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Chinese Small-Cap Stocks Start Unraveling

China MediaExpress and Duoyuan Printing listing news added to this update.

BOSTON ( TheStreet) -- Chinese small-cap stocks got walloped in the first quarter, as concerns over the accuracy of financial statements filed with the Securities and Exchange Commission drove share prices lower.

U.S. equities had their best first quarter in more than a decade, with the benchmark Dow Jones Industrial Average notching a 6.7% gain. Some Chinese small-cap stocks, on the other hand, have dropped as much as 75% this year, felled by the resignation of auditors to the restatement of earnings to fraud accusations by short sellers, who profit from a decline in share prices.

In contrast, large-cap Chinese stocks trading on U.S. exchanges as American Depositary Receipts, or ADRs, are outpacing the broader market. Baidu (BIDU) has surged more than 40% this year, and China Unicom (CHU) has jumped 21%. Each company is valued at more than $40 billion.

Many small-cap shares of Chinese companies gained listings on the Nasdaq and New York Stock Exchange through a back-door process called a reverse merger. Critics argue that the process allows companies based overseas to merge with shell companies in the U.S., circumventing scrutiny they would usually face by going public through a rigorous initial public offering. In the case of a Chinese reverser merger, or RTO, the U.S. shell company acquires the Chinese company, essentially taking the Chinese company public with little regulatory oversight.

In December, TheStreet reported that the Securities and Exchange Commission is investigating allegations that U.S. firms and individuals have joined with partners in China to steal billions of dollars from American investors through stock fraud involving Chinese RTOs.

Investigating Chinese Reverse Mergers

Individuals with direct knowledge of the investigation told TheStreet that the SEC is focusing on stock promoters, investment bankers, auditors and law firms that have been active in recruiting Chinese companies to U.S. stock exchanges and raising capital for those companies by selling new shares.

Months later, regulators continue to apply pressure to many of these companies. The SEC has gone as far as to revoke registrations of certain companies' securities. Meanwhile, the Public Company Accounting Oversight Board, or PCAOB, continues to pursue auditors of the financial statements of China-based companies.

On March 15, the PCAOB released a research note on audit implications for Chinese reverse mergers, following up on a previous alert by the board that found U.S. registered accounting firms weren't conducting audits of China-based companies in accordance with PCAOB standards.

"This state of affairs is bad for investors, companies and auditors alike," PCAOB Chairman James Doty said in a statement. "If Chinese companies want to attract U.S. capital for the long term, and if Chinese auditors want to garner the respect of U.S. investors, they need the credibility that comes from being part of a joint-inspection process that includes the U.S. and other similarly constituted regulatory regimes."

According to data provided by the PCAOB, Chinese reverse mergers represented 26% of all reported reverse mergers from January 2007 through the end of March 2010. By comparison, 56 initial public offerings, or IPOs, of Chinese companies were completed, accounting for 13% of all IPO activity in the U.S.

In the time since TheStreet originally reported on the dangers investors face from Chinese reverse mergers, more than 20 small-cap China stocks have fallen dramatically, costing investors millions of dollars. TheStreet has kept a running tab on the decliners, which are presented in chronological order on the following pages.

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