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Loopholes From Here to China

NEW YORK ( TheStreet) -- When allegations of fraud torpedoed the stock of China-based Rino International (RINO) last month, investor J.M. Hughes lost 56% of his investment -- or nearly $19,000 -- in less than a week.

The attack came from a short seller -- a firm betting that the stock would decline -- so at first Hughes wondered whether the source ought to be "held accountable." It turned out that the allegations were on target, and that the short seller had uncovered accounting discrepancies that U.S. regulators, auditors and exchanges had missed.

Rino came clean, acknowledging in a filing with the Securities and Exchange Commission that two customer contracts questioned by the shorts had not in fact been signed. Worse, the company said there might be problems with 20% to 40% of its other customer contracts. Rino shares, which had traded near $19 before the trouble started, dropped to $6 when trading was halted Nov. 18. The Nasdaq then delisted the stock, and Rino now trades on the Pink Sheets, recently at around $3.50. All told, investors saw more than $400 million in market value wiped out.

Today, Hughes wonders where the regulators and auditors were.

"Something that simple should have been picked up by the auditors," he wrote to TheStreet.

The Shanghai Numbers

Thousands of investors hurt by the collapse of China-based companies are raising the same kinds of questions. Blow-ups of this kind among China-based small caps have cost investors at least $34 billion, over the past five years, a study by TheStreet showed. Most of the losses relate to companies that have gained access to U.S. exchanges through a back-door process known as a reverse takeover, or RTO. Rino is one example.

The RTO process folds a China-based company into an American shell company whose stock is publicly traded. Essentially, the combination of the two companies brings the Chinese company public in the U.S. without regulatory review, allowing the promoters to avoid the regulatory scrutiny normally applied to an initial public offering or a request for a listing of American Depositary Receipts.

The increasing frequency of the blow-ups among RTOs -- together with related charges and counter-charges of fraud -- have prompted the Securities and Exchange Commission to launch an investigation. The SEC has declined to comment, but sources directly involved say the agency is asking questions about a complex web of enduring business relationships and not limiting the focus to a few isolated cases.

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