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SEC Warns on Reverse Merger Stocks

(Updated with further detail from the SEC's investor bulletin on reverse mergers.)

NEW YORK ( TheStreet) -- The Securities and Exchange Commission put out an investor bulletin Thursday afternoon warning the world of potential fraud among companies that came public in the U.S. through a controversial method called a reverse merger.

Though the agency didn't single out companies hailing from China, a burgeoning fraud scandal among a raft of Chinese small-cap stocks that entered the market through the reverse merger process gave the SEC's bulletin a clear context.

For nearly a year now, short-seller reports and media exposés alleging accounting fraud (as well as outright theft of capital raised from U.S. investors) have served to make toxic the entire Chinese small-cap stock sector. The trend has accelerated since March, as a series of companies have seen their auditors abruptly resign, refusing to sign off on the 2010 financial numbers that stock issuers must file with the SEC in their 10-K annual reports. Trading in the shares of more than 15 Chinese companies have been halted or delisted. Many stocks in the sector generally have lost more than half their value year-to-date -- tens of billions in evaporated market cap.

Investigating Chinese Reverse Mergers

As reported by TheStreet in December, the agency launched an investigation last year into small Chinese companies that have gained listings in the U.S., mostly through reverse mergers, an entirely legal process by which a privately held business obtains a stock registration by combining with a shell company that does have such a registration.

The process is criticized as being a way to skirt the more rigorous scrutiny that regulators give bigger issuers looking to raise capital through initial public offerings. In 2009, there was a spike in the number of tiny Chinese companies doing reverse mergers and then "uplisting" their shares to major exchanges, often with the same stock promoters, investment banks, auditors and securities lawyers involved.

The SEC has set up a task force to look at Chinese small-caps, focusing not only on individual companies but also on those "gatekeepers" that help entrepreneurs in China raise capital on this side of the Pacific, according to people familiar with the probe.

In a press release announcing the bulletin on Thursday, the SEC's director of investor education and advocacy, Lori J. Schock, said "Given the potential risks, investors should be especially careful when considering investing in the stock of reverse merger companies."

For some market observers, the warning brought the phrase "day late and a dollar short" to mind.

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