NEW YORK (TheStreet) -- From its headquarters on the Avenue of the Stars, not far from Beverly Hills, a little-known investment firm called WestPark Capital has long promised to make the dreams of Chinese entrepreneurs come true.
The firm has billed itself as one of the most innovative boutique investment banks involved in helping small Chinese companies travel across the Pacific in pursuit of riches on U.S. equity markets. Several years ago, WestPark even invented a special breed of reverse merger, marketed as a way for companies to avoid the perceived dirtiness of most kinds of reverse mergers, but still attain public listings "fast."
Now, for a handful of WestPark's clients and their investors -- and probably for WestPark itself -- those dreams have devolved into horror shows.
Over the last week and a half, exchange officials have halted the trading in four Chinese companies brought public by WestPark onto the
: a pair of consumer-electronics makers named
( NIV) and
China Intelligent Lighting and Electronics
, which were founded by the same brother-sister team and which share head offices in the same corporate park; along with
China Century Dragon Media
( CDM), a television advertising producer, and
China Electric Motor
, which manufactures micro motors. All are located in or near Shenzhen, a city on the other side of the water from Hong Kong. It's an area that has long held a reputation for organized crime and illicit activity in general, including financial fraud.
(NIVS, China Intelligent Lighting and China Century didn't respond to requests for comment. China Electric's CFO spoke with
in an interview,
of this story.)
WestPark has thus become ensnarled in a much larger trend. Since before the financial crisis, more than 150 companies hailing from the People's Republic have gone public in the U.S. via reverse mergers, and allegations of fraud have beset so many of them that
the entire RTO practice has become tarred.
Still, the four trading halts, which came in quick succession over the last two weeks of March, were remarkable enough that a speech by SEC Commissioner Luis Aguilar on Monday, in which he called Chinese reverse mergers a "disturbing trend," referred to the four companies
WestPark denies that its involvement with the four companies has anything to do with the problems they've encountered. In a statement prepared in response to a list of queries made by
, the firm made pains to distinguish between its brand of reverse merger and the standard kind, saying its version requires as much regulatory scrutiny as a traditional IPO.
The problems encountered by the companies are "not about the structure or the means through which they became public," WestPark said in the statement. Instead, the firm said the whole issue can be traced to another source.
As it happens, all of these companies, including the not-yet-public China Wesen, share another common denominator: the same audit firm, a midsized accountancy based in Houston called
, which specializes in small-cap and penny-stock companies.
The audit firm claims to have found evidence that employees at each of the four companies forged bank statements, SEC filings and interviews by
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
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
, "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.
Accounting for Past Mistakes
It all started, according to MaloneBailey's Qin, when the firm instituted a more-rigorous process for examining Chinese companies for the fiscal 2010 audit cycle.
As allegations and revelations of fraud hit one Chinese reverse-merger stock after another last year -- often brought to light by short sellers who profit when share prices decline -- the resulting scandals sparked the SEC and its auditor regulator, the PCAOB, to launch a broad inquiry into the matter.
The SEC set up a task force to investigate fraud allegations directed at Chinese reverse-merger companies, and to examine the role of the U.S.-based firms that help bring them public here -- the so-called gatekeepers -- including promoters, investment banks and auditors. No such firms have been accused of wrongdoing by federal officials.
The scene, however, has intensified this year, with explosive fraud allegations and company-specific SEC probes leading to a handful of trading halts and/or delistings, such as
( DYP) and
(Defenders of Chinese listings in the U.S. maintain that the incidence of fraud among Chinese companies is no greater or lesser than it is among American companies. Still, of the 13 stocks with trading halts currently in place on major U.S. exchanges, nine are Chinese -- or 70% of them.)
MaloneBailey's head of China auditing, George Qin
With the scandal widening, Qin says that MaloneBailey decided to adopt a new "procedure" for the 2010 audits of its Chinese clients. Instead of relying merely on documents provided to auditors by the companies themselves, MaloneBailey would now obtain original bank statements and analyze them for their authenticity. "The PCAOB doesn't even require that," Qin said.
(Though the PCAOB's rules don't specifically require auditors to fetch original statements from a client's bank, if something makes the auditor question the reliability of available information, then the auditor might obtain original bank-account statements as part of its audit procedures, said PCAOB spokeswoman Colleen Brennan.)
MaloneBailey's heightened rigor appears to have had an immediate impact. Before the controversy erupted, the firm had about 25 Chinese clients, according to Qin, who was born and raised in Liaoning Province. (That ranks the MaloneBailey the No. 4 auditor of U.S.-listed Chinese companies this year, according to the Web site AuditAnalytics.com, behind only Deloitte & Touche, PricewaterhouseCoopers, and the New York-based Friedman.)
By analyzing bank statements for possible forgery, Qin says, the firm uncovered evidence of fraud at nine of its Chinese clients -- roughly a third. He refused to name the companies. Most appear to be listed on the over-the-counter bulletin board and the Pink Sheets. (Presumably, some of these companies haven't yet publicly disclosed MaloneBailey's red flags.) A search showed that
, whose stock is listed on the OTCBB, announced on April 1 that it wouldn't be able to file its 10-K on time because MaloneBailey had resigned back on March 11.
The alleged chicanery has followed a pattern, Qin says. In many instances, "bank employees are colluding with clients. The bank employee would provide us with falsified bank statements." He said his firm developed methods to detect whether those statements are real. Among other things, the firm's auditors -- many with experience working at Chinese banks, Qin says -- examine the "chops" that every official document in China needs to carry. Like a seal, a chop is meant to certify that a document is genuine. According to Qin, MaloneBailey auditors are able to detect fraudulent chops.
All of which raises the question: Why hadn't MaloneBailey been auditing Chinese companies using this "method"
from the very beginning
"We didn't know there was so much fraud in China when we did the 2009 audit," Qin says. "We noticed this in 2010; that's why we designed those procedures. But you're right. From hindsight, if we have done the same procedures in the 2009 audit, we would have caught the errors of fraud last year."
That doesn't quite answer the question, however, when it comes to China Century Dragon, which started trading on the Amex only in February. As part of that public offering, MaloneBailey had signed off just months ago on China Century's financials, as filed with the SEC in its S-1 registration statement.
When asked about this, Qin reiterated that he wouldn't comment on specific companies. He also declined to comment on WestPark.
This is the first of a two-part series on Westpark Capital, accounting firm MaloneBailey and recent allegations of improper accounting at a handful of Chinese companies. Click here for Part 2 of this story.
-- Written by Scott Eden in New York
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