or country of origin and whether this spillover effect changes when investor sentiment shifts. Using a sample of fraud allegations against Chinese companies that became public through Chinese reverse mergers (CRMs), we investigate whether firms that experienced negative spillover effects on their stock prices are those from the same country and/or with the same method of listing as the firms accused of fraud. We first show that the negative spillover effect channeled through the firm's country of origin becomes stronger when investor sentiment about Chinese companies becomes pessimistic, as evinced by significant declines in the stock prices of non‐fraudulent Chinese companies, including both CRMs and Chinese IPOs. Second, we show that the negative spillover effects on CRMs are stronger than those on Chinese IPOs and non‐Chinese reverse mergers, suggesting that both country and listing method are applicable to CRMs. Our findings indicate that (i) investor sentiment plays an important role in the spillover process involving fraud allegations and (ii) while the two channels could coexist, negative spillover effects that spread through the country of origin play a more prominent role than those that spread through the method of listing.

Reverse mergers and stock price crash risk: evidence from China

“…Previous studies investigate the performance of RM firms and Chinese RM companies operating in the US market. Such companies exercise stronger negative spill-over effects of fraud allegations than Chinese IPO companies (Darrough et al, 2020). Interestingly, some scholars hold a contrasting opinion.…”

“…A large part of the relevant literature has explored RM transactions in the US market. Some scholars highlight the fact that Chinese RM firms in the US market are more prone to fraud charges, and have poor financial statement quality and corporate governance (Darrough et al, 2020;Givoly et al, 2014;Chen et al, 2016), while other scholars argue that the performance of these firms is not worse than their peers (Lee et al, 2015).…”

The Impact of US-CN Audit Agreement on US-listed Chinese Companies and Its US Peers

“…This departure from the inspection regime was believed to give a signal of lack of supervision and have an impact on the investor's sentiment as a whole. Prior research found that when fraud allegations against Chinese companies became public, a negative spillover effect existed as the stock prices of non-fraudulent Chinese companies witnessed a dramatic decline, and the effect enhanced when investors became pessimistic [3]. Given the wide implication, US-listed Chinese companies were once examined as a group to find whether their frauds are outliers or are parts of an iceberg from the perspective of board independence, because of the recent happened Luckin Coffee fraud case [4].…”

Mitigating industry contagion effects from financial reporting fraud: A competitive dynamics perspective of non-errant rival firms exploiting product-market opportunities

“…While earlier studies on financial reporting frauds focus on the consequences for the errant firms, subsequent studies examined the consequences for other firms associated with the errant firms. These studies examine various channels of association, including director interlocks (Cowen and Marcel, 2011; Fich and Shivdasani, 2007; Kang, 2008), industry ties (Akhigbe and Madura, 2008; Gleason et al, 2008; Paruchuri and Misangyi, 2015), and country-of-origin ties (Darrough et al, 2020; Kang and Chintakananda, 2019). A key finding is that financial reporting frauds result in negative spillover effects.…”