Eric Jackson is a contributing writer to TheStreet whose views on these stocks are independent of TheStreet's news coverage.

NEW YORK ( TheStreet) -- The Securities and Exchange Commission took a step in the right direction this week by punishing a small U.S. audit firm for work it had done for a Chinese company.

The SEC's settlement with Moore Stephens Wurth Frazer & Torbet LLP of Orange County is related to overstatements of financial results that China Energy Savings Technology made in 2004 and 2005.

Last month, I wrote in RealMoney that there were many small U.S. auditors operating in China that are basically a joke. They are not performing audits in the manner an average person would expect them to be done. In many cases -- not just a few -- I believe that these audit firms are simply signing off on numbers given to them by management to bank their auditing fees (which can be up to $300,000 for one year from one client) and in the hopes of winning new clients from that company's pre-IPO investors.

These cases appear to be isolated to the smaller-capitalization Chinese companies who initially go public in a reverse takeover (RTO) of an existing shell company on the over-the-counter (OTC) exchange with the intention of later uplisting to the Nasdaq or New York Stock Exchange.

The SEC's action on Monday likely is the tip of the iceberg of its investigations into this area.

I recently reached out to the SEC and asked to share some of my observations on how I've seen many of these RTOs operate over the last year. Last week, I spoke with several senior people from the Commission. Judging by the number of people on the call and their seniority, it's clear they are looking deeply at this area.

Unlike some, I think it's unfair and incorrect to assume all Chinese stocks that have less less than $500 million in market capitalization and have gone public via RTOs are frauds.

However, I do believe that fraud is common in this population. In my opinion, the biggest issue is the veracity of these companies' financial statements. And for that, I blame the auditors.

There definitely is a web of American investors and service providers associated with these Chinese RTOs who have a vested interest in seeing these companies go public: investors, lawyers, auditors, investment banks and stock exchanges.

All of these parties deserve criticism -- as do the Chinese founding CEOs who agree to this. (Sometimes they're complicit; sometimes they're just naive.)

In many ways, it falls on the SEC's shoulders (or short-sellers) to blow the whistle on frauds. The SEC has to start somewhere, and I think that going after the accountants makes the most sense.

There are several U.S. audit firms doing business in China that are very small (e.g., one or two partners and/or one office). Several have been associated with frauds already (e.g., Frazer Frost, associated with RINO International ( RINO))

From my experience talking to people in China (such as management teams and other accountants), I believe it's fairly common for these U.S. firms to hire third parties (locals) to come in and audit their Chinese clients. In other words, they outsource the actual audit work. These "audits" are perfunctory and basically take management's word on the numbers. The auditors back in the U.S. bless the numbers and get paid by the company. These auditors also seek other referral business from the company's pre-IPO investors (an unspoken quid pro quo).

Several of these small auditors have been censured by the Public Company Accounting Oversight Board (PCAOB). But such censure essentially means, "You did a bad thing, now get back to work." What's the point of that? The accused audit firms dispute the PCAOB's findings, don't change and the cycle goes on. And these PCAOB censures are just for the work the firms do in the U.S. -- not what they outsource and do in China.

Here's a 2007 PCAOB report on Sherb & Co., in which the board told Sherb:
"The audit deficiencies we identified in one of the audits reviewed included a deficiency of such significance that it appeared to the inspection team that Sherb did not obtain sufficient competent evidential matter to support its opinion on the Issuer's financial statements."

This was for a U.S. audit, not one done in China. In the same report, Sherb responded to the PCAOB's criticisms by saying it was "dedicated to achieving the highest level of audit quality. In that regard, we feel we share the PCAOB's goal of using the inspection process as a means of improving audit quality and as a result the reliability of financial reporting."

Well, I guess that PCAOB took that to mean the case was closed. No action was taken against Sherb. Sherb's five current Chinese clients include China Education Alliance ( CEU), which recently came under fire from a short-seller for having a nonfunctioning office and Web site.

The SEC oversees the PCAOB and the securities that get sold in this country. I believe the Commission needs to directly (or get the PCAOB to) audit these audit firms and shut them down if it finds they're operating in a "pay to play" manner. That's exactly what the SEC has done with Moore Stephens (although this fine and ban was for only one office of the company, not its entire network of offices).

If the SEC finds evidence of misrepresentations in these Chinese companies' financial statements (or disclosures around related-party transactions), it should seek to delist them. I believe the SEC also should force the exchanges to start asking more difficult questions before accepting these uplistings from the OTC.

If I worked at the SEC, I would begin by focusing on the following audit firms and their work in China:
  • Frazer Frost
  • Moore Stephens (not just the Orange County office but all of its offices)
  • Kabani & Co.
  • Sherb & Co.
  • Child Van Wagoner & Bradshaw
  • Marcum Josephson (formerly Stonefield Josephson)
  • Alliott AGCA Inc.
  • Jimmy CH Cheung & Co.

China will continue to receive enormous interest from American investors -- both institutional and retail -- in the coming decade. There are many ethical and well-managed Chinese companies. But there are bad apples -- not just over in China, but also right here in the U.S. among the service providers like these small auditors. The area deserves to be cleaned up, and I'm heartened to see the SEC move this week to do so.

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At the time of publication, Jackson had no positions in companies mentioned in this article.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. You can follow Jackson on Twitter at www.twitter.com/ericjackson or @ericjackson

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