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Chinese stock scams latest U.S. import Add to ...

It seemed like the perfect China play, a way for investors to cash in on the world’s fastest growing economy.

China MediaExpress Holdings Inc. , which provides advertising on buses that clog the smog-choked streets of the country’s largest cities, was on a tear on the Nasdaq stock exchange. After rising 45 per cent in 2009, the stock gained another 49 per cent in 2010.

That came to a halt in late January. In a research report, Andrew Left, an investor who runs Citron Research from his Los Angeles home, termed the company a “phantom” that was literally “too good to be true.” The stock plummeted 14.4 per cent after Mr. Left’s comment, to $17.84 from $20.86 in one day.

Citron’s report was followed by similarly damning charges from Carson Block of Muddy Waters Research, who called the stock a “’pump and dump’ scheme.” Soon after, Roddy Boyd, the editor of thefinancialinvestigator.com in Wilmington, North Carolina, visited the company’s offices and posted videos that he said made it “exceptionally clear” the place was bogus.

China MediaExpress’ stock hasn’t recovered. Shares lost 47 per cent in four days, and were trading at $11.88 on March 11 when the stock was halted on the Nasdaq stock exchange. It hasn’t traded since.

In March, the company delayed its year-end filings and its finance chief resigned. The Hong Kong-based company said on March 11 its auditor, Deloitte Touche Tohmatsu Hong Kong, a member firm of the “Big Four” accounting company’s global network, severed ties to the company.

The story of China MediaExpress has become an increasingly common one as U.S. investors chase the next hot Chinese stock - only to find themselves victims of scams.

Many of the questionable Chinese companies gain access to U.S. capital markets through a back door. In what’s known as a reverse merger, a private company buys enough shares of a public firm to essentially become publicly traded. That allows the company to pay a much lower fee to be listed than it would with an initial public offering - not to mention sidestep the more rigorous filing demands of an IPO.

Of the more than 600 companies that obtained entry to U.S. exchanges this way between January 2007 and March 2010, a total of 159 were from the China region, according to the Public Company Accounting Oversight Board (PCAOB). While many are legitimate, some turn out to be outright pump-and-dump schemes and other scams.

A study by financial web publication TheStreet indicated such schemes involving small-cap Chinese firms may have cost investors at least $34-billion over the past five years.

This has taken U.S. exchanges by surprise. NYSE and Nasdaq have delisted several companies and have a veritable “skid row” of more than a dozen firms that have been halted for weeks or months pending requests for information about accounting problems and late regulatory filings.

What are regulators doing about it? Although their stocks are traded on U.S. exchanges, the companies are based in China. That makes it unclear whose jurisdiction they fall under - creating a regulatory void that companies can easily exploit.

On top of that, Beijing has barred America’s PCAOB, established under Sarbanes-Oxley, from reviewing China-based accounting firms - even if they are registered auditors with the accounting agency.

That loophole enables Chinese companies to hire big name and no-name firms locally; as a result, they face no redress from U.S. authorities for bad practices.

“There may be honest firms in China, but you can’t monitor or control them,” said Hamid Kabani, president of Kabani & Co in Los Angeles, a firm that has audited reverse merger stocks. “I can’t see how a U.S. firm can satisfy whether the (Chinese) firm is (is legitimate).”

In the absence of stricter regulation on companies and auditors, it is left to independent investors like Andrew Left or Carson Block to ferret out suspicious activity.

They, too, are not without controversy. Mr. Left, Mr. Block and their peers are short-sellers who profit when a stock collapses - and critics point out that they can in theory benefit even if their research proves faulty.

But it’s also true that they face extraordinary business challenges.

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