NEW YORK (TheStreet) -- The Securities and Exchange Commission is investigating allegations that U.S. firms and individuals have joined with partners in China to steal billions of dollars from American investors through stock fraud, according to people familiar with the probe.
Individuals with direct knowledge of the investigation say that the SEC is focusing on stock promoters, investment bankers, auditors and law firms that have been active in recruiting Chinese companies to U.S. stock exchanges and raising capital for those companies by selling new shares.
On Monday, the SEC made an example of an auditing firm that it said had failed to protect U.S. investors from overstatement of revenue by a Chinese firm. The commission said it had reached a settlement with the firm -- Moore Stephens Wurth Frazer & Torbet -- and with Kelly Dean Yamagata, a partner. As part of the settlement, the firm will be temporarily barred from accepting new auditing assignments in China and will pay $129,500.
The case relates to audits the firm did for China Energy Savings Technology, a China-based company that has been the focus of a series of SEC fraud complaints since 2006.
John Heine, a spokesman in the SEC's public affairs office, would neither confirm nor deny a new investigation, citing agency policy against commenting on active investigations. But the questions that SEC investigators are asking hint at their direction. Those questions suggest a suspicion that stock manipulators have devised a kind of template for stock fraud -- one that exploits fundamental weaknesses in the regulatory apparatus of the two countries -- and now use the template to cheat investors in deal after deal.
Word of an SEC probe surfaced during the course of a three-month analysis by TheStreet, which included interviews with scores of investment professionals focused on China stocks, together with reviews of SEC documents, company statements and market data. Some of the same sources later provided information to the SEC.
Of special concern to the commission is a class of company brought public in the U.S. through a back-door process known as a reverse merger, sources directly involved in the investigation have told TheStreet.
Recently, many reverse merger companies have been buffeted by a series of allegations of fraud. The allegations have had repercussions across the sector. Investors in the U.S. have suffered related losses in excess of $34 billion, a review by analysts at TheStreet showed. That total adds up all the market-cap losses for 150 stocks that appear to have been used to bring Chinese companies to U.S. exchanges. The list of 150 included stocks damaged by association with such allegations as well as those directly implicated. Losses were measured from a stock's peak price at any time over the past five years to its present price.
Over the past year, the SEC has received multiple calls for investigation of fraud among China-based stocks. Many investment professionals believe an investigation is due. One is Peter Humphrey, a corporate investigator and due-diligence expert based in Beijing. Humphrey estimates that as many as a third of Chinese companies listed on major U.S. exchanges -- the Nasdaq, Amex and New York Stock Exchange -- are likely reporting fictional profits. He said he bases that estimate on due diligence research done for clients and on discussions with client, in connection with acquisitions and investments in Chinese companies. If the estimate is wrong, it's likely too low, Humphrey says.
While investors who own individual stocks have the greatest exposure to the type of fraud alleged, millions of other American investors also are at risk, through investments in China-oriented ETFs and mutual funds.
To be sure, many Chinese small-cap companies have established the strength of their businesses with financial statements that withstand the tough scrutiny of investment professionals. But frequently lack of transparency and full disclosure -- along with the formidable barriers of language, distance and culture -- make it difficult for individual investors to tell the good from the bad.
Concern about a lack of protection for U.S. investors prompted Congress to ask the SEC for action earlier this year.
In a letter dated Sept. 9, the House Financial Services Committee complained about a general lack of rigor in the auditing of Chinese companies. Addressed to SEC Chair Mary Schapiro and her counterpart at the Public Company Accounting Oversight Board, the letter asked how the agencies planned to tackle the problem.
Frequently the prime movers in the process are Chinese, and never leave China. They enlist the help of bankers, auditors and stock promoters in the U.S. with promises of huge profits in the event of success. Often, the promoters -- some Chinese and some American -- are bailing out just as the public gets in.
The SEC is focusing its investigative efforts on the American end of the network. The agency lacks the power to compel compliance with subpoenas in China -- a fact that has not escaped the notice of dealmakers in China.
A distance of 8,000 miles, together with formidable language and cultural barriers, makes it tough for any investor to get to the bottom of a business scenario in China. Even sophisticated investment professionals spending millions on due diligence have been duped. For the moment, the frequent lack of transparency between the two countries is seen as camouflage for stock cheats. But recurring allegations of fraud and new stock blow-ups have raised questions about the reliability of accounting practices at China-based companies generally.
Some well-known blow-ups suggest the character of the broader problem:
China Energy Savings Technology: This company -- the focus of yesterday's SEC action -- billed itself as a manufacturer of "energy savings products." It agreed to sell $50 million in stock through a PIPE (private investment in a public equity) in January 2006 and soon registered to sell 10 million additional shares in a public offering. A month later, the company disclosed that the SEC had opened an "informal" inquiry into its operations. Within weeks, many of the top people in the company resigned -- directors, executives, all the key participants -- and the company went dark in China, SEC records show. In April, 2009, the SEC obtained judgments finding four of the principals liable for fraud, on the basis that they had used a phony shareholder base and phony stock transactions to boost the price of stock that was essentially worthless, pocketing more than $25 million from American investors. The judgments ordered them to disgorge their profits and to pay penalties. The company is defunct.
Short investors often get embroiled in heated public debates with long investors who are betting on the success of the Chinese companies whose shares they own. Defenders of Chinese investment opportunities caution that fraud and stock blow-ups are common in any volatile sector, often coinciding with exciting growth stories.
"We've had less fraud with Chinese companies than we've had with similar-sized U.S. companies," says Peter Siris. Siris runs Guerrilla Capital, a hedge fund. The fund has invested in some 150 Chinese businesses that have come public on America exchanges, many through reverse mergers.
Siris argues that a lot of the accusations percolating through the sector have been trumped up by short investors to increase the value of their own positions. He concedes that inexperienced Chinese executives have made what he calls innocent mistakes as they learn how to become good corporate citizens in the U.S.
Crocker Coulson, whose investor-relations firm represents some 50 Chinese companies, acknowledged that there has been financial chicanery by some reverse merger companies. Coulson said that the attention given to the bad seeds is overblown and that "people have seized on that to go out and attack high-quality companies that have done nothing wrong -- on thin evidence." Coulson and many others on Wall Street have faith that the Chinese economy will continue to reward investors with rapid growth.
Lawyers experienced in the litigation of securities fraud cases believe that the current investigation by the SEC could well come to nothing in the end, leading into the same quagmire that has frustrated a lot of American investors. Ultimately, the truth about the operations of Chinese companies lies in China, where U.S. regulators lack authority.
-- Reported by Scott Eden and Robert Holmes in New York
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