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It was the photographs that clinched it for Chris Carey.

Researching stocks in 2010, Carey noticed the same Caucasian man sticking out amid groups of mostly Chinese executives in the traditional snapshots taken at ceremonies celebrating a company going public on Nasdaq or other stock exchanges. Tall, red-haired and resembling a humourless David Letterman, the man was a spectral presence in the photos. "When I looked at the SEC filings for those companies, he was nowhere to be found," says Carey, "and so then I began to dig further into how these companies came to go public."

Carey scrutinizes the margins of the markets for, which is majority-owned by the American billionaire Mark Cuban. Carey had been looking into Chinese reverse takeovers, specifically a firm called Telestone Technologies Corp., a wireless equipment manufacturer based in Beijing and listed on Nasdaq. The mysterious redhead, Carey learned, was a Canadian by the name of S. Paul Kelley. He's a venture capitalist from Oakville, Ontario. It turned out Kelley had helped bring not just Telestone but a raft of other Chinese companies onto the North American capital markets via reverse takeovers.

Kelley's work provides a window on the how-to of Chinese RTOs. It's a modus operandi that involves a network of mostly Wall Street bankers, lawyers, entrepreneurs and auditors who have brought hundreds of Chinese companies to North American investors since 2004, introducing some $50-billion worth of stock (all currency in U.S. dollars unless otherwise noted). The soundness of these companies was thrown into question after a number of them blew up spectacularly, most notably Sino-Forest Corp., which was accused in 2011 of making false claims about forests it owned in China. Once the largest publicly traded timber company listed on the TSX, Sino-Forest had entered the markets through the back door of a reverse takeover in 1994. "I'm of the view that the vast majority of Chinese companies listed on North American markets are committing fraud to some extent," says Carson Block, founder of Muddy Waters Research, the short-selling firm that triggered the Sino-Forest scandal. "These reverse takeovers deserve immense scrutiny," says Louis Gagnon, a finance professor at Queen's University. "It's just a fact that many of these are not viable companies. It's a great cause of concern in the marketplace."

The story of Chinese RTOs engineered from Canada is, in no small part, the story of S. Paul Kelley.

* * *

Unlike the conventional route of bringing a company to market through an initial public offering, reverse takeovers allow firms simply to purchase a shell company that's already listed on the markets and, via a share swap, merge with the corpse—it's the corporate version of Invasion of the Body Snatchers. By doing so, the RTO engineers sidestep some of the due diligence that regulators and underwriters require for IPOs.

In the case of Chinese companies, it's often assumed in North America that a reverse takeover is conducted by the company itself. "We are victims of our arrogance," Block says, "because we think, 'Of course Chinese companies want to list here.' But during the past decade, there has been so much liquidity in China that if you really had a good business, you didn't need to get financing in North America. All the money you wanted was easily available in China."

So if Chinese companies don't need our capital, why have so many alighted on North America's markets? As it turns out, it's not just Chinese businesspeople masterminding these mergers—it's Canadians and Americans who see them as a sure-fire way to get rich. People such as Kelley, who is the son of Stafford Kelley, a controversial mining promoter.

Stafford's career took a hit after he became embroiled in a scandal involving Hucamp Mines Ltd., an Ontario junior mining company that began trading on the CDNX exchange in 2000. Stafford, who briefly consulted for the firm, traded its shares for more than a year. After trading in Hucamp shares was shut down by the Ontario Securities Commission in 2002, Stafford was discovered to have engaged in trades between various accounts to generate a false picture of market activity. In 2008, he consented to an OSC order that banned him from trading in the markets for five years and fined him $10,000 (Canadian).

Paul worked for his father from 1997 to 2001, working in investor relations; his name appears as an investor relations contact on a Hucamp press release. Paul then stepped out on his own, borrowing two of his father's dormant numbered companies in Canada and setting up a company in New York, MCC Group USA, Inc. (Today he has a New York-based firm called Asia First Financial Corp., with offices in the Chrysler Building.) "Basically I was starting to do more business within the United States and what I was doing was mostly taking companies public from not only Canada, the U.S. but other jurisdictions into the U.S. to trade on the U.S. market," Kelley said in a court document.

Kelley's RTO career took off when he met the Canadian businessman Jay Chiang in 2002. They became friends, having breakfast or lunch together and discussing religion.

* * *

Scandal has dogged Jay Chiang throughout his career. He made his first real money when he and his brother ran Aamazing Technologies, which distributed computer monitors in California and Canada. Money from that business allowed Chiang and his wife, Christina, a former singer and actress in Taiwan given to using numerous aliases, to buy a 10,000-square-foot mansion in Richmond Hill, Ontario, for $1.1 million (Canadian). But in 1998, Chiang declared bankruptcy after being served a $9.7-million judgment in California's courts for failing to pay a supplier.

Chiang went on to establish a company that moved telecom traffic between Asia and North America. It had generated $15 million in sales by 2000. Around this time, Chiang met Jack Tang, a Beijing businessman. Chiang and Tang decided to take advantage of the flourishing business in reverse takeovers. But they needed someone familiar with North America's capital markets to help them. Enter Paul Kelley. In 2002, the three men, along with a silent partner, set up a network of companies, one of which was Winner International Group Ltd. (WIG), to engineer reverse takeovers.

Their first step was to find companies in China that could be persuaded to participate in reverse takeovers. Most of the companies Tang approached were small or medium-sized—firms that plausibly needed capital and had easy-to-tell stories for North American investors. Convincing the companies wasn't difficult. After all, the companies wouldn't actually be footing the bill for the RTOs themselves—a bill that could be anywhere from $2 million to $3 million once the shell had been purchased, the auditors and lawyers had been paid, and the company had been up and running for a year or two.

The money instead came from Winner and various partners. A recent Canadian court decision says Chiang put up money to run Winner. According to other court documents, Kelley's company, MCC Management, acted as a conduit—paying almost $7 million in expenses for the RTO companies on behalf of Winner from 2004 to 2008.

The next step was to find a shell—a defunct company—listed on the North American markets. It didn't matter whether the shell's former life had any connection to the Chinese company's line of business. For example, Orsus Xelent Technologies Inc., a Beijing-based cellphone distributor, ended up on AMEX (now NYSE MKT) after Chiang, Kelley and Tang merged it with the shell of Universal Flirts Inc., an online dating service.

In 2004, the partners engineered their first RTO with Telestone, the wireless equipment manufacturer. Three more companies would follow in quick succession—Orsus Xelent, New Oriental Energy & Chemical Corp. and Kandi Technologies Corp.

Since they would be putting up several million dollars to bring each listing to market and to cover ensuing expenses, the partners now needed to earn back their investment. Kelley, Chiang and Tang bought shares in the public company at a pre-public offering price—that is, at a discount to what the public would pay. Kelley later said in a court document that the number of shares he was allowed to buy was negotiated on a transaction-by-transaction basis.

"Whereas the whole process might cost $2 to $3 million, if you can get your stocks relatively early on, you can use them to pay for your later costs, your post-closing costs," says Aaron Blumenfeld, a Bay Street lawyer who represents one of Jay Chiang's creditors in an ongoing lawsuit. "So your actual out-of-pocket investment might not be that huge. If you calculate right and you're buying the shares at X and they're going to market for, say, three X or four X, you're going to have your profit locked in, especially if you sell shares out relatively quickly."

Kelley later said in a court document that Chinese companies like Telestone would end up owning 70% of the shares, with the remaining 30% split between the public float, himself and his partners. Winner received anywhere from 600,000 to 1.5 million shares for each firm it brought public. In the case of Orsus Xelent, Winner received 1.45 million shares.

Of course, to make their money back and earn a profit, Kelley and his partners had to ensure the stock went up rather than flatlining or declining. So they spent up to two years promoting the companies to investors in "dog and pony" shows.

To trade Winner's shares in the RTO companies, Kelley opened accounts with various brokers, including E*Trade. "For my own personal interest [the E*Trade account] allowed me to keep some management over the process of what was being bought and sold, more particular sold in this case," Kelley said in court. "Just so that, you know, they weren't being sold at the incorrect time."

In the end, the trading proved profitable: Winner International reaped more than $20 million by trading in shares of just the initial four RTOs. It's difficult to say how much Kelley pocketed himself from the RTOs.

* * *

While its newly minted companies were being touted in road shows, Winner also paid stock-research outfits that later produced enthusiastic evaluations of the firms' prospects. In October, 2007, a Florida-based research firm called RedChip issued a report on Orsus Xelent with a "strong buy" recommendation and a 12-month price target of $6.65—which was more than double the market price at the time. Orsus Xelent's share price rose 7.3%, to $3.25, the day after the RedChip report became publicly available. A review of trading records showed that roughly 16 million shares changed hands over the next week or so. Orsus Xelent's stock ended that period at $5.09.

But the report was optimistic. In 2007, Orsus Xelent had forecast sales of 50,000 of its X180 cellphones, as well as the sale of 300,000 over time. As it turned out, the company sold only about 10,000 of the phones, virtually all in the first half of 2007. That was the last report of sales of the X180. RedChip later disclosed that it received $34,500 for the report while its affiliate, Aurelius Consulting Inc., was being paid $10,000 a month under a services agreement with Orsus Xelent. Court documents show that Winner paid Aurelius $20,000 in November, 2006.

In March, 2008, RedChip dropped research coverage on Orsus, which, by its filing for the fourth quarter of 2010, was down to just $5,000 in cash and $93 million in accounts receivable—many of them so aged that the company had to take a writedown of $33.8 million. By June, 2011, the company had "no discernible business operations," according to a report by the research firm GeoInvesting.

The same pattern occurred with New Oriental Energy & Chemical Corp. In the fall of 2007, the website issued a report touting the company's growth potential and its financial performance. disclosed in the report that it had been paid $30,000 by Kelley's MCC Management for a 90-day advertising campaign. New Oriental Energy's shares rose 16% the day the report appeared, to $6.98, on a volume of 340,507 shares. Over the next two trading days, the stock rose as high as $7.45, with an additional 277,822 shares changing hands. Within nine days of the StockUpTicks report, the share price fell back to the $6 mark it had been at prior to the campaign.

Along with dog-and-pony shows and stock analyses that proved to be anything but independent, another hallmark of the Winner reverse takeovers was information fed to investors about how the firms were performing.

Kandi Technologies Corp., which manufactures go-karts and small electric cars, went public in an RTO that Kelley and his partners conducted in 2007. Chris Carey of pointed out that although the company claimed to have sold 1,005 electric vehicles in the second quarter of 2010, a subsequent annual report indicated that only 658 had been sold for the entire year. This past summer, Kandi declared that it had signed a letter of intent to make up to 20,000 electric cars for the Chinese city of Hangzhou. The news drove up Kandi's stock. Chinese media reports suggested that the first 100 vehicles would be delivered in August, but the company's third-quarter report, released in November, indicated that none of the fleet had yet been sold.

Then there is the case of Telestone. In 2011, the Forensic Factor, a stock research firm with a short position in Telestone, wrote that despite the company's claiming spectacular revenue and earnings growth, it had failed to generate a penny of cumulative cash flow; that its accounts-receivable policy did not appear to conform to standard accounting rules; that two teams of auditors had resigned in a seven-month period; and that the firm was claiming to develop a new industry standard in wireless technology while spending less than $1 million a year on research. The Forensic Factor concluded that Telestone was either producing falsified financial results or failing to conform to GAAP accounting standards.

Soon afterward, an investigation firm called JadeStone, which carries out due diligence on Chinese companies, conducted its own inquiries into Telestone, including an on-site visit to its factory in Shijiazhuang, China. Among JadeStone's findings was that Telestone's real production capacity was 75% below company statements and there were differences of as much as 98% between Telestone's financials as reported to the SEC and those appearing in local Chinese tax filings. A Telestone manager on site told JadeStone's investigators that production was $15 million a year. "This figure is consistent with all of our findings and is 83% less than the company's reported annual production of $90 million," said JadeStone, which also took a short position on the stock. By this past fall, Telestone's stock was down to $1.41 compared to a high of about $10 in the fall of 2011. The company disputes the reports by Forensic Factor and JadeStone.

* * *

Kelley has conducted reverse mergers for at least 11 Chinese companies. Four of these were done with Winner, before his business relationship with Chiang terminated in 2007 after Chiang went to jail for several months after ignoring six Ontario court orders related to the nearly $10 million he owed his former supplier.

"Everyone realizes that four out of every five companies that go public by backing into a shell go bankrupt within five years," Kelley said in an investor presentation reported by a Wall Street financial newsletter in 2009. In his case, Kelley said, none of his companies had gone belly up because of his rigorous due diligence. But of the 11 companies he had helped get listed, eight had fallen to penny-stock status by the end of 2012. Of the eight, several were delisted from the exchanges where they traded and one other merged with another company.

Undoubtedly, this dismal result has something to do with investors souring on Chinese reverse mergers in the wake of Sino-Forest and other scandals. But just as undoubtedly, it has something to do with the quality of the companies. Kelley declined to be interviewed for this story. One journalist who has heard Kelley speak is Wall Street veteran Bob Flaherty, who now says of RTO promoters: "The thing I saw wrong was not these companies going public; it was the fact you had this inside group coming in and getting the stock at extremely low amounts. ... It was not the Chinese really making money on this"—although others clearly were.

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