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China Stock Battles Destroy Value

Not so fast, said Block. In a response published as a press release, he insisted he had the right entity after all. There on the business license, for example, was the signature of the chairman of Orient Paper, Liu Zhenyong.

Two regular contributors to TheStreet's sites, Eric Jackson and Rick Pearson, have countered Block's attacks on the company. Jackson and Pearson provide commentary to TheStreet as guest contributors, like Op-Ed columnists in major newspapers. TheStreet also published Muddy Waters' commentary.

Both Pearson and Block participated in a tour of Orient Paper's production facilities about a year ago, and Pearson later posted a video of the tour. The two sides interpreted what they saw very differently. Pearson's most recent commentary published by TheStreet explains that he is still long the stock. Jackson has said he no longer owns Orient Paper shares, but continues to believe that Block's charges are false.

In an attempt to clear its name, the company launched an internal probe of its books under the auspices of its legal counsel, Loeb & Loeb, a firm that has represented many Chinese reverse-merger companies. Loeb hired a Big Four accountancy, Deloitte & Touch, to assist in an investigation of Block's allegations. On Nov. 29, the company announced that the investigation had produced a positive report, finding no evidence of fraud.

"Let me make it clear. Deloitte was camped out at their offices for three months!" says Crocker Coulson, Orient Paper's investor-relations representative. Coulson often takes warrants to buy stock in the Chinese companies he represents as payment for his services, though he holds no stake in ONP, he says. "There are almost no Chinese companies that could withstand that level of scrutiny."

Still the crossfire goes on.

"This is a self-serving whitewash," says Larry Rosen, referring to Orient Paper's announcement on the outcome of its investigation. Rosen is a New York lawyer who has built a business as a class-action attorney specializing in shareholder suits against Chinese small-cap companies hit by steep stock-price declines and attendant controversy. He has filed a suit against Orient Paper. "But we'll see," Rosen went on. "I've been proven wrong before. Occasionally it happens. But personally I don't think this press release is worth the bytes it's written with."

Explore the Small World of RTOs

Muddy Waters says it stands by its original report.

In many ways, the fracas over Orient Paper is typical of recent controversy in the world of small-cap Chinese stocks, where integrity sometimes seems to be a moving target and analysts can view the same set of facts and draw opposite conclusions.

Longs argue that a good many of the accounting mistakes that have raised havoc for investors were in fact innocent errors, not deliberate misstatements. They say that Chinese executives have recently improved their skills in the area of financial reporting and are now much better able to meet the standards of the U.S. capital markets.

Still, Chinese companies listed in the U.S. tend to have corporate structures reminiscent of Russia's nested dolls, with operating subsidiaries inside holding companies inside holding companies. In that kind of environment, the accounting can get complicated.

Often, the thing that you've bought shares in is a so-called variable-interest entity, or VIE -- which means shareholders own a stake in a contract with the management of the business in China, not a stake in the actual business. Be careful there. Experienced securities lawyers caution that small-cap Chinese companies have an uneven record in regard to such contracts.

Novice investors will want to bear in mind that experienced Wall Street operators are normally "selling their own book." In other words, trying to talk others into buying or selling something they themselves have already bought or sold. In the case of the shorts, they frequently sell borrowed shares before attacking a company, hoping that public attacks will bring down the price and allow them to replace the borrowed shares on the cheap.

Short sellers say they perform a public service when they out fraudulent Chinese companies. They say the longs are at best naive and at worst complicit in foisting shoddy companies upon unsuspecting retail investors in the U.S.

The longs call the shorts predatory manipulators. They charge that the shorts cynically orchestrate "short attacks" to manufacture doubt and torpedo the shares of legitimate companies. They say the shorts have unfairly tarred the entire China sector -- and many solid, growing companies -- with research that is sloppy at best.

Investors will be wise to take commentary from either side with a grain of salt.

Finally, be prepared for turbulence. Orient Paper may prove to be the growth company its backers claim it is, but the stock is still down 30% since the short attacks began. Investors in China need to be ready to ride out that kind of storm.

Eric Jackson, the contributor to TheStreet who originally liked Orient Paper, says that individual investors are not well-positioned to understand China-based stocks.

"I'm lucky. I have people on the ground in China. I can go places and find out information," Jackson said. "But what can a retail investor do? They're really relying on the word of the auditor. I think there are auditors ... basically signing off on whatever numbers the company gives them, just to get a fee. And hoping to get referral business from other Chinese companies."

Jackson said he would advise the average investor to stay away from the RTOs.

"If I were giving advice to a friend of mine, I would say avoid it," Jackson said. "I would say: You're not smart enough to sort through what's really going on, so it's probably not worth the risk."

Speaking on behalf of their company, the researchers at Muddy Waters suggested that investors looking at China-based small caps should pay particular attention to assets listed on a company's balance sheet. Where revenues are being fabricated, a company will frequently inflate assets to support the revenue claims, sometimes to a degree that gives a fraud away, the researchers said.

"Finally," the Muddy Waters researchers said, "if it seems too good to be true, it probably is, even in China."

-- Reported by Scott Eden in New York

>To contact the writer of this article, click here: Scott Eden.

>To follow the writer on Twitter, go to http://twitter.com/ScottEden.

>To submit a news tip, send an email to: tips@thestreet.com.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.
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