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By Carl Delfeld

China is a terrific growth story, but it’s important to ask sometimes if the fever’s gotten a little out of hand. It’s easy to get carried away and tough to avoid the perils and pitfalls of any emerging market.

You have to search hard to find the real gems in any market. And that can be tedious. More than 600 mutual and exchange-traded funds and almost 300 companies listed on U.S. exchanges have “China” in their name. Many of these are China-based companies trading as ADRs (American Depository Receipts). This is a common way for foreign companies to list their shares on U.S. markets.

The explosion of Chinese companies coming to the United States in order to raise capital shows in the numbers. China now has 67 companies listed on the NYSE, 52 companies on the Nasdaq and 119 companies listed over-the-counter (OTC). In comparison, India has only 11 companies on the NYSE, three firms listed on the Nasdaq and three companies listed OTC.

Now, to some extent, these numbers reflect the more aggressive and entrepreneurial nature of Chinese enterprises. This is laudable, but you also have to ask a key question: With China awash in liquidity, why are all these companies coming here to raise capital?

Backdoor IPO’s: The New “In” for Chinese Companies

What really caught my eye wasn’t just the large number of Chinese companies using the OTC or “pink sheet” market to list their shares, but the clever, indirect way in which they did it.

Rather than launch as an initial public offering (IPO), a process that comes with a high degree of due diligence and transparency, many chose a “backdoor” IPO.

A backdoor IPO works like this:

  • The Chinese company finds a listed shell company, merges into it, changes the name and presto – they are a public company able to take on investor cash.
  • They don’t have to show their books to an underwriter, go on a road show, or take part in any other stage of the traditional IPO process.

Just because the company has the name China in it and operates in a profitable sector, investing early in these companies is very risky and tends to provide far less upside than you might think.

I highly recommend you tread carefully here. While many of these backdoor China IPOs are legitimate, some have blown up after being found to falsify revenue and earnings. One Chinese company went by five different names and trading symbols in five years and changed the jurisdiction in which it was incorporated, shifting from California, to British Columbia, Canada, to Nevada.

Backdoor IPO’s Getting De-Listed From U.S. Markets

The past few months have brought at least 24 de-listings and trading halts for a number of companies according to the SEC.

Here’s a quick rundown of some of these backdoor China IPO’s that have run into deep trouble – along with their current problems:

  • China Agritech (OTCPK:CAGC) – Shareholder lawsuit pending. Dismissed its auditor, Ernst & Young.
  • China Sky One Medical (OTCPK:CSKI) – Under investigation by the SEC.
  • Orient Paper, Inc. (NYSEMKT:ONP) – Re-auditing previous financials due to license issues with previous auditor, (Davis Accounting Group).
  • China Electric Motor (OTCPK:CELM) – Shareholders lawsuit filed, claiming underwriters violated federal securities laws by issuing materially false and misleading information.
  • China Natural Gas (OTC:CHNG) – Class action lawsuit alleges directors and officers issued materially false and misleading statements. CFO of company resigned in late 2010.
  • Duoyuan Printing (OTC:DYNP) - SEC investigating company for fraud; NYSE de-listed April 4, 2011.
  • China MediaExpress Holdings, Inc. (OTCPK:CCME) – Deloitte quit as auditor because “no longer able to rely on the representations of management.” CFO resigned. Stock trading halted March 11.

Why Investors Should Steer Clear of Backdoor China IPOs

The growing list of failed companies and incidents of investigations and potential fraud does not instill much confidence… It’s important for investors to know why they should stay away from these backdoor China IPOs…

The best way to manage risk in China is to avoid the smaller companies. A study by an oversight board showed that 60 percent of China backdoor IPOs reported less than $50 million in annual revenues or assets. A trading service like The Oxford Club’s New Frontier Trader screens for these issues. You can also learn more about a company by checking the SEC’s EDGAR database.

Forewarned is forearmed. Never buy any stock or fund based on its name alone. China is a captivating story but be careful what tools you use to capture this growth.

Disclosure: Investment U expressly forbids its writers from having a financial interest in any security they recommend to our subscribers. All employees and agents of Investment U (and affiliated companies) must wait 24 hours after an initial trade recommendation is published on online - or 72 hours after a direct mail publication is sent - before acting on that recommendation.

Source: The Best Way to Limit Your Risk in China