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L.A. Firm's China Ventures Turn Sour (Pt. 1)

The audit firm claims to have found evidence that employees at each of the four companies forged bank statements, SEC filings and interviews by TheStreet show, presumably in a bid to inflate their income statements and/or the assets on their balance sheets. It's long been suspected that some Chinese companies, trying to pass their U.S. audits, will fashion counterfeit bank documents so as to corroborate revenue or cash holdings that don't in reality exist. If the firm's allegations are true, MaloneBailey appears to have unearthed some of the first pieces of hard evidence pointing to that type of fraud.

MaloneBailey raised these red flags just days before each company was slated to file its 10-K annual report with regulators. The firm then either resigned from, or was dismissed by, three of the companies: NIVS IntelliMedia, China Intelligent Lighting and China Century Dragon. At the fourth client, China Electric Motor, MaloneBailey remains as auditor.

A fifth WestPark client audited by MaloneBailey -- a company called China Wesen Recycling -- was in the public-offering pipeline, set to price 1.2 million shares on either the Nasdaq or the NYSE Amex. (WestPark had arranged a $5.5 million private placement for Wesen in December.) But the company disclosed to the SEC on April 1 that it wouldn't be able to file its 2010 annual report on time.

George Qin, the partner in charge of Chinese clients at MaloneBailey, declined to comment on the specifics of the cases. But, he said in an interview with TheStreet, "If a company takes swift actions to work with us to discover to the truth of the fraud, we will stay on and work with them. If the company tries to refuse ... then we resign."

Needless to say, the moves by Qin and MaloneBailey have unleashed a ruckus.

Both China Century Dragon and China Intelligent Lighting have disclosed formal Securities and Exchange Commission investigations into whether the companies committed fraud. The NYSE Amex, meanwhile, has told China Century that in order to protect investors it would begin the delisting process immediately. The audit-committee chair of China Intelligent resigned his post. The boards of all four companies have formed "special committees" to look into the accusations. Shareholder class-action lawyers have flocked to the companies like vultures to carrion. RedChip Research, a stock-promotion outfit that has long touted Chinese reverse-merger stocks, has "suspended coverage" of three of the four companies, backpedaling swiftly from its bullish stance on their businesses (RedChip didn't cover China Century; it had buy ratings on the rest.)

The situation underscores the bloody fallout that can occur whenever U.S.-listed Chinese companies are accused of fraud. It's an old story. Everyone questions the due diligence of everyone else, and the buck gets passed: Underwriters blame auditors. Auditors blame company executives. Executives cast doubt on the practices of investment banks and stock promoters (not to mention short sellers). And regulators and exchanges roust themselves from their torpor only when the symptoms of fraud grow too acute to ignore.

Meanwhile, small retail investors in the U.S. -- many of them drawn to these investments by the macro-economic fact of China's explosive growth -- are left holding the proverbial bag.

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