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SEC Probes China Stock Fraud Network

Recently, many reverse merger companies have been buffeted by a series of allegations of fraud. The allegations have had repercussions across the sector. Investors in the U.S. have suffered related losses in excess of $34 billion, a review by analysts at TheStreet showed. That total adds up all the market-cap losses for 150 stocks that appear to have been used to bring Chinese companies to U.S. exchanges. The list of 150 included stocks damaged by association with such allegations as well as those directly implicated. Losses were measured from a stock's peak price at any time over the past five years to its present price.

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.

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