SEC Probes China Stock Fraud Network

"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(CSKI), Fuqi International(FUQI) and Rino International(RINO). 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.

Sources with knowledge of the current SEC investigation say that the commission has shown interest in at least six additional companies. The agency's interest is not focused narrowly on individual cases, informed sources have told TheStreet. Rather, enforcement officials seem to view individual cases as manifestations of a systemic problem.

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.