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Fraud allegations, delistings could cost American investors dearly

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By Lou Kilzer
Sunday, Feb. 26, 2012
 

Legal issues involving half of the Chinese companies trading on American stock exchanges could leave investors holding securities paper would be worth more as confetti, a Tribune-Review investigation found.

Other investors in Chinese stocks are not much better off after a year of stinging allegations that many of the securities are rife with fraud, abuse and fictional transactions.

The Trib studied more than 125 Chinese companies and found at least 105 on American stock markets -- Nasdaq, the New York Stock Exchange, and over-the-counter -- were subject to federal enforcement action or investigation, fraud lawsuits or delisting.

The problems, which surprised regulators at the Securities and Exchange Commission, cost American investors tens of billions of dollars, experts say.

"This is a problem of epic proportions," said Dan David, vice president of GeoInvesting, a Philadelphia-area firm that tracks Chinese stocks. "It's much larger than Bernie Madoff."

Not only are the losses far larger than the $18 billion Madoff fraud, but the number of victims is incalculable. People who don't invest in stocks could be hurt because the Chinese securities wind up in many small-cap and emerging-market mutual funds or pension funds.

Brian Stoffel, a contributor to the Motley Fool investment website, told the Trib that an investor with a diversified portfolio likely would not feel much of a sting, but someone who loaded up on Chinese startup stocks who was expecting huge profits could take a serious hit.

The SEC strongly defends its watchdog abilities. Evidence gathering "doesn't happen instantly," said Kara Brockmeyer, chief of the Foreign Corrupt Practices Act unit of the agency's enforcement division.

Because China limits or forbids foreign investment in many of its industries, Western bankers and lawyers began using something called variable interest entities, or VIEs. Chinese-owned VIEs have agreements with foreign investors, who provide capital but cannot own the VIE.

No one has legally tested the enforceability of such agreements in China, said Paul Gillis, a lawyer and visiting professor of accounting at Peking University's Guanghua School of Management. He said 48 percent of Chinese companies listed in the United States use VIEs.

"Some lawyers say there is no way a (Chinese) court will enforce the contracts since they violate public policy," Gillis wrote in an email.

On the off-chance that China would want to enforce VIE contracts, they must be registered with Chinese authorities. Fredrik Oqvist, who partnered with Gillis on a VIE study, reported last month that only 11 percent of Chinese VIEs are properly registered.

"The logic behind this is so bizarre that I don't know how anyone can buy into it," said investor John Bird of Austin, among the first to uncover fraud in Chinese securities. "The worth of these securities is manufactured. They are artificial things."

Going after enablers

Bird and others blame the SEC, which regulates U.S. stock markets.

"The SEC was 100 percent, absolutely not prepared for what happened," GeoInvesting's David said. "When an American company misrepresents its financials, there is a consequence. There are no consequences for Chinese firms. A ruling in the U.S. is not enforceable in China."

The FBI last month raided the Manhattan offices of New York Global Group, which specializes in bringing Chinese companies to American markets. The SEC and its Public Company Accounting Oversight Board are trying to negotiate access to Chinese auditing firms' books and procedures, as it requires of other auditing firms, said David Feldman, a New York partner with Richardson & Patel LLP, which has helped Chinese companies form in the United States.

Negotiations are not going well, Feldman said.

"China could change its laws and say it's OK, but China hasn't chosen to do so yet," he said.

In January, the SEC's oversight board chairman, James Doty, told reporters that 36 Chinese-based auditors "have not performed the basic obligations." If China does not allow inspections by the end of the year, he said, "I am not optimistic about a resolution."

Feldman contends that much of the alleged Chinese fraud is unproved, though he acknowledges the SEC faces a difficult burden in investigating Chinese companies.

Brockmeyer warned the American investment community that nurtured Chinese companies: "We're also looking at the role played by the gatekeepers, such as outside auditors and stock promoters."

From boom to bust

Many Chinese companies trading in America became hot stocks when they entered the market in the mid-2000s, but cracks soon appeared.

A 2011 Stanford Law School report found that between mid-2010 and the end of 2011, 42 investors filed lawsuits against Chinese companies. That number is "unprecedented," the school said, and could indicate "that investors and regulators are uncovering problems in these issuers."

Yet for some, Chinese stocks remained alluring.

Take, for example, SinoTech Energy Ltd., a Beijing-based company incorporated in the Cayman Islands in order to trade on the Nasdaq, according to federal records. In November 2010, it issued a $168 million initial public offering underwritten by investment banks UBS AG, Citigroup Global Markets and Lazard Capital Markets.

The banks helped SinoTech with SEC filings, including the initial registration statement and prospectus. For its first annual report, SinoTech enlisted Ernst & Young, one of the world's "Big Four" accounting firms.

SinoTech, billing itself as "a fast-growing and profitable provider of enhanced oil recovery" in the People's Republic, foresaw a bright future. By December 2010, it reported a quarter-to-quarter profit increase of more than 100 percent.

But in 2011, investors announced plans to sue UBS and SinoTech. One lawsuit cited an independent analyst's report alleging, among other things, that SinoTech's sole import agent and its chemical supplier were empty shells and its largest customer had "unverifiable operations."

SinoTech fought the allegations and formed a committee to investigate.

Nasdaq halted trading of its stock in August and delisted the company a month later. The chief financial officer, the head of the company's audit committee and Ernst & Young resigned. The accounting firm withdrew its opinion about the company's annual report. The company's chairman stepped down after an internal investigation discovered that "a significant portion of the corporate funds" were transferred to his bank account. He pledged to return the funds.

The company now trades on the "pink sheets" -- over-the-counter securities at the bottom of the pecking order for American securities. In less than a year, its stock fell from the IPO price of $8.50 a share to 13 cents.

Going in reverse

Wall Street's best and brightest are supposed to vet IPOs, but that's not the case with reverse mergers, a more pervasive form of securities trading by Chinese companies in the United States.

In a typical reverse merger, a Chinese company seeking to trade on an American exchange acquires a bankrupt or nearly defunct American company with stock market trading rights. The name changes to the Chinese company with the merger.

The company then owns an asset-free shell in America. The ownership typically runs through an offshore subsidiary, often in the British Virgin Islands, and then to a wholly owned enterprise in China. That firm often has a contractual agreement to one of the VIEs that Gillis, the Peking University accounting professor, described.

The setup enables the firm to raise money through private placements, trade on American markets and offer investors stock through secondary public offerings.

"Fraud in reverse mergers is pandemic," said GeoInvesting's David.

It was not always that way, David said. He initially made money from Chinese reverse mergers and other stocks. In 2010, he began hearing rumors of fraud, and several high-flying Chinese stocks began to tank. He sent investigators to China.

"What they brought back was mind-blowing," he said. "They found that fraud was much more pervasive than what anyone thought."

Bird, nationally recognized as the first to investigate Chinese companies, said he became suspicious in 2009 while researching China Sky One Medical Inc., a maker of hemorrhoid treatments, among other things.

The need for Sky One's hemorrhoid products appeared to be intense in China because the company reported that it was selling products almost faster than Bird thought it could make them. Sky One did not respond to an email request for comment.

Curious, Bird asked sources in China to look into company filings with the State Administration for Industry and Commerce.

The SAIC collects filings and surveys from 11 Chinese agencies and expects them to be accurate. Lying to the SAIC is a serious offense.

Bird said he found "amazing" discrepancies between what Sky One -- a Nevada reverse merger with operations in Harbin, China -- told the SAIC and what it told the SEC.

Collecting SAIC reports for more than 30 companies, Bird said he took the results to SEC officials, who "were astonished."

"You see, the SEC is not allowed by China to go over there and get these records on its own," he said.

David said he has a solution to the problem: Subject Chinese companies to the securities trading regulations and consequences that American firms face.

 

 
 


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