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Investing in China Just Got a Whole Lot Riskier

Stocks in this article: BIDU AGVO CCME CBEH SBAY CEU

The following commentary comes from an independent investor as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- Some say State Administration for Industry and Commerce (SAIC) filings for Chinese reverse takeovers (RTOs) don't matter. And neither do State Administration of Taxation (SAT) documents that are inaccessible to independent third parties such as auditors. Think again.

SAIC and SAT filings do matter. Deloitte Touche Tohmatsu (DTT) finally chose to reference SAIC and SAT documents in its probe into China MediaExpress Holdings (CCME) operations:

Issue raised: Information on file with the State Administration of Industry and Commerce as to certain subsidiaries appearing to be inconsistent with comparable financial information provided to DTT.

Issue raised: The verification of certain subsidiary tax payments with the local office of the State Administration of Taxation.

If auditors are referencing SAIC filings in audits, shouldn't they be important to investors? Investors who ignore them may find that their portfolios of diamonds in the rough with glorious price-to-earnings ratios of 5 or less are piles of worthless paper. (Investors also need to be aware that companies that amend past filings likely aren't alerting SAT agencies of changes.)

Investigating Chinese Reverse Mergers

Short sellers -- those who benefit from a decline in share prices -- have pointed to differences between SAIC filings and financial reports filed with the U.S. Securities and Exchange Commission as a basis for fraud accusations. Short sellers claim that companies like China Sky One Medical (CSKI) and China Education Alliance (CEU) are exaggerating sales and income to U.S. regulators to attract investors.

Several companies have downplayed the discrepancies between SAIC and SEC filings. In September, China Green Agriculture (CGA) argued that individuals who are knowledgeable about China do not rely on SAIC filings as a basis for determining a company's financial position.

"Oftentimes, Chinese companies access SAIC filings to learn more about their competitors to gain a commercial advantage," China Green said in the statement. "As a result, many companies have understated their financial results in such filings."

I will even go a step further and say that investing in companies that downplay the significance of SAIC filings or have failed to include auditor comments attesting to the independent viewing of SAT documents (mainly when SAIC filings don't match) will expose your portfolio to meaningful risks.

It seems things can't get any worse for investors who desire to go long in the Chinese RTO space.

Well, it just did. By now, anyone who follows China should be aware of VIE and FIE corporate structures. Simply put, an FIE structure is dictated by a direct ownership of a Chinese operating company by an offshore entity (for example, U.S. British Virgin Islands or Hong Kong), while a VIE structure is enforced by management/consulting contracts between Chinese operating subsidiaries and a Chinese intermediary directly owned by an off shore entity.

VIE arrangements were crafted by ambitious lawyers to enable Chinese companies to go public in the U.S., circumventing Chinese laws that prohibit foreign ownership in domestic companies operating in certain industries. Keep in mind that the Chinese government hasn't clearly commented on the legality of VIE arrangements.

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