Buyer, Beware of Chinese Stocks

The perils of investing in Chinese companies are real, although that news gets lost in headlines that routinely blare the wonders and almost superhuman strength of China’s economy.  

China is turning to U.S. capital markets to raise money, and investors have responded. In the past three years, over 350 Chinese companies went public on U.S. stock exchanges with a market cap of $50 billion. U.S. investors have been lured by the tremendous growth in the Chinese economy while Chinese entrepreneurs seek to raise capital the American way. 

But the spate of lawsuits against the Nasdaq-listed Chinese retailer Mecox Lane exemplifies a trend of investors recently suing Chinese companies. Mecox Lane was accused in a lawsuit last week of misleading investors before its initial public offering in October, Bloomberg reported. 

Mecox knew by Sept. 30 that rising costs would make it impossible for the company to achieve its projected results, Ahmed Arfa, a shareholder, said in the complaint filed in federal court in Manhattan. Mecox Lane said it believes the complaint “lacks any merit” and plans to “defend themselves vigorously.” 

Still, U.S. investors should be cautious as many of these Chinese stocks may be rife with fraud.

Most of these Chinese IPOs are done as “reverse mergers” of Chinese companies with dormant U.S.  “shell” corporations listed on US exchanges. 

Many of these mergers were originated by stock promoters who have a history of fraudulent dealings, at least one of whom served jail time for bank fraud. 

There are reports of many companies falsifying financial statements and fabricating sales and profit figures, including Orient Paper (ONP), Rino International (RINO), and China Marine Food Group (CMFO). 

There seems to be a systemic problem with vastly different financial information filed by Chinese companies with the SEC and China’a State Administration for Industry and Commerce (SAIC).  

This is a widespread concern in the investing community. “In the U.S. context, auditors provide a major influence in refining and improving disclosure. A serious question in respect of Chinese companies is whether management is fully committed to abiding by U.S. principles of accurate disclosure and whether outside auditors in the (People’s Republic of China) have a comparable professional commitment to promote accurate financial records and reporting by their clients,” said Amy Sommers, a partner at Squire Sanders in Shanghai, in an interview this week with Forbes. “Without confidence that audited financial statements reasonably reflect the performance of Chinese companies, can investors make informed investment decisions? I see this as a legitimate long-term challenge in respect of China issuers.” 

Another huge red flag are Chinese companies using unknown or small auditing firms or firing big 5 accounting firms who audited their books. The PCAOB in fact has issued an alert to investors regarding the lax auditing standards that many small accounting firms employ when auditing Chinese reverse merger stocks. Issued this summer, the PCAOB’s reports states that a U.S. audit firm issued an audit report on the financial statement of an issuer in the China region, despite the fact that the firm’s personnel did not travel to the China region during the audit. The U.S. audit firm simply retained an accounting firm in the Chinese region, and that was that.  

A Barron’s study of 158 Chinese reverse merger companies showed that these companies underperformed the Chinese “Halter Index” by 75% and found significant questions as to whether the companies’ financials were being accurately represented to U.S. investors.

For U.S. investors, the promise of riches from investing in the booming Chinese economy should be tempered with a heavy dose of buyer beware.

John Montague Faces the Court of Public Opinion

Last June, I wrote on this blog (see below) about a double-standard when it comes to prosecuting fraudsters.  In the post entitled, “Two Americas and the Prosecution of Securities Fraud,” I detailed a case we filed against a financial advisor in Southern New Jersey named John R. Montague of Questar Capital Corporation, which is a subsidiary of the insurance behemoth, Allianz.

Mr. Montague’s working class, retirement age clients allege that he stole millions and ran a Ponzi-like scheme to defraud them.  Unfortunately, while law enforcement agencies have concentrated their efforts on criminals like Bernard Madoff and Kenneth Starr who bilked the rich and famous, while Mr. Montague has walked around a free man.  Apparently, fraudsters who prey on working class investors are low on the priority list.

In light of today’s Philadelphia Inquirer story, it is clear that Mr. Montague needs to be brought to justice sooner rather than later.

Two Americas and the Prosecution of Securities Fraud
by Jacob Zamansky on June 14th, 2010 at 3:47 pm
Former presidential candidate  Senator John Edwards is hardly someone to be cited in a blog post about morality and fairness, but he was spot on in his rallying cry about there being two Americas.  This painful reality was driven home to me in recent weeks while pursuing a case in New Jersey’s Gloucester County, a predominantly working class area in the backyard of my hometown, Philadelphia.

The case involves a purported “financial advisor” named John Montague, who was a registered representative with Questar Capital Corporation. The FBI has been investigating Montague since at least last August and possibly longer, but there appears to be no movement in the case.  I represent some elderly investors who Montague defrauded for over $1 million. Given that there are likely many other victims of  Montague’s alleged wrongdoing, it’s quite possible that Montague’s misappropriation of funds is well in excess of what  has already been documented.

My firm has long been a source of leads and other information for prosecutors and law enforcement agents, however, the Montague case doesn’t appear to be a priority for the FBI. For example, the US Attorney’s office is handling the investigation of Kenneth Starr, a money manager whose well heeled clients reportedly included a litany of bold-faced names such as Al Pacino, Uma Thurman, and Neil Simon.  With miraculous speed, prosecutors managed to nearly double the $30 million originally thought to be allegedly swindled by Starr. “In the less than two weeks since Kenneth Starr’s arrest, this investigation has maintained its velocity,” Manhattan US Attorney Preet Bharara told reporters last week.

Furthermore, Bernie Madoff, who orchestrated the biggest Ponzi scheme of all time, was convicted and sentenced in less time that it has taken the FBI to complete its investigation of Montague. The receiver overseeing the liquidation of the fraudster’s enterprise is reportedly expected to recover more monies than originally anticipated - so much so that some vulture funds are already buying up the claims.

The Montague case isn’t the only example of the wheels of justice grinding to a near halt when working class investors are defrauded of their monies.  I represent some working class investors in Long Island who were defrauded by a convicted felon named Peter Dawson more than three years ago.  Although Dawson sits in prison, Bank of America, Washington Mutual and other financial institutions who enabled Dawson’s fraud have yet to be held accountable.

There is a disturbing lesson here: When it comes to prosecuting securities fraud and garnering restitution for investors, working-class people shouldn’t expect the same level of prosecution and recovery as their wealthy brethren.