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SEC Warns on Reverse Merger Stocks

"What's next? Are they going to warn us that smoking is bad for you?" said one researcher and financial analyst who specializes in studying Chinese reverse mergers. "I mean, it's typical: The SEC coming in to tag bodies after the massacre."

Of the bulletin, he added: "This does no one any good now. And given that retail investors have the most exposure, it just goes to show that the agency is not doing enough to protect those investors who need the most protection."

SEC spokesman John Nester declined to comment on those critiques.

Short sellers, who bet on an asset's decline in value, have been warning the SEC since at least 2009 about the propensity for fraud among Chinese small-caps, according to people with knowledge of the matter.

The issue started to gain traction in Washington last summer and fall. In July 2010, the regulatory body that oversees U.S. accounting firms -- the Public Company Accounting Oversight Board -- issued its own warning to auditors, instructing them to be more diligent in analyzing the financials of Chinese companies. In September, the House Financial Services Committee sent a letter to the SEC and the PCAOB that communicated broad concern about the degree of scrutiny that regulators were giving to Chinese stock issuers. The committee, headed by Spencer Bachus, has hinted at a desire to hold hearings on the matter, but nothing has yet been scheduled.

This year, in an April speech, SEC Commissioner Luis Aguilar effectively confirmed the existence of a broad investigation into alleged fraud among Chinese reverse mergers. Later in the same month, the SEC's chairman, Mary Schapiro, wrote in a letter to Congress that her agency "has moved aggressively to protect investors from the risks that may be posed by certain foreign-based companies listed on U.S. exchanges." She cited a "proactive risk-based inquiry into U.S. audit firms" with a significant number of foreign clients, "including in the PRC."

Lately, fear of fraud has spread even to bigger Chinese companies that came public in the U.S. through IPOs. Longtop Financial (LFT), for example, saw its auditor resign and allege a series of illicit acts by the company's management, going so far as to insinuate that the executives were colluding with their local banks in order to inflate financial numbers. Similar charges were levied by the auditors of ChinaMedia Express (CCME), whose stock was demoted to the Pink Sheets last month. The SEC is investigating both companies.

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