SEC's Smart Step at Fighting China Fraud

Eric Jackson is a contributing writer to TheStreet whose views on these stocks are independent of TheStreet's news coverage.

NEW YORK (TheStreet) -- The Securities and Exchange Commission took a step in the right direction this week by punishing a small U.S. audit firm for work it had done for a Chinese company.

The SEC's settlement with Moore Stephens Wurth Frazer & Torbet LLP of Orange County is related to overstatements of financial results that China Energy Savings Technology made in 2004 and 2005.

Last month, I wrote in RealMoney that there were many small U.S. auditors operating in China that are basically a joke. They are not performing audits in the manner an average person would expect them to be done. In many cases -- not just a few -- I believe that these audit firms are simply signing off on numbers given to them by management to bank their auditing fees (which can be up to $300,000 for one year from one client) and in the hopes of winning new clients from that company's pre-IPO investors.

These cases appear to be isolated to the smaller-capitalization Chinese companies who initially go public in a reverse takeover (RTO) of an existing shell company on the over-the-counter (OTC) exchange with the intention of later uplisting to the Nasdaq or New York Stock Exchange.

The SEC's action on Monday likely is the tip of the iceberg of its investigations into this area.

I recently reached out to the SEC and asked to share some of my observations on how I've seen many of these RTOs operate over the last year. Last week, I spoke with several senior people from the Commission. Judging by the number of people on the call and their seniority, it's clear they are looking deeply at this area.

Unlike some, I think it's unfair and incorrect to assume all Chinese stocks that have less less than $500 million in market capitalization and have gone public via RTOs are frauds.

However, I do believe that fraud is common in this population. In my opinion, the biggest issue is the veracity of these companies' financial statements. And for that, I blame the auditors.