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Loopholes From Here to China

Stocks in this article: RINO CXTI ONP CGA GFRE BBCZ

"If these Chinese companies are having problems, how many problems do you think the SEC is having?" Bernstein said. "It's a combination of lack of resources and being overwhelmed."

Even the harshest critics of the RTO category concede that there are plenty of Chinese companies -- even small caps -- offering solid opportunities for investors. At the same time, the skeptics caution that individual investors will likely find it difficult to separate the good from the bad.

"The problem is that it's difficult for investors and U.S. regulators to bridge the language, cultural, and structural barriers to understand what's really going on in China," says Carson Block, the short-oriented researcher who started the stir over Rino.

Block argues that a lot of surprises involving RTO companies stem from inadequate research by American investors.

"Chinese companies disclose in their U.S. filings that they have internal control weaknesses," Block says. "Investors would do well to take these disclosures seriously."

The Challenge for the Exchanges

Investors like J.M. Hughes may be forgiven for assuming that a company's mere presence on a major American stock exchange guarantees some degree of integrity. Chinese companies unable to secure a domestic listing have found it easier to get listed in the U.S. by exploiting the RTO as a loophole. When the legitimacy of one of those companies is brought into question, the exchanges have no option but to delist the company.

"Companies falling below or failing to meet the markets' continuing listing standards are notified and dealt with swiftly, in a transparent process that ensures timely information and updates to shareholders and all other constituents," a spokesperson for the NYSE explained.

In that event, the damage to investors can be even worse than it was for Hughes. When the NYSE Amex delisted shares of Bodisen Biotech (BBCZ) -- a stock that had once traded as high as $21.30 -- the stock tumbled to a low of 45 cents.

The exchanges try to filter out problem companies with requirements for listing that might seem perfectly adequate -- at first glance.

To secure either a new or upgraded listing on either the Nasdaq or the NYSE, a company must have a board of directors that meets regularly and includes a majority of outside directors. Companies must also establish an audit committee, consisting solely of independent directors with financial experience. Under the Sarbanes-Oxley Act of 2002, audit committees have very specific legal responsibilities in the U.S., including adequate oversight of financial reporting, hiring external auditors and maintenance of regulatory compliance with accurate financial statements.

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