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Auditors Play Defense on China Stocks

Frazer Frost has disintegrated. Formed a year ago as an independent firm representing a partnership between Frost, PLLC, and Moore Stephens Wurth Frazer & Torbet, LLP, Frazer Frost had counted more than 20 Chinese reverse merger companies as clients. The partnership has ceased operations. Requests for comment from the parent firms brought no response.

There is no question that auditors are key players in China deals. Properly audited financial statements are a key requirement for any new issuance of shares in the U.S. Audit firms in this country are normally given unrestricted access to a company's financial records. They are expected to check the veracity of statements in detail, verifying that customers and vendors exist, visiting facilities, cross-checking revenues and receivables, whatever it takes.

Audits of China-based companies are complicated by differences that relate to both standards and fees. Fees charged by Chinese audit firms tend to be a lot lower than those charged by U.S.-based firms, while standards at the Chinese firms are not so high, experts say.

Those factors work together to encourage RTO companies to retain Chinese audit companies for work in China. Jacob Frenkel, a former SEC attorney who specializes in small-cap fraud cases, says that U.S.-based audit firms frequently accept the China-based firms as affiliates and sign off on work done in China without investigating properly themselves.

"One of the problems," says Frenkel, now a partner at Maryland-based law firm Shulman Rogers, "is that even when it comes to Chinese accountants, there have been a good number of cases where they proved to be the facilitators of fraud, rather than fulfilling their roles as gatekeepers."

Only Monday, the SEC announced a settlement with Moore Stephens Wurth Frazer & Torbet, requiring the firm to pay $129,500 in connection with its work for a China Energy Savings Technology, a now defunct small cap that has been the focus of a series of SEC fraud cases dating back to 2006. The SEC asserted that MSWFT had good reason to exercise "heightened skepticism" with regard to China Energy, and failed to do so.

The fallout from allegations of fraud can be widespread. RINO International (RINO), a company that specializes in heavy environmental projects, was targeted in November by short-oriented research firm Muddy Waters. The allegation -- published on the internet -- was that Rino didn't have as many customer contracts as it had claimed. The company's CEO soon told auditors that the charge was partly true. The stock was delisted as a result.

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