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China's Big Risk: Corporate Fraud

Stocks in this article: RINO CCME CAGC LFT CHA CHL CHU

NEW YORK ( TheStreet) -- Ask a random group of people who follow the markets what the greatest risk facing China is these and you'll likely hear:

  • Rampant inflation
  • Resource scarcity like water, food, fuel, and other commodities
  • Property bubble
  • Growing disparity between the rich and the poor
  • An artificially high yuan relative to the dollar

But there's a new risk on the horizon facing China -- and it's one that's totally within its own power to control: the perception of rampant corporate fraud.

Notice I didn't say there is currently rampant fraud, but there is an undeniable unease and distrust growing in America over increasing cases of Chinese fraud.

It started last year in the relatively small but prolific world of "reverse take-over" IPOs. There have been a number of high-profile cases of Chinese companies -- including RINO International (RINO), China MediaExpress (CCME) and China Agritech (CAGC) -- with market capitalizations in excess of $500 million being accused of fraud by short-sellers, failing to supply an adequate response, and then seeing their shares delisted back to the pink sheets.

Although the details from these cases were shocking, the casual observer could believe that the problem had been ring-fenced to this particular sector of the market: smaller companies, dealing with smaller auditors, and lesser-known investment banks. The cases certainly call out for action from the NYSE and Nasdaq, as well as the SEC and PCAOB, but at least they were relatively small companies.

But the case of Longtop Financial (LFT) --- a financial software firm whose stock is currently halted on the NYSE -- is more troubling. It's a much larger company than the reverse mergers; its stock was worth over $2 billion last year. It went public in the traditional way, with Goldman Sachs (GS) no less as its underwriter. And it had Deloitte, a "Big Four" auditor, vetting the books. Yet, its CFO and Deloitte both resigned a couple of weeks ago and the stock will most certainly see a significant drop in value when it re-opens.

Yesterday, the Central Commission for Discipline Inspection of the Communist Party of China announced it was launching an anti-corruption investigation into China's largest telcos: China Telecom (CHA), China Mobile (CHL) and China Unicom (CHU).

Also, the equivalent of the Chinese auditor general has recently spoken out about the need to clean up at least 17 cases of a certain amount of fraud among the largest state-owned enterprises.

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