WestPark Capital's RTO Deals

WestPark Capital's CEO, Richard Rappaport invented a mechanism he called WRASP, in which a company becomes publicly traded through a reverse merger and trades directly on a senior exchange (NYSE, Amex, or Nasdaq), avoiding the OTCBB completely. Rappaport praises his invention, stating that it has "generally proven to be less costly, less time consuming, involves less risk and even less dilution of ownership than a traditional IPO or a reverse merger. ... The 'WRASP' generally possesses superior liquidity, valuation and institutional coverage, combining the benefits of an IPO and Reverse Merger."

In the past two years, WestPark completed five such WRASP deals. A sixth, China Wesen Recycling Technology, is currently in the IPO pipeline.

• March 2009 - NIVS IntelliMedia Technology (NIV, NYSE Amex)
• October 2009 - ZST Digital Networks (ZSTN, Nasdaq)
• January 2010 - China Electric Motor (CELM, Nasdaq)
• June 2010 - China Intelligent Lighting & Electronics (CIL, NYSE Amex)
• February 2011 - China Century Dragon Media (CDM, NYSE Amex)

Now the New York Stock Exchange has halted trading in three of those five stocks last week. CDM was halted on March 21, at market open, and both NIV and CIL were halted on March 24 at 9:51am. NYSE Regulation issued a press release about the CDM halt, stating that it "is evaluating both the need for certain public disclosure, as well as the overall suitability for continued listing of the Company’s common stock." The company was requested to provide additional information to NYSE Amex on or before March 24, 2011, and while the company announced that it intends to fully cooperate with the regulators, the trading halt is still in place this weekend.

NYSE issued a similar press release for the NIV trading halt. But here we have since learned a lot more details about what happened. In an 8-K Filing late Friday, it was revealed that Malone Bailey submitted its resignation as the Company's independent auditor. The firm based its resignation on what it characterized illegal acts involving the Company's accounting records and bank statements and discrepancies in accounts receivable. And if we look at MaloneBailey's resignation letter in detail, we can see that this is likely another case of accounting fraud:

In our resignation letter dated March 24, 2011, MaloneBailey cited that MaloneBailey found accounting fraud and irregularities in forging accounting records and bank statements during 2010 NIVS audit. On March 21 with email and On March 22, 2011, MaloneBailey, LLP, informed Charles Mo, NIVS independent board member and the chairman of the audit committee about "significant difficulties encountered during the 2010 audit." During the conversation, MaloneBailey, LLP informed Mr. Mo that two other public companies audits were conducted at the NIVS accounting department location. These two companies are located in Beijing and Guangzhou. However, their books and records were shipped to NIVS accounting department and MaloneBailey conducted the audits of these two public companies at NIVS accounting department. NIVS accounting personnel were involved in coordinating the two audits. MaloneBailey found accounting fraud and irregularities in these two audits. After the discovery, we encountered difficulties with management trying to limit our scope of the NIVS audit.

NIV and China Intelligent Lighting (CIL) have a lot in common. They share the same facilities, same auditor, and there are many connections within senior management (founders, directors). It is reasonable to assume at this point that the trading halt for CIL was imposed for related issues.

Which brings us back to WestPark Capital and Richard Rappaport. It might just be coincidence that 60% of the firm's "WRASP"-IPOs were halted within three days, but I wouldn't bet the farm on this. In fact, I would be very careful with the two remaining stocks, CELM and ZSTN, until we learn more details. The latest of WestPark's deals just became a public company last month, and should CDM's situation be similar to that of NIV, it will fall back directly to WestPark and the quality of its pre-IPO due diligence process. The firm has been in trouble already last year, when FINRA fined WestPark to pay $400,000 for failing to supervise brokers with histories of disciplinary actions (a matter of general securities fraud), and suspended its former Chief Compliance Officer and Chief Operations Officer for several months.

Here is a list of all reverse merger deals of the past few years, involving shells owned by WestPark Capital / Richard Rappaport:

• Asia Time (ATYM.PK, SRKP 9 Inc.), delisted from NYSE Amex on April 23, 2009
• China Century Dragon Media (CDM, SRKP 25 Inc.)
• China Electric Motor (CELM, SRKP 21 Inc.)
• China Intelligent Lighting & Electronics (CIL, SRKP 22 Inc.)
• China Shenghuo Pharmaceutical (KUN, SRKP 8 Inc.)
• China Wesen Recycling Technology (SRKP 23 Inc.), pre-IPO
• Feigeda Electronic Technology (SRKP 20 Inc.), not yet listed
• Highpower International (HPJ, SRKP 11 Inc.)
• NIVS IntelliMedia Technology (NIV, SRKP 19 Inc.)
• Yinlips Technology (SRKP 17 Inc.), unlisted, applied for NYSE Amex listing on June 16, 2009
• ZST Digital Networks (ZSTN, SRKP 18 Inc.)

Delayed 10-K Filings

Here is a little summary of Chinese companies that ran into problems with their full-year audit. The deadline for non-accelerated filers ends on March 31, so I do expect many more companies to file for an extension in the next seven days.

China Agritech (CAGC) was last trading at $6.25, down 49.07% for the year, and down 62.35% from the November 9 high at $16.60. The Trading China Tracker Score is UNDER REVIEW.

CAGC fired its auditor (Ernst & Young) earlier this month, and without an auditor it is impossible that we will see a 10-K filing before the end of the extended deadline. The stock is currently halted and there is a good chance that it won't reopen on Nasdaq.

"The Company could not complete the filing of its Annual Report on Form 10-K for the year ended December 31, 2010 due to a delay in obtaining and compiling information required to be included in the Company's Form 10-K, which delay could not be eliminated by the Company without unreasonable effort and expense. In addition, the Company has dismissed its auditors and is in the process of finding a new independent registered public accounting firm to audit the financial statements for the year ended December 31, 2010."

China Automotive Systems (CAAS) is currently trading at $7.69, down 43.54% for the year, and down 57.24% from the October 13 high at $17.98. The Trading China Tracker Score is 10 (Buy).

The company engaged PricewaterhouseCoopers in December as their previous auditor, Schwartz Levitsky Feldman, resigned. Now the Annual Report is delayed, as the company has to make a bunch of restatements. According to the filing, China Automotive expects to complete the report "as soon as practicable", but not within the standard 15-day extension period.

"The Company announced that it expects to restate its previously issued financial statements for fiscal year 2009 and the first three quarters of fiscal year 2010 to reflect non-cash gains or losses related to the accounting treatment for the Company's convertible notes issued on February 15, 2008 based on the guidance outlined in Accounting Standard Codification (ASC) 815. The Company undertook a review to determine the total amount of the errors and the accounting periods in which the errors occurred. The Company's review was overseen by the audit committee of the board of directors of the Company. The Audit Committee concluded on March 12, 2011 that the Company's previously issued audited consolidated financial statements as of and for the fiscal year ended December 31, 2009 and unaudited interim consolidated financial statements as of and for the quarterly periods ended March 31, June 30 and September 30, 2010 should no longer be relied upon because of these errors in the financial statements. The Company's board of directors agreed with the Audit Committee's conclusions. The Company intends to restate these financial statements. Because of the nature and timing of the review, the Company is unable to file its Annual Report on Form 10-K for the fiscal year ended December 31, 2010 with the SEC on March 16, 2011, the prescribed due date. The Company does not expect that such filing will be made within the extension period provided for under Rule 12b-25. The delay could not be eliminated without unreasonable effort or expense. The Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2010 will be filed as soon as practicable after the Company has completed the restatement process.

China Biologic Products (CBPO) is currently trading at $15.50, down 5.44% for the year, and down 17.25% from the October 6 high at $18.73. The Trading China Tracker Score is 4 (Hold).

CBPO is one of those companies that upgraded auditors in December, from tainted (RINO, CHME) firm Frazer Frost to Big Four firm KPMG. The delay is not surprising, given that most former Frazer Frost clients came under heavy pressure, and KMPG hasn't done any audit work on CBPO before. The stock held up very well in the recent China small caps turmoil, but the short interest in CBPO is very high, many people seem to bet on KMPG not signing off on the report. I would definitely wait for the 10-K - which should be filed by the end of March - and check if it comes out clean (internal controls).

"The Registrant is unable to file its Form 10-K within the prescribed time period without unreasonable effort or expense due to the fact that it has not completed the process of preparing and integrating its operating and financial information into statements for the fiscal year ended December 31, 2010. The Registrant anticipates that it will file its Form 10-K no later than the fifteenth calendar day following the prescribed due date, as permitted by Exchange Act Rule 12b-25."

China MediaExpress (CCME) was last trading at $11.88, down 25.01% for the year, and down 50.44% from the January 28 high at $23.97. The Trading China Tracker Score is UNDER REVIEW.

The CCME story is well-known. The company's auditor resigned, and an internal investigation has commenced. The allegations are very serious and a best-case scenario would be a set of restatements that leaves the company with a meaningful cash position and a sizable business. It is unlikely that CCME will be able to engage a new auditor before the investigation has concluded, therefore a 10-K filing should probably not be expected before summer. We will see if Nasdaq allows a months-long trading halt, or if the stock will re-open for trading on the pink sheets.

"The Company cannot at this time estimate when the internal investigation of the relevant issues will conclude. The Company intends to file the Form 10-K as soon as reasonably practicable."

China Medicine (CHME) was last trading at $1.16, down 33.34% for the year, and down 56.23% from the November 10 high at $2.65. The Trading China Tracker Score is -1 (Sell).

CHME announced last night that "certain accounting and reporting errors were identified with respect to improper activities by certain employees." This will result in numerous restatements, and the upcoming form 10-K will be delayed for probably a very long time. I would avoid this name at all cost until we know more about what's going on there.

"As previously disclosed in the Current Report on Form 8-K filed by China Medicine Corporation with the Securities and Exchange Commission (SEC) on March 23, 2011, the Company announced that it expects to restate its previously issued financial statements for fiscal years 2008 and 2009, and the quarters within the fiscal years 2008, 2009 and 2010 in order to correct certain accounting and reporting errors that impact the accuracy of the previously issued financial statements (as defined below). The Board of Directors of the Company, after consultation with and upon recommendation of the management of the Company and its Audit Committee, concluded that the Company's previously issued financial statements contained in its Annual Report on Form 10-K for the fiscal years 2008 and 2009, and the Quarterly Reports on Form 10-Q for the periods within the fiscal years 2008, 2009 and 2010 should no longer be relied upon. The Company intends to restate the previously issued financial statements. Because of the nature and timing of the review, the Company will be unable to file its Annual Report on Form 10-K for the fiscal year ended December 31, 2010 with the SEC by March 31, 2011, the prescribed due date. The Company does not expect that such filing will be made within the extension period provided for under Rule 12b-25 of the Securities Exchange Act of 1934, as amended. The delay could not be eliminated without unreasonable effort or expense. The Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2010 will be filed as soon as practicable after the Company has completed the restatement process."

Feihe International (ADY) is currently trading at $9.63, down 9.50% for the year, and down 30.72% from the November 8 high at $13.90. The Trading China Tracker Score is -2 (Sell).

Feihe has already announced full-year numbers in a press release, but the 10-K filing is still missing. The company expects to file its annual report by the end of the 15-day extension, or by March 31, 2011.

"The registrant is unable to file its Annual Report on Form 10-K for the year ended December 31, 2010, within the prescribed time period because the information required for an accurate and full completion of the report, including but not limited to the financial statements that form a part thereof, could not be provided within the prescribed time period without unreasonable effort or expense. The registrant expects to file its Annual Report on Form 10-K as soon as practicable, and in no event later than the fifteenth calendar day following the prescribed due date."

Fuqi International (FUQI) is currently trading at $3.29, down 48.44% for the year, and down 61.16% from the October 11 high at $8.47. The Trading China Tracker Score is UNDER REVIEW.

The last quarterly or annual report that we have seen from FUQI was filed on November 9, 2009. Nasdaq has granted the company several extensions, the last of which expires on March 28, 2011. By that date the Company must file with the SEC all delayed reports and any required restatements. It seems very unlikely that FUQI can comply with this request, which means that the stock might face a delisting from Nasdaq as early as next week.

"The Registrant has also been unable to complete and file its Annual Report on Form 10-K for the year ended December 31, 2009 due to the time and effort required by the Registrant to conduct a review and analysis of the accounting errors, the impact of the accounting errors on its condensed consolidated financial statements, and preparation of the amended Quarterly Reports on Form 10-Q/A to present the Restatements, in addition to the time and effort required to complete the audit for the year ended December 31, 2009. In addition, due to the foregoing, the Registrant has been unable to prepare and file its Quarterly Report on Form 10-Q for the three months ended March 31, 2010, its Quarterly Report on Form 10-Q for the three and six months ended June 30, 2010, and its Quarterly Report on Form 10-Q for the three and nine months ended September 30, 2010, by their respective due dates. Due to additional time and efforts expended in an attempt to complete the Restatements and prepare and file the annual report for the year ended December 31, 2009 and quarterly reports for March 31, 2010, June 30, 2010, and September 30, 2010, the Registrant is unable to file its Annual Report on Form 10-K for the year ended December 31, 2010. The Registrant will file its Annual Report on Form 10-K for the year ended December 31, 2010 as soon as it is able; however, the Registrant is not able to provide a reasonable estimate as to such filing at this time, which will not occur within the fifteenth calendar day after the prescribed due date for such report."

Fushi Copperweld (FSIN) is currently trading at $8.73, down 1.69% for the year, and down 22.47% from the November 3 high at $8.47. The Trading China Tracker Score is 13 (Strong Buy).

Similar to CBPO, Fushi Copperweld is also a former Frazer Frost client which changed auditors to KPMG (January 24), and now has to file for a delayed Annual Report. Short interest is high and as the stock is still trading at January levels, it has room to the downside if the 10-K doesn't come out clean or if the delay is longer than currently expected. The company announced preliminary results on March 11, but it is prudent to wait for the audited numbers with the Annual Report.

"In the process of preparing our financial statements for the year ended December 31, 2010, management reevaluated the application of GAAP in certain past accounting treatments, which are non-cash and non-operating items. While it is unfortunate that these reconsiderations are causing a delay in our filing, we stress the fact that these are all non-cash adjustments related to various corporate-level account treatments and will not materially affect our non-GAAP, core operating results such as revenue, gross profit and operating income. The Company plans to file its Form 10-K for the year ended December 31, 2010 and publish financial fourth quarter and full year results as soon as practicable following the completion of this reevaluation. However, due to the time needed, we are not in a position to file our 10-K within the required time period."

Home System Group (HSYT) is currently trading at $0.14, down 94.40% for the year, and down 96.00% from the October 18 high at $3.50. The Trading China Tracker Score is 9 (Buy).

HSYT filed for a 10-K extension a whole two weeks before the due date, which is unusual at best. The company gave only the standard explanation without going into detail: "Certain financial and other information necessary for an accurate and full completion of the Form 10-K could not be provided within the prescribed time period without unreasonable effort or expense." With all these uncertainties, HSYT is for gamblers only at this point.

HQ Sustainable Maritime (HQS) is currently trading at $3.20, down 32.92% for the year, and down 36.89% from the January 7 high at $5.07. The Trading China Tracker Score is 6 (Hold).

"HQ Sustainable Maritime Industries is unable to file its Report on Form 10-K for the year ended December 31, 2010 within the prescribed time period due to delays in compiling the information for the preparation of the financial statements. The Registrant fully expects to be able to file within the additional time allowed by this form."

Kingold Jewelry (KGJI) is currently trading at $2.55, down 37.50% for the year, and down 75.00% from the October 6 high at $10.00. The Trading China Tracker Score is 9 (Buy).

"During the process of evaluating its internal control over financial reporting and completing the preparation of its consolidated financial statements, the Company plans to amend and restate its third quarter 2010 financials to reflect solely a non-cash stock compensation expense resulting from the issuance of 100,000 shares of restricted common stock in December 2010 pursuant to the terms of a pre-existing consulting contract. In connection with this adjustment, the Company has engaged a third party valuation firm to assist the Company and its auditors in properly valuing the compensation expense. It is expected that the final results of the valuation report will be available no later than March 25, 2011. The impact of this non-cash adjustment on the Company's net income is expected to be not more than $0.02 per share for the three and nine months ended September 30, 2010. As a result, the Company is unable to finalize its financial statements for the year ended December 31, 2010 until such results have been obtained. In connection with the Company's evaluation of its internal control over financial reporting, the Company has identified some control issues that it is analyzing to determine if they rise to the level of material weaknesses that would require disclosure in its Form 10-K for the year ended December 31, 2010."

ShengdaTech (SDTH) was last trading at $3.55, down 27.54% for the year, and down 44.95% from the November 8 high at $6.45. The Trading China Tracker Score is UNDER REVIEW.

SDTH announced an investigation into "potentially serious" issues with its financials on March 15, and trading has been halted by Nasdaq shortly after. It could take months for SDTH to complete this investigation, and the wording of the announcement suggests that restatements are necessary.

"On March 15, 2011, Shengdatech announced that it had appointed a special committee of the Board of Directors to investigate potentially serious discrepancies and unexplained issues relating to the Company and its subsidiaries' financial records identified by the Company's auditors in the course of their audit of the consolidated financial statements for the fiscal year ended December 31, 2010. The special committee is composed of the independent directors comprising the Company's audit committee. The audit committee retained O'Melveny & Myers LLP as independent outside counsel, which has initiated an internal investigation. The outside counsel to the committee has notified the Staff of the Securities and Exchange Commission of the commencement of the internal investigation. Given that the investigation only recently commenced, the Company cannot predict at this time whether that investigation will require any adjustments to its financial statements, and if so whether such adjustments will be material. Due to the pendency of the internal investigation, the Company will not be able to file its Annual Report on Form 10-K in a timely manner. The Company cannot at this time estimate when the internal investigation of the relevant issues will conclude. The Company intends to file the Form 10-K as soon as reasonably practicable."

Wonder Auto Technology (WATG) is currently trading at $5.79, down 23.21% for the year, and down 49.66% from the November 9 high at $11.50. The Trading China Tracker Score is UNDER REVIEW.

And another company that upgraded auditors to Big Four (PricewaterhouseCoopers) recently, and now faces a possibly long delay with their 10-K filing. Restatements for its financial statements all the way back to 2008 are to be expected, and WATG already said that they most likely won't make the extended deadline at the end of this month.

"As previously announced on February 23, 2011, in connection with the preparation of its consolidated financial statements for the fiscal year ended December 31, 2010, Wonder Auto Technology concluded, that its financial statements as of and for the years ended December 31, 2008 and 2009, included in its Annual Report on Form 10-K for the year ended December 31, 2009, as well as the financial statements included in its Quarterly Reports on Form 10-Q for the quarters ended March 31, June 30 and September 30 during each of the years 2008 and 2009 should no longer be relied upon due to a cutoff error regarding timing of revenue in such periods. Additionally, the Company is still evaluating the impact of the cutoff-errors on its financial results for the year ended December 31, 2010 and on its internal control over financial reporting as of December 31, 2010. As a result, the Company is unable to complete its Form 10-K within the prescribed time period. The Company remains committed to completing its Form 10-K at the earliest possible time, but does not currently anticipate its completion within the fifteen calendars following the prescribed due date."

Portfolio Changes - March 18, 2011

Agfeed Industries (FEED) is currently trading at $1.97, down 33.00% for the year, and down 42.74% from the November 9 high at $3.44. The Trading China Tracker Score is -5 (Sell).

Since we added FEED to our portfolio (November 5, 2010), the company posted disastrous 2010 results. Large write-downs of its Chinese hog farms led to a Fourth Quarter loss of 42 cents a share, much worse than expected. FEED slashed its workforce by nine percent and did not give FY 2011 guidance. Related to the unacceptable performance, the company saw a mass exodus of executives in February. Both the Chairman of the Board and the President/CEO resigned from their positions.

We are closing our position in the China Model Portfolio for a loss of 37.86% or $1,892. We are no longer betting on FEED being able to turn its business around in the foreseeable future. Additionally the stock did not pass our initial safety/risk test in regards of corporate governance, credibility and investor protection.

China Housing & Land Development (CHLN) is currently trading at $2.14, down 21.90% for the year, and down 41.21% from the January 7 high at $3.64. The Trading China Tracker Score is 8 (Buy).

China Housing announced fourth quarter and full year earnings on March 14, both pretty much in line with expectations. Form 10-K for 2010 has been filed, and CHLN's Canadian auditor MSCM LLP attested the company effective internal control over financial reporting as of December 31, 2010. Guidance for 2011 has been issued, calling for about 50% revenue growth and a 140%-179% increase for total contract sales over 2010 numbers. Although we see room for improvement, the stock passed our initial safety/risk test, and we are keeping the position in our portfolio with a target price of 6x 2011 earnings ($0.70) or $4.20.

China MediaExpress (CCME) is currently halted. Last available quote was $11.88, down 25.01% for the year, and down 50.44% from the January 28 high at $23.07. The Trading China Tracker Score is UNDER REVIEW.

Trading in CCME will likely stay halted for a while, it is unlikely that the stock will be allowed to reopen on Nasdaq with the revelations of last week. We will sell the shares in our portfolio at the close of the first Friday the stock is trading again, as the rules for the portfolio do not allow us to liquidate the position at any different time. I would expect CCME to follow similar trading patterns as RINO when it reopens: a sharp drop at the open to sub-$5 levels, followed by a bounce driven by short covering and a slow fade from there on. It is very unlikely that long investors will see significant positive developments from here on, given the magnitude of the disaster that was unfolding last week.

China RuiTai International (CRUI) is currently trading at $0.55, down 45.00% for the year and from the February 2 high at $1.00. The Trading China Tracker Score is 13 (Strong Buy).

RuiTai is set to report full year numbers for 2010 by the end of March. Based on reported financials the stock is extremely cheap, but in the current environment it is prudent to wait for the 10-K filing before making an investment decision. We will apply our safety/risk test when the annual report is available, then review our portfolio position.

China XD Plastics (CXDC) is currently trading at $6.14, up 13.07% for the year, and down 16.47% from the February 17 high at $7.35. The Trading China Tracker Score is 11 (Buy).

China XD is also scheduled with their next annual report on or before March 31, 2011. The stock is holding up very well within the group of small cap Chinese companies, still posting nice gains of more than 13% for the year. Our initial safety/risk test came out inconclusive, while price action, institutional support, and management continuity is in favor of the company, we see risks in the ownership structure and recent lack of updates from management. We will review our position in early April when we should have a new 10-K filing.

ChinaCast Education (CAST) is currently trading at $5.99, down 22.81% for the year, and down 25.04% from the November 9 high at $7.99. The Trading China Tracker Score is 5 (Hold).

ChinaCast reported strong earnings last week, and guided for 21-23% revenue growth in FY 2011. The stock came under heavy pressure early last week, but recovered nicely with a 12% gain on Friday alone. The company announced a large $50 million buyback program for the next 12 months, and management seems committed to creating shareholder value. Our safety/risk test came back positive with Deloitte Touche Tohmatsu (CCME's auditor) signing off on the financials (10-K filing). However, it should be noted that Deloitte identified material weaknesses and has expressed the opinion that CAST has not maintained effective internal control over financial reporting as of December 31, 2010. Those weaknesses are a "lack of sufficient skilled resources in the finance team to meet the demands of rapidly expanded businesses," and a "lack of contemporaneous documentation of certain decisions made by the Board of Directors." We believe that CAST should be able to address these issues successfully.

I will complete the review of our China Model Portfolio positions next week, when I will hopefully have a bit more time to do the write-up. But as we can only make changes to the portfolio at Friday's close, the following positions will all be closed now:

Agfeed Industries (FEED)
Jade Art Group (JADA)
New Energy Systems (NEWN)
Sino Agro Food (SIAF)
U.S. China Mining Group (SGZH)

Chinese Fraud is Widespread

The downfall of China MediaExpress (CCME) has changed the landscape of U.S.-listed Chinese stocks forever. The events of last week, including developments at China Agritech (CAGC), Subaye (SBAY), China Integrated Energy (CBEH) and ShengdaTech (SDTH) prove that Chinese fraud on U.S. exchanges is much more widespread than I originally thought. Numerous trading halts initiated by the exchanges, and more details about the SEC investigation in Chinese reverse mergers, deal-makers and investment banks involved show that U.S. regulators are stepping up to address the issue. Even though we have always advised extreme caution when investing in this space, we have clearly been too optimistic going forward, put too much weight on auditor integrity (incl. Big Four) and third party due diligence (analysts, institutional investors).

China MediaExpress

The battleground for longs versus shorts was China MediaExpress, a high profile self-proclaimed leader in the booming Chinese advertising industry that reported stellar quarterly results throughout 2010. The company was considered among the safest of the RTO/SPAC stocks based on a large number of indicators which supported the credibility of the company and its reported financials. CCME had a Big Four auditor (Deloitte Touche Tohmatsu) since 2009, a large institutional investor (CV Starr) that even increased its position in the stock last fall, consistently bullish analyst reports (Northland called it its Top Pick 2011, Global Hunter repeatedly released detailed research and raised price targets), and supposedly $170 million cash on its balance sheet. The company announced a share buyback program (although never executed) and promised to pay a dividend this spring.

Despite all these bullish signs, short interest in the stock kept rising to staggering levels, even before Muddy Waters and Citron Research released their short reports. The warning signs were always there, both CCME longs and shorts were engaged in a fierce battle over details, but in the end this was a battle between short sellers, who wanted to profit from a collapsing share price, and the reputation of Deloitte, Starr, Global Hunter and other well-known names in the industry, backed by magnificent financial reports. Longs could easily argue that jumping on the Deloitte-Starr-GH bandwagon would be a much safer bet than following the short argument that all those big names got it totally wrong.

Now the battle is over. Deloitte resigned as CCME's auditor. Dorothy Dong, the representative of CV Starr on China MediaExpress's Board of Directors resigned as well, and Global Hunter's senior analyst, Ping Luo, is no longer working for the firm. CCME's stock is halted indefinitely, without an auditor and CFO - Jacky Lam resigned as well - it is unclear when (if ever) we see another 10-K from the company, and the fallout of this scandal sent the average Chinese RTO stock down another 20% last week. Dorothy Dong's resignation letter gives us a good account of what happened with China MediaExpress:

As you know, numerous allegations of a serious nature relating to the conduct of certain members of CCME's management (and that of its subsidiaries) have come to light in the past several weeks. Specifically, by letter dated 3 March 2011, Deloitte Touche Tohmatsu issued a letter to CCME's Audit Committee detailing numerous irregularities it encountered during its audit of CCME, including in particular, irregularities concerning the bank account balances for CCME's PRC subsidiaries.

Subsequently, by letter dated 11 March 2011 to the Audit Committee and the Board of Directors of CCME, Deloitte resigned as auditor of CCME, citing "no tangible process" had been made with respect to the issues raised in its 3 March 2011 letter, and stating that it had "lost confidence in the representations of management (which underpin any audit) ... and reliable financial reporting."

What do we learn from this? CCME's cash balance is most likely massively overstated, and with that the likelihood that we have seen correct financial quarterly reports for 2010 is very low, as most of the cash is supposed to come from operating cash inflows last year ($30 million in Q3/2010 alone). When Deloitte now speaks of numerous problems "of a serious nature", it heavily devalues the quality of its own work over the past 16 months, and especially also the work of Starr and all the analysts we were supposed to rely on. The most plausible scenario is that CCME's founder, majority owner, Chairman and CEO Zheng Cheng, was deliberately defrauding investors with the sole purpose to enrich himself.

China Agritech

Adding to this scandal is the story that is unfolding around China Agritech (CAGC), another Chinese reverse merger that got heavily attacked by short sellers. The stock was halted by NASDAQ on March 14 before the open, and NASDAQ said trading will remain halted "until China Agritech has fully satisfied NASDAQ's request for additional information." More details came to light after the halt, and all of them point to what I would call highly deceptive behaviour by the company:

On March 13, China Agritech issued a press release, announcing a delayed 10-K filing due to the formation of a special committee in order to "investigate certain allegations made by third parties with respect to the Company and certain related issues." The next day, right before the stock was halted, CAGC announced the dismissal of Ernst & Young Hua Ming (another Big Four) as auditor, based on the management questioning Ernst & Young's independence and "in order to give the public fair and truthful financial results."

The real reasons for both the formation of the special committee and the "dismissal" of Ernst & Young were hidden from investors. In fact it turned out that the "third parties" making allegations included Ernst & Young, and that the auditor threatened to resign if the company wouldn't correct its deceptive press releases. An 8-K form, filed on March 18, tells us a more detailed story of what has really happened at CAGC:

"On March 13, 2011, the Company announced that it formed a special committee of its board in order to investigate certain allegations made by third parties with respect to the Company and certain related issues and that the Company would not be able to meet the its Form 10-K filing deadline. E&Y informed the Company that, in its view, there was a material omission of fact from the Company's press release relating to the formation of the special committee, as the press release did not specifically disclose that the independent investigation was related to issues which were identified during the performance of the Company's year end audit. E&Y further advised the Company's representatives that E&Y may resign as the Company's auditors if a revised press release was not issued. The Company, however, believed that the specific disclosure in the press release about the investigation combined with the disclosure of the indefinite delay in the 10-K filing, was a clear indication to the market that issues had arisen in connection with the annual audit which would have to be addressed.

E&Y informed the Company that the issues identified in performing their audit may, if further investigated, have adverse implications for the financial statements covering the three quarterly reports filed by the Company on Form 10-Q during 2010, and advised the Audit Committee to inform the predecessor auditors of the issues identified, so that they can assess the impact on prior financial reports."

Immediate Conclusion

Last week was a game changer, and right now it is no longer possible to reasonably contain the risks when investing in Chinese small caps, especially reverse mergers and blank-check deals. The number of fraudulent companies in this space is much higher than a common sense approach would even have considered possible - maybe even higher than 50% - and for a retail investor those risks are just too high here. The only stocks we should consider for an investment, at any price, are those with a clean 2010 full-year audit backed by a tier one accounting firm. And even those are not free of fraud-risk.

The shake-out will continue, we will see more Chinese RTO stocks imploding in the next few weeks. And, most importantly, the magnitude of fraud will force U.S. regulators to act swiftly. We have seen as many as five Chinese RTO stocks with an exchange-forced trading halt last week, and this trend will continue. Wall Street can not afford to be seen as a facilitator of systemic Chinese securities fraud, and investors in those stocks are simply not protected.

We will make the necessary adjustments to our China Model Portfolio later today.

China Energy Recovery - Explosive Growth Ahead

It doesn't happen very often that a pink sheets quoted Chinese microcap catches our attention, but China Energy Recovery (CGYV) is quite special in many aspects. The company designs, manufactures and installs waste heat energy recovery systems for industrial customers, and is set to become a leader in its industry. When the recently initiated second phase of its expansion program is completed in 2012, CGYV's site will stand as the largest single facility for energy recovery systems in China. Phase One of this expansion has already been finished and CGYV's capacity for 2011 increased almost five-fold over 2010.

China Energy Recovery's auditor is Big Four firm PricewaterhouseCoopers (PwC). This alone is extremely unusual for a tiny microcap with a book value of under $8 million (March 2010). Common sense tells us that this is not our typical pink sheets company when they engage a very expensive top tier auditor and especially also when PwC accepts them as a client. Since the engagement, PwC has carried out a complete review of CGYV's financials which resulted in restatements for 2008 and 2009 financials, and a long delay for the 2010 reports. This is how the formerly OTC-quoted stock ended on the pink sheets.

The company is now moving to bring their SEC filings up to date by submitting the remaining quarterly reports for 2010. The first quarter 10-Q has been filed this week and we can expect the others to follow soon. With the 2010 annual report the company would be back in compliance with the reporting requirements and could get rid of its pink sheets status.

The news flow over the past six months has been very positive:

• September 16, 2010: New Production facility announced. Increases manufacturing capacity by 377% from 356,000 square feet to 1.7 million square feet. Another 100% expansion scheduled for 2012.
• November 3, 2010: PricewaterhouseCoopers completes restatements of 2008 and 2009 numbers. Annual report (10-K) for 2009 filed. $22.2 million in total revenue and net loss of $886,480 or $0.03 per share.
• November 5, 2010: $22.7 million contract for two waste heat recovery systems announced. Scheduled for December 2011 and January 2012.
• November 11, 2010: $10.9 million contract for a heat energy recovery system announced. Scheduled for August 2011.
• December 10, 2010: Company initiated phase two of its expansion plan which will triple capacity when completed in 2012. Management notes that when complete CGYV's "site will stand as the largest single facility dedicated to the design and manufacture of energy recovery systems in China."
• December 21, 2010: CGYV secures $4.5 million loan facility with Bank of China.
• January 10, 2011: $74.7 million contract for two major waste heat recovery systems announced. Scheduled for October and December 2011.
• January 19, 2011: $4.2 million contract for a waste heat recovery system announced. Scheduled for November 2011 delivery.
• February 24, 2011: $7.5 million contract for two waste heat recovery units announced. Scheduled for delivery in the third quarter and December 2011. 2011 contract total now exceeds $115 million.
• March 3, 2011: First Quarter 2010 10-Q filed with the SEC. Reported revenue of $4.1 million (+212% YoY) and operating loss of $538,513 (-35% YoY).

The additional capacity from the Phase One expansion came online in December 2010, so we can not expect much growth for the past year. As the company's CEO stated in a recent press release, "production constraints limited growth, a condition that persisted through fiscal 2010 while our new manufacturing facility was under construction." We should see 2010 total revenue come in between $20 million and $25 million, pretty much in line with 2009 results. But from now on the future looks very bright and the company should see explosive revenue growth.

Trading China reached out to the company to clarify some open questions, and Simon Dong, financial controller of China Energy Recovery, was kind enough to respond:

1. Can we expect the remaining 2010 quarterly reports in the near future?

We do expect the remaining 2010 quarterly reports to be filed soon. The delay of Q1 is also due to restatement of 2009 figures took more than expected time.

2. Does the company plan to file their annual report within the deadline and regain fully reporting status this month?

Yes, the Company strongly wish to file annual report within the deadline, we closely cooperate with our auditor, PwC to issue the report on time.

3. In the last update the company announced: "CER's 2011 contract total now exceeds $115 million." Can you give an estimate for how much of this revenue will be recognized in FY 2011?

Most of the 115 million, we estimate about USD 100 million above will be completed in 2011.

Reported revenue of $100 million for 2011 would quadruple the results for 2010 and 2009, explosive growth that won't be ignored by the market as the financial results are backed by a best-in-class auditor. And it won't end there. The Phase Two expansion, scheduled for 2012 completion, "will more than triple the size of the current facility," and with both stages complete, CGYV's "manufacturing capacity will exceed its original Shanghai-based capacity by a factor of 10."

Those numbers suggest that CGYV can grow from $22.2 million in revenue for 2009 to $100 million in 2011 and $200-250 million in 2013. Long-term growth prospects for the energy recovery industry are excellent, as this technology serves two of China's main goals: lowering industrial pollution and reducing carbon emissions. We are adding CGYV to our China Model Portfolio today after the close.