Tuesday, March 08, 2011

Knight in Shining Armor

Former U.S. Senator Christopher Dodd had to go halfway around the world to make the case for the financial service sector reform and investor protection measures passed by the U.S. Congress last year  -  Dodd’s final year in the Senate.  This week Dodd was the guest of the securities firm Rodman and Renshaw, which held a two-day investor conference in Shanghai, China.  Dodd was a key note speaker and panelist during the conference.

The panel addressed questions regarding the “increased scrutiny faced by U.S. listed Chinese companies.”  Dodd made a surprisingly cogent case for the Financial Services Reform Bill passed by Congress in July 2010.  According to Dodd, the individual investor should have greater confidence in the U.S. equity market through the disclosure and transparency requirements of the legislation.

It is hard to argue with the virtues of disclosure.  However, in the China situation it appears more than just greater disclosure may be needed to restore investor confidence.

There have been cases wherein Chinese companies have taken advantage of the great distance between investors in the U.S. and operations in China to falsify the size and scope of operations.  China Yingxia International, Inc., that once traded on the OTC/BB under the symbol CYXI is one of the most extreme cases so far.  Its chairmwoman, Yingxia Jiao, had claimed over 240 products from nutritional foods to dietary supplements to cosmetics and personal care items.  However, by the end of 2009, the story began to unravel.  Jiao was recently sentenced to death in China for illegal fundraising and fraud after the company failed to make interest payments to creditors in China.

There have been allegations of fraud at as many as thirty companies based in China and listed or quoted on U.S. stock exchanges or quotation services.  The final verdict is out on most of them.  The few that have reached a conclusion often involve some discrepancy by the company’s auditor.  In December 2010, the SEC reached a settlement with Moore Stephen Wurth Frazer & Torbet LLC related to improper professional conduct in the audit of China Energy Savings Technology, Inc., which was once listed on the Nasdaq under the symbol CESV.  The accounting firm has been barred from practicing as an independent accountant for two years for failing to complete proper audits of China Energy.  The SEC found that China Energy had overstated revenue and did not provide proper explanations of revenue recognition.  China Energy was fined $35 million for fraudulent financial reports.

Requirements for disclosure and transparency would do little to prevent these situations.  However, a truly independent and thorough audit may have prevented and certainly would have disclosed the fraud to investors sooner. 

As Dodd and his fellow panelists fielded questions about fraud among China-based, U.S.-listed companies, there was talk among members of the audience about the lack of skilled accounting professionals.  Neither the companies nor the audit firms can hire the right people for audit and accounting functions to fulfill the unique needs of China operations with U.S. listed securities. 

Consumer protection is laudable.  The consumers’ champions might not be Congressmen with their new laws.  Instead the consumer needs more white knights with the accountant’s green eye shades as their shining armor.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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