SEC, Congress and Chinese-company Accounting

The big story this week comes from The Wall Street Journal's Dennis Berman, who first wrote about an upcoming SEC probe into Chinese reverse merger and auditing practices.

"The Securities and Exchange Commission has begun a crackdown on the practices of the "reverse takeover" market for Chinese listings, according to people with knowledge of the probe. Specifically, the SEC's enforcement and corporation-finance divisions have begun a wide-scale investigation into how networks of U.S. accountants, lawyers, and bankers have helped bring scores of Chinese companies onto the U.S. stock markets, these people say. The SEC has also begun homing in on individual Chinese companies for accounting violations and lax auditing practices, these people say, beyond a number of previously announced investigations."

A couple hours later, TheStreet.com's Scott Eden followed up with a more detailed look into this issue. Eden said that in early September the U.S. House Financial Services Committee wrote letters to both the SEC Chairwoman Mary Schapiro and the PCAOB (Public Company Accounting Oversight Board), asking how those authorities planned to tackle the problem of sub-par auditing of Chinese companies. The letter demanded that "all market participants can trust the accuracy of the audit work for U.S. publicly-traded companies," including Chinese companies listed in the U.S. and especially also reverse mergers.

This is certainly a valid demand, and the SEC has already launched investigations into three Chinese RTO companies earlier this year: China Sky One Medical (CSKI), Fuqi International (FUQI) and Rino International (RINO). Especially the drama around RINO was a game-changer, and as I wrote here on this blog about one month ago, the fall-out from RINO was expected to be significant. It is very likely that there are more than those three companies with severe accounting "problems," and while the RINO disaster might have sped up an SEC investigation into the whole sector, we all knew that something like this would eventually have to happen. Scott Eden wrote in his article that the SEC "has shown interest in at least six additional companies," but concluded that the probe will not just be focused on individual companies, instead looking into a "systemic problem" that might exist in the Chinese RTO space.

If you are a long investor in China stocks, don't make the mistake to view this new development as a bad thing for the sector. It is entirely positive. The RINO's of the world have to be found, and as long as that doesn't happen the whole sector has to live with negative, often unsubstantiated allegations. It will also put pressure on Chinese management teams who, in many cases, still fail to understand their responsibilities as a public company, fail to take appropriate action to improve corporate governance and strengthen investor confidence. The majority of U.S.-listed Chinese stocks, also reverse mergers, is not deserving of the fraud allegations, but many of them apparently need this kind of pressure to differentiate themselves from RINO and co. - I expect many positive developments in this space next year.

Back to accounting, we have seen many Chinese companies upgrading their auditors this month:

- December 16: China Integrated Energy (CBEH) appoints KPMG
- December 15: Skystar Bio-Pharmaceutical (SKBI) Appoints Crowe Horwath
- December 13: China Automotive Systems (CAAS) appoints PricewaterhouseCoopers
- December 6: Wonder Auto (WATG) appoints PricewaterhouseCoopers

But this can just be a start. There are many Chinese companies still using auditors that don't seem appropriate for their size and level of maturity. All of them will have to upgrade their auditors in 2011, and if they don't then healthy skepticism should be in place. Any company with several hundred of millions in annual revenue can easily afford a top tier accounting firm, and if they don't choose to go that way, we should ask the question: "why not?" Is it that they are afraid of too much scrutiny? Is is that they don't get accepted as clients by one of the Big Four?

The new Trading China Custom Screen Tool makes it easy to identify companies with sub-par auditors. Filtering for Chinese stocks with a senior exchange listing and no Top10-ranked accounting firm, then sorting the results by market capitalization, gives you a good idea of companies that will have to take action. We might even find some of the six additional names, Scott Eden says the SEC has shown interest in, on that list.

Most striking is the large number of Frazer Frost-audited companies on that list. Frazer Frost, the auditor of RINO International, was a business combination of Moore Stephens Wurth Frazer Torbet, LLP (MSWFT) and Frost, PLLC, that broke apart after the RINO scandal. Since December 1st, both MSWFT and Frost resume operations as separate entities again. MSWFT has a history of problems and has been fined this week by the SEC to pay $129,500 in relation to allegations of professional misconduct stemming from the material overstatement of the financial results by a Chinese company back in 2004 and 2005. MSWFT also agreed not to accept any new clients from China, Hong Kong, or Taiwan until an independent evaluation of the firm has satisfied the SEC, and Frazer regains compliance with SEC standards.

In light of these developments all of Frazer Frost's current Chinese clients should feel forced to upgrade auditors as soon as possible, definitely in time for the 2010 annual report, usually due by the end of March. Those companies that don't take appropriate steps should be treated with extreme caution. The list of current Frazer clients is long, including Harbin Electric (HRBN), China Biologic Products (CBPO), China Valves Technology (CVVT), China Fire & Security (CFSG), and SinoCoking Coal (SCOK).

California-based Kabani & Company Inc. is another small firm with a large number of Chinese clients. Most of Kabani's clients are small, OTC-quoted companies, but there are two striking exceptions: L&L Energy (LLEN) and China Green Agriculture (CGA). Kabani has been singled out as a sub-par choice in several articles this year, most notably by Barron's influential "Beware This Chinese Export" piece in August.

With a market capitalization of more than $300 million, and a U.S.-based (Seattle) management team, LLEN must know that Kabani is no longer an appropriate choice for the company, and that the reputation of the auditor is being questioned by U.S. media. Yet the company reappointed Kabani for their 2011 fiscal year in September, continuing to be the (by a wide margin) largest Chinese client of the firm. In an obvious attempt to strengthen management credibility LLEN decided to hire or appoint several retired White House officials. In August, Norman Mineta (former U.S. Secretary of Transportation) was hired for an annual salary of $250,000. This week LLEN hired Edmund Moy, former Director of the U.S. Mint and special advisor to President George W. Bush, for an undisclosed salary.

Kabani's second largest Chinese client is China Green Agriculture (CGA), a company that has already come under pressure by short sellers this year. In late November, China Green retained Ernst & Young to assist the company with strengthening internal controls, and said they were continuing "discussions on the hiring of a new independent auditor." CGA seems to on the right track, however we'll have to wait if words are followed by actions anytime soon.

There are several other small U.S. accounting firms with a bunch of Chinese clients. Child, Van Wagoner & Bradshaw is a Utah-based firm with six partners and an office in Hong Kong. The 2009 PCAOB inspection of Child found several significant deficiencies. Among their clients are Longwei Petroleum (LPH, $265 million market cap) and Yuhe International (YUII, $175 million). Both these companies are growing fast, expanding their business rapidly, and I would expect them to be mature enough already to upgrade their auditors to at least a Top 10 firm.

And the last accounting firm I want to mention here is Sherb & Co., another small U.S. firm with many reverse merger clients. Almost periodically there are issues with Sherb clients, most recently China Education Alliance (CEU) came under severe pressure with fraud allegations that found their way to mainstream financial media and led to the stock being halted twice this month. The largest of Sherb's Chinese clients, China Integrated Energy (CBEH), took immediate action and upgraded to a Big4 auditor. This is what you want to see as a long investor, let's hope many others will follow suit.