Worthless Stocks from China (Must Read)

(Many thanks to Joshua Wallis for finding this)

This is a great article on Chinese microcap companies listed on U.S. exchanges via reverse mergers. Many Chinese companies have become intrigued by these mergers because of the ease and low cost of becoming listed in the U.S.

One of these companies, China Sky One Medical, was of particular attention to John Bird who began shorting the stock upon investigation of their inventory claims:

They're turning their inventory over faster than a doughnut shop, thought Bird. Or, as he later put it, "It's like somebody telling you they just drove over here at 600 miles per hour. It's not going to happen."

Many investors believe that because these companies are listed on U.S. exchanges, they are sanctioned by U.S. regulation. Quite the contrary:

Although the stocks trade on U.S. exchanges, and thus project a sense of having to play by American rules, the assets and the principals of many of the companies reside in China. The companies operate on their terms, leaving injured parties and the SEC powerless.

Bird experienced this when he attempted to compare Sky One's filings to the SEC with those of the SAIC, the Chinese government agency responsible for market supervision and regulation. His findings were astonishing:

According to the filing, Sky One's operating unit, Harbin Tian Di Ren, had 2008 sales of 6.93 million yuan, roughly $1 million at 2008 exchange rates. Yet to the SEC, Sky One reported 2008 sales of $91.8 million, with Harbin Tian Di Ren accounting for at least 65 percent, or $59.7 million.

So where were the auditors in all of this? Well...

A July 12 audit alert from the PCAOB noted that some U.S. accountants were issuing opinions for companies without visiting China or reviewing the audit work done by local assistants. The examples cited were all companies based in China, Hong Kong, and Taiwan. In the 27 months ended Mar. 31, 2010, the report said, at least 40 U.S. accounting firms with fewer than five partners and fewer than 10 professional staffers had issued audit reports for Chinese companies.

Buyer Beware.

Nadine