The Securities and Exchange Commission put out an investor bulletin on June 9 warning the world of potential fraud among companies that came public in the U.S. through a controversial method called a reverse merger. Though the agency didn't single out companies hailing from China, a burgeoning fraud scandal among a raft of Chinese small-cap stocks that entered the market through the reverse merger process gave the SEC's bulletin a clear context. For nearly a year, short-seller reports and media exposés alleging accounting fraud (as well as outright theft of capital raised from U.S. investors) have served to make toxic the entire Chinese small-cap stock sector. The trend has accelerated since March, as a series of companies have seen their auditors abruptly resign, refusing to sign off on the 2010 financial numbers that stock issuers must file with the SEC in their 10-K annual reports. Trading in the shares of more than 15 Chinese companies have been halted or delisted. Many stocks in the sector generally have lost more than half their value year-to-date -- tens of billions in evaporated market cap.
As reported by TheStreet in December, the agency launched an investigation last year into small Chinese companies that have gained listings in the U.S., mostly through reverse mergers, an entirely legal process by which a privately held business obtains a stock registration by combining with a shell company that does have such a registration. The process is criticized as being a way to skirt the more rigorous scrutiny that regulators give bigger issuers looking to raise capital through initial public offerings. In 2009, there was a spike in the number of tiny Chinese companies doing reverse mergers and then "uplisting" their shares to major exchanges, often with the same stock promoters, investment banks, auditors and securities lawyers involved. The SEC has set up a task force to look at Chinese small-caps, focusing not only on individual companies but also on those "gatekeepers" that help entrepreneurs in China raise capital on this side of the Pacific, according to people familiar with the probe. In a press release announcing the bulletin on Thursday, the SEC's director of investor education and advocacy, Lori J. Schock, said, "Given the potential risks, investors should be especially careful when considering investing in the stock of reverse merger companies." For some market observers, the warning brought the phrase "day late and a dollar short" to mind. "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. In its bulletin on reverse mergers Thursday, the agency noted the recent enforcement actions it has taken against a handful of companies, most of which were micro-cap or "penny" stocks trading on the over-the-counter markets. Most reverse mergers begin life on the over-the-counter markets. The SEC has suspended trading in shares of six companies and revoked the registrations of several others. The most dangerous potential frauds, experts say, are the companies that have graduated from penny-stock status to the major exchanges. As such, the Nasdaq Stock Market in April applied to the SEC in order to institute rules that would make it more difficult for reverse-merger companies to list on its exchanges. The application document released by Nasdaq noted that it had unearthed cases of apparent manipulation in the stocks of reverse-merger companies that had applied to the exchange for a listing. In these instances, according to Nasdaq, "it appeared that promoters and others intended to manipulate prices higher to satisfy Nasdaq's initial listing bid price requirement." In other cases, companies have "gifted stock to artificially satisfy the 300 round lot public holder requirement."