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China IPO Scandals Yield More Lawsuits, Few Fixes

China-based Puda Coal won a coveted New York Stock Exchange listing in September 2009 with a story that might have seemed compelling to U.S. investors.

The company claimed to produce high-grade coking coal for steel makers, a valuable commodity in China's go-go economy. To be sure, its stock was volatile and thinly traded. And Puda came public in the U.S. by buying an existing shell company, avoiding the rigor and oversight of the usual Securities and Exchange Commission registration process. But by early 2011 it had a $431 million market value, and analysts forecast annual earnings growth of 78%.

By August, though, the stock was delisted and shareholders were left holding an empty bag. Last month, the SEC charged Puda's chairman and former CEO with defrauding investors, the latest chapter in what is becoming a long saga of financial scandals rocking new U.S.-listed Chinese firms.

A year after the scandal began, the fallout continues, with more cases coming to court, such as the Puda action, in which the SEC alleges that executives secretly transferred the company's assets to themselves even as they raised more money in the U.S. market.

No progress has been made in addressing the difference in U.S. and Chinese accounting, disclosure and business practices that caused some firms to fall afoul of regulators here.

Short-Sellers Called Foul The scandals began last year when short-selling websites like alfredlittle.com and Muddy Waters made often credible accusations of fraud against Deer Consumer Products (NASDAQ:DEER - News), Longtop Financial Technologies and many other Chinese companies trading in the U.S.

In Longtop's case, a Citron Research report questioned the size of its true cash holdings, "supersized margins" and other claims .

Some firms like Deer sued the bloggers and are still in court. Others like Longtop have delisted.

Meanwhile, the number of securities fraud cases involving Chinese companies in the U.S. is rising. Part of that may be catch-up to prior allegations. But such dust-ups will become common, some lawyers predict, as China steps up its investments here, and gaps between U.S. and Chinese business practices become more glaring.

"People should expect regulators, plaintiffs' lawyers and short-sellers to be looking at Chinese companies with a great deal of scrutiny from now on," said Timothy Harkness, a partner in Freshfields Bruckhaus Deringer's U.S. commercial securities litigation practice.

U.S. and Chinese regulators have been meeting fruitlessly to find ways to oversee Chinese accounting firms that do the books of U.S.-listed Chinese companies. So far, the two sides are mired in legal and political disagreements and have failed to agree on mutual steps to resolve the problem.

NERA Economic Consulting, a unit of Oliver Wyman Group, said in a recent report that the number of Chinese companies sued for stock fraud in U.S. courts rose to 39 in 2011 following last year's accounting scandals, up sharply from 10 in 2010 and one in 2009.

"It's a big jump. The only (securities) cases that rose more sharply were those relating to the 2008-09 freezing of the credit markets," Harkness said.

The feeling is that more Chinese fraudsters are yet to be uncovered and that more will try to list here.

"U.S. securities markets have experienced fraud since their inception, despite our best efforts to eliminate poor disclosure, Ponzi schemes and the like," Harkness said. "We should expect that China — with a huge and growing economy — will have a similar experience.

He says it's too soon to tell if the reverse-merger mania, where many Chinese firms qualified for backdoor listings in the U.S. by taking over defunct U.S. shell companies, has faded. Some analysts blame such reverse mergers, which received less scrutiny from U.S. regulators, for exacerbating the accounting scandals.

"I would expect further accounting issues to arise for new issuers," Harkness said.

A sticking point for the U.S. involves the Chinese audit firms that check the books of Chinese firms listed here in partnership with larger U.S. companies like Deloitte. The Chinese auditors aren't inspected by the U.S. Public Company Audit Oversight Board as required under Sarbanes-Oxley accounting rules.

The PCAOB met last July with the China Securities Regulatory Commission to arrange joint inspections of audit firms and certain Chinese companies and brokers.

The PCAOB never said what happened. Talks reportedly collapsed when Chinese officials rejected the proposal, saying it would violate China's sovereignty.

In November, Sen. Charles Schumer, D-N.Y., sent a letter to PCAOB head James Doty asking for tougher inspections of the auditors who work for Chinese firms that issue U.S. securities.

"We've yet to see China put in place an effective rule of law that serves to protect the rights of U.S. investors or Chinese nationals when it comes to investing in any Chinese (corporation)," said GVA Research principal David Garrity.

Chinese regulators tend to defend local companies in these disputes, saying they're just unfamiliar with U.S. rules.

Tax Dodging? Michael Williams, a former SEC attorney who heads the Williams Securities law firm in Tampa, Fla., says one difference is that Chinese companies typically report different revenue figures for tax purposes in China and for listings in the U.S. market.

Analysts say the Chinese practice partly reflects a tendency by some Asian companies to underdeclare taxable revenue. While the practice amounts to illegal tax evasion, it often isn't caught due to inefficient government tax administration, technical loopholes and politics. When it is, violators often get fines or slaps on the wrist.

"Chinese business culture and U.S. business culture are radically different," Williams noted.

Harkness adds that local firms that do business with China's government are banned from publicly divulging that information in reports because it's considered a state secret.

Williams says it's wiser for Chinese firms to forgo listing in the U.S. via reverse-merger shell companies and opt for listings through self-underwriting. That takes longer to clear, but receives closer SEC inspection before trading begins — avoiding regulatory trouble.