Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. He is a contributing writer to TheStreet whose views on these stocks are independent of TheStreet's news coverage.

BEIJING ( TheStreet -- In China's small-cap space, the short-attack phenomenon is relatively new, so it is hard to know what the long-term effects will be on individually attacked stocks or on the space as a whole.

China MediaExpress ( CCME) is the latest company to be on the receiving end of a series of short-seller attacks. The stock continues to trade with significant volatility on high volume, meaning that there is still a sizable amount of disagreement between the longs and the shorts.

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I have recently heard of investors "betting the farm" (sometimes on margin) on CCME because they "know" it is legitimate and should seemingly go straight back to $20 or more once it is legitimized. I also have heard from investors who have been aggressively writing puts on the stock because they are confident it will go up, and the option premium they receive looks relatively high.

I don't have a position in CCME, but I do have several observations, which are largely based on the post short attack performance of other China small-caps, including Orient Paper ( ONP).

Orient Paper was the subject of several short attacks beginning in June 2010. The company's share price fell by 50% in two days to around $4 for a 75% decline from ONP's 2010 high.

Of all the short attacks so far, I believe ONP's response was the most thorough and aggressive. The company responded with a point-by-point rebuttal of the short seller's key points, conducted an independent investigation headed by Deloitte, and just this week completed the appraisals of its equipment, which were a key point of the short reports.

In addition, numerous investors in ONP, including TheStreet reporter Eric Jackson, Wall Street Media and myself, visited the company's facilities and provided photos of new and existing equipment, employees, trucks and lots of paper being produced.

All of this was in direct contrast to the claims by shorts that ONP was effectively an empty shell that had absconded with the proceeds of a recent financing. The problem is that nobody cares. The share price currently sits at around $5, around 40% below pre-attack levels, and is also below the $5.50 level, where it sat before the investigation results were released.

The taint of fraud has simply scared off enough investors that the share price simply won't go up. As a result, I have finally finished selling the last of my ONP shares, and I will look to buy back in once I think there is the possibility for upward momentum.

In my opinion, CCME's future share-price performance could face a similar, if not worse, fate than ONP for a number of reasons. I am not encouraging anyone to sell, but rather I am suggesting that the aggressive risk-takers who are "betting the farm" and writing put options take a moment to consider the potential downside risks with CCME.

The purpose of this article is not to attack CCME (that has been done enough already), but rather it is to highlight the very real downside risk that still exists, even after the share price has fallen by 50%.

I would very much like to see CCME be completely validated. However, for those taking substantial risk positions, I feel that investors should be aware of the potential for significant downside, potentially in a single day, if any negative information is suddenly confirmed by the company or if research analysts change their views.

While many of the short-sellers' claims seem to be refutable and without merit, the attack itself could be a self-fulfilling prophecy for the share price. The problems are as follows:
  • Problem No. 1: The burden of proof lies with CCME and not with the short-sellers. Short-sellers deliberately exaggerate their claims and often use dubious evidence to incite maximum panic on the day of the report's release.

    However, in the case of CCME, even if 90% of the information is wrong, that would still make CCME a 10% fraud, resulting in a stock price that could potentially trade near cash value, which is around $7 a share.

    The shorts only need to be 10% correct, whereas CCME needs to be 100% correct on all details. CCME is in the media and advertising business, and its operations are spread over a wide area, making it a very difficult company to accurately audit for any auditor, Big 4 or otherwise. And as a result of the short attacks, the company will now be under the microscope by auditors, investors, law firms and research analysts.
  • Problem No. 2: Long-term damage to the company's business prospects has already been done. CCME is a media company, and the media industry is notoriously sensitive to any type of bad press or negative imagery.

    One claim by the shorts is that a Baidu search for CCME (in Chinese) yields very few results. That is no longer the case. Now, a Baidu search results in numerous stories of a company potentially committing a massive fraud. In the image-sensitive advertising business, this has the clear potential to scare off tier one customers. As in the case of ONP, even if the company is ultimately validated, the smear itself can result in permanent damage to the business and the share price.
  • Problem No. 3 Deloitte is only the auditor until it is not. Deloitte is a top-quality, Big 4 auditor, but the reality is that in a complicated and fairly opaque business like advertising, a standard audit does not necessarily confirm every minute detail of every piece of revenue and expenses. A standard audit is not a forensic audit.

    Deloitte also was the auditor for Duoyuan Printing (DYP) until just before the 2010 10-K was filed when Deloitte was suddenly "dismissed."

    The shares are now down by 70% and trade at a 30% discount to last reported cash on the balance sheet. I am by no means criticizing Deloitte. The fact is that during the course of 2010, certain things "changed" at DYP that prevented Deloitte from signing off on the numbers. Just because Deloitte has signed off on CCME's numbers in the past does not preclude the possibility that "things have changed" for CCME during 2010, which on paper was very much a standout year.
  • Problem No. 4 : CCME's response to date has been very weak, and after an initial pop, the share price has continued to fall. Investors overall are clearly not fully satisfied yet. Unlike ONP, CCME has not had a conference call to address concerns and has released only a fairly brief statement stating that SEC financials should be relied upon and a few other clarifications on its advertising of Apple products via a local distributor.

    The company also contradicted several factual errors in the short-sellers' reports. Investors are all still waiting for a point-by- point rebuttal as well as concrete proof of client relationships, revenue and cash.

    However, it is looking like we may need to wait until the release of the 10-K in March to get full information. The risk for those who are selling options or trading on margin is that many holders will not want to bear the risk of holding until after the 10-K is released, and as a result, the share price could see a substantial dip even before it hopefully recovers.

It is worth repeating, for the good of the China small-cap space, that I would like to see CCME be completely validated and its share price recover. However, past experiences with short-sellers' attacks on stocks including ONP, CVVT, and TSTC have shown that the damage done can be severe and difficult to reverse, even when the arguments of the shorts are mostly without merit. For those investors who choose to play CCME, I would strongly suggest they consider scaling their risk accordingly.

Disclosure: The author has no positions in any of the stocks mentioned

The author can be reached at comments@pearsoninvestment.com

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This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.

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