Buyer Beware for China Stock Investors

| About: Mecox Lane (MCOX)

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 (NASDAQ:MCOX) 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 September 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 U.S. 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 (NYSEMKT:ONP), Rino International (OTC:RINO), and China Marine Food Group (OTCPK: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 has, in fact, 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.