The Securities and Exchange Commission is investigating allegations that U.S. firms and individuals have joined with partners in China to steal billions of dollars from American investors through stock fraud, according to people familiar with the probe.
Individuals with direct knowledge of the investigation say that the SEC is focusing on stock promoters, investment bankers, auditors and law firms that have been active in recruiting Chinese companies to U.S. stock exchanges and raising capital for those companies by selling new shares.
On Monday, the SEC made an example of an auditing firm that it said had failed to protect U.S. investors from overstatement of revenue by a Chinese firm. The commission said it had reached a settlement with the firm — Moore Stephens Wurth Frazer & Torbet — and with Kelly Dean Yamagata, a partner. As part of the settlement, the firm will be temporarily barred from accepting new auditing assignments in China and will pay $129,500.
The case relates to audits the firm did for China Energy Savings Technology, a China-based company that has been the focus of a series of SEC fraud complaints since 2006.
John Heine, a spokesman in the SEC’s public affairs office, would neither confirm nor deny a new investigation, citing agency policy against commenting on active investigations. But the questions that SEC investigators are asking hint at their direction. Those questions suggest a suspicion that stock manipulators have devised a kind of template for stock fraud — one that exploits fundamental weaknesses in the regulatory apparatus of the two countries — and now use the template to cheat investors in deal after deal.
Over the past year, the SEC has received multiple calls for investigation of fraud among China-based stocks. Many investment professionals believe an investigation is due. One is Peter Humphrey, a corporate investigator and due-diligence expert based in Beijing. Humphrey estimates that as many as a third of Chinese companies listed on major U.S. exchanges — the Nasdaq, Amex and New York Stock Exchange — are likely reporting fictional profits. He said he bases that estimate on due diligence research done for clients and on discussions with client, in connection with acquisitions and investments in Chinese companies. If the estimate is wrong, it’s likely too low, Humphrey says.
While investors who own individual stocks have the greatest exposure to the type of fraud alleged, millions of other American investors also are at risk, through investments in China-oriented ETFs and mutual funds.
To be sure, many Chinese small-cap companies have established the strength of their businesses with financial statements that withstand the tough scrutiny of investment professionals. But frequently lack of transparency and full disclosure — along with the formidable barriers of language, distance and culture — make it difficult for individual investors to tell the good from the bad.
Concern about a lack of protection for U.S. investors prompted Congress to ask the SEC for action earlier this year.
In a letter dated Sept. 9, the House Financial Services Committee complained about a general lack of rigor in the auditing of Chinese companies. Addressed to SEC Chair Mary Schapiro and her counterpart at the Public Company Accounting Oversight Board, the letter asked how the agencies planned to tackle the problem.
“American investors deserve high-quality and independent financial reporting so that all market participants can trust the accuracy of the audit work for U.S. publicly-traded companies,” the letter said. It was signed by Reps. Chris Lee of New York and Spencer Bachus of Alabama, who will take up his new role as chairman of the Financial Services Committee in January. The rest of the letter communicated a broad concern about fraud among China-based companies.
Until now, many investors buying China-based stocks traded on U.S. exchanges have felt abandoned by regulators.
To date, Wall Street has seen only one major SEC prosecution in the sphere. That was the case of China Energy Savings Technology — the subject of yesterday’s action.
Three China-based reverse merger companies so far have disclosed current SEC investigations: China Sky One Medical, Fuqi International and Rino International. China Sky One Medical has conceded inaccuracies in filings in China in a press release. Fuqi has received a delisting notice from the Nasdaq, but has not yet been delisted. Rino recently admitted that some of its claims about contracts were false, and Nasdaq has delisted that stock. China Sky One and Rino declined to comment for this article. Through a spokesman, Fuqi said it is “fully cooperating with the SEC” and that it has no further comment.
Reverse mergers — sometimes called reverse takeovers, or RTOs — are perfectly legal in the U.S., and have been used in the past to give birth to solid public companies, including the parent company of the New York Stock Exchange itself. If there is a flaw in the process, the flaw is that it allows stock manipulators to circumvent regulatory scrutiny.
The process is complex. First, the sponsors find a Chinese company with a plausible growth story and sell the founders on the idea of raising capital in the U.S. They then gain control of a U.S. company that is little more than a shell, but a living shell, with stock that remains listed on a public exchange in the U.S. The U.S. company buys the Chinese company, essentially taking the Chinese company public in the U.S. with little regulatory oversight. The sponsors and company founders can then use optimistic growth projections to float new issues of stock among American investors eager to participate in the economic miracle of China.
Frequently the prime movers in the process are Chinese, and never leave China. They enlist the help of bankers, auditors and stock promoters in the U.S. with promises of huge profits in the event of success. Often, the promoters — some Chinese and some American — are bailing out just as the public gets in.
The SEC is focusing its investigative efforts on the American end of the network. The agency lacks the power to compel compliance with subpoenas in China — a fact that has not escaped the notice of dealmakers in China.
A distance of 8,000 miles, together with formidable language and cultural barriers, makes it tough for any investor to get to the bottom of a business scenario in China. Even sophisticated investment professionals spending millions on due diligence have been duped. For the moment, the frequent lack of transparency between the two countries is seen as camouflage for stock cheats. But recurring allegations of fraud and new stock blow-ups have raised questions about the reliability of accounting practices at China-based companies generally.
Review some well-known blow-ups at this link