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SEC's Smart Step at Fighting China Fraud

There definitely is a web of American investors and service providers associated with these Chinese RTOs who have a vested interest in seeing these companies go public: investors, lawyers, auditors, investment banks and stock exchanges.

All of these parties deserve criticism -- as do the Chinese founding CEOs who agree to this. (Sometimes they're complicit; sometimes they're just naive.)

In many ways, it falls on the SEC's shoulders (or short-sellers) to blow the whistle on frauds. The SEC has to start somewhere, and I think that going after the accountants makes the most sense.

There are several U.S. audit firms doing business in China that are very small (e.g., one or two partners and/or one office). Several have been associated with frauds already (e.g., Frazer Frost, associated with RINO International (RINO))

From my experience talking to people in China (such as management teams and other accountants), I believe it's fairly common for these U.S. firms to hire third parties (locals) to come in and audit their Chinese clients. In other words, they outsource the actual audit work. These "audits" are perfunctory and basically take management's word on the numbers. The auditors back in the U.S. bless the numbers and get paid by the company. These auditors also seek other referral business from the company's pre-IPO investors (an unspoken quid pro quo).

Several of these small auditors have been censured by the Public Company Accounting Oversight Board (PCAOB). But such censure essentially means, "You did a bad thing, now get back to work." What's the point of that? The accused audit firms dispute the PCAOB's findings, don't change and the cycle goes on. And these PCAOB censures are just for the work the firms do in the U.S. -- not what they outsource and do in China.

Here's a 2007 PCAOB report on Sherb & Co., in which the board told Sherb:

"The audit deficiencies we identified in one of the audits reviewed included a deficiency of such significance that it appeared to the inspection team that Sherb did not obtain sufficient competent evidential matter to support its opinion on the Issuer's financial statements."

This was for a U.S. audit, not one done in China. In the same report, Sherb responded to the PCAOB's criticisms by saying it was "dedicated to achieving the highest level of audit quality. In that regard, we feel we share the PCAOB's goal of using the inspection process as a means of improving audit quality and as a result the reliability of financial reporting."

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