Chinese Stocks Are Still in Danger of Blowing Up

NEW YORK (TheStreet) -- Chinese stocks listed on U.S. exchanges are ticking time bombs.

The Securities and Exchange Commission and FBI are all but powerless to criminally pursue their officers and even their auditors. In short, there is (almost) no one guarding the hen house. In fact, the regulatory situation is shaping up to become worse, not better. I will return regulations later but, for now, let's look at the ghosts of Chinese stocks past, present and future.

Ghosts of Chinese stocks past: Chinese stocks listed on American exchanges clearly appear regulated by well-known auditors. Unfortunately, many companies change to suit the needs of company executives more often than "face changes" in a Sichuan Opera. Since many of the Chinese companies couldn't pass or didn't want the scrutiny of an initial public offering, they often used a method called a " reverse merger."

A reverse merger is relatively simple in concept. First, find a company with an active exchange listing with little to no assets. Second, take over the company. Finally, insert the assets of Chinese company along with changing corporate name, etc. The final product is an American-listed and -traded Chinese company. First point: The SEC should never have allowed this to happen and it will soon become painfully clear why as you read further.

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Some companies are undoubtedly in it for the long haul and report filings that are correct, but many play fast and loose with shareholder assets. The merits of accusations vary; however, not the impact:

RINO International traded an average volume of a million shares a day with a share price peaking over $35. Management accusations of misdeeds resulted in investor losses. SilverCorp Metals ( SVM) shares lost over 25% when Alfredlittle.com accused management of fraud. Sino Clean Energy ( SCEI) lost over half its value and Deer Consumer Products ( DEER) over 70% after fraud accusations.

Ghosts of Chinese stocks current: Qihoo 360 ( QIHU) is interesting. Despite allegations of fraud by Citron Research, the shares are holding up. Rick Pearson has good stuff for investors looking at China.

Fushi Copperweld ( FSIN), unlike Qihoo 360, fell more than 10% as a result of Muddy Waters Research's fraud accusations.

Despite more than one company previously given a clean bill of health by global auditor Deloitte crashing and leaving investors holding the bag, the company remains highly respected and a gold standard of auditing. Deloitte of China is a limited independent company following the rules and laws of the People's Republic of China and not the SEC. China's law requires non-disclosure of information many investors would like to know, information that may prove or disprove accusations of fraud as well as increasing transparency.

The showdown: Deloitte is now stuck between a rock and a hard place. Unfortunately, the rock gets bigger by the day. In September, the SEC filed a lawsuit against Deloitte to force the auditor to turn over documents to aid its investigation of Chinese reverse mergers. The American Deloitte would have quickly accommodated the SEC demands for a U.S. company. China Deloitte has thus far refused to cooperate, citing Chinese law forbidding disclosure of "state secrets." Peter Henning wrote an article on the situation.

China is digging in its heels while the SEC will appear even more foolish if they prove incapable of regulating stocks trading on U.S. exchanges. Conversely, China is busy laughing and with little motivation to adjust its position.

According to Forbes' Francine McKenna, the SEC allowed Deloitte of China to sign off on corporate audits without fear the SEC may demand documents at some point. As I understand the situation, no one is watching the auditors, and everyone knows it. The Public Company Accounting Oversight Board's (PCAOB) Web site says, as of Dec. 31, that 13 companies lack PCAOB inspections for at least four years. Six of the 13 are Chinese, including: Baker Tilly China, Ernst & Young Hua Ming CPA, PricewaterhouseCoopers Zhong Tian.

If you are now thinking Chinese executives are outside U.S. law enforcement, auditors are without SEC oversight, and almost all barriers to prevent management from cooking the books are gone -- you understand the situation correctly.

Ghosts of Chinese stocks future: Chinese stocks can crash without fraud. If the SEC no longer allows an auditor to sign off on company filings, the stocks will face delisting. It may appear extreme at first glance; however, the SEC needs to end the lack of control over the situation. The SEC also needs to stop the circus sooner rather than later.

Stocks most impacted from the possibility of widespread fraud, restatement of reports, economic slowdown or delisting include:

iShares FTSE China 25 ( FXI) is an ETF comprising the most liquid and largest asset public companies. The FXI is as much a play on China in general as it is a direct method of widespread equity exposure. The FXI is also likely the most conservative method as a result of its diversification.

SINA Corp. (USA) (SINA)

SINA provides online media and mobile services in China.

Sina is up over 10% today on a strong earnings report, although it didn't manage to close much different than the gap up open.

Baidu.com Inc. (ADR) (BIDU)

Baidu provides Internet search services. The company offers a Chinese language search platform on its Web site, Baidu.com; and a Japanese platform on Baidu.jp. The company was founded in 2000 and is headquartered in China.

Baidu, the "Google of China," is trending lower after two weeks of losing ground.

Renren Inc. (RENN)

Renren operates a social networking Internet platform in China. It's the most actively traded stock I looked at. I have written about and remain bearish on Renren overall and in light of my fears of manipulation.

Sporting a price-to-earnings multiple over 40, the odds are against making money in the long run. That's more than double the value that I like to see for long-term investments.

E Commerce China Dangdang (DANG)

E-Commerce China Dangdang Inc. operates as a business-to-consumer e-commerce company in China.

Qihoo 360 Technology Co. Ltd. (QIHU)

Qihoo 360 Technology provides Internet and mobile security products in China. Qihoo is subject to fraud allegations, as described earlier.

Youku Inc. (ADR) (YOKU)

Youku operates as an Internet television company in China, which enables consumers to search, view and share video content across devices. Youku is reporting losses and I cannot find an edge with an investment here.

Sohu.com Inc. (SOHU)

Sohu.com provides Chinese online media, search, gaming, community and mobile services in the China. I would not short Sohu here in this price area. It's oversold based on technical analysis and due for a bounce. A test of a moving average is appealing for a short entry, though.

Fushi Copperweld Inc. (FSIN)

Fushi Copperweld, through its subsidiaries, engages in designing, developing, manufacturing, marketing and distributing copper-clad bimetallic wire products. Fushi is subject to fraud allegations as described earlier.

Disclosure: Author holds no positions in the stocks mentioned.

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