Crouching Fraud, Hidden Problems

China isnt just exporting into the U.S. toxic toys or poisonous pet food. Its also exporting toxic companies to invest in -- and not just the problematic reverse mergers that have made headlines recently.

Disclosure Insight looked at five years worth of SEC filings for 27 China-based companies listed here, and looked at 100 different risk factors for each company. A big 24 got negative ratings, says John Gavin, founder and chief executive of Disclosure Insight. Problems included SEC probes, accounting/auditor problems, fights with the boards or executive suites, and other investigative activity. Just eleven were reverse mergers (for names of the companies, see below).

A reverse merger occurs when a company buys a U.S.-listed shell and pours its operations into that entity. That way it not only gets a listing on a U.S. exchange, but it can then raise investor money without having to endure the regulatory scrutiny of an initial public offering.

Problems with reverse mergers have the tort bar up in arms. I flagged this problem of foreign companies flooding into U.S. markets to you when I co-wrote a cover story back when I was at Forbes Magazine in 2006.

And now, more than a quarter of the 94 U.S. securities fraud lawsuits filed in the first half seeking class-action status were targeted at so-called Chinese reverse mergers, according to a study released on Tuesday by the Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research in Boston. Hungry for revenue from new listings, the exchanges are often to blame for putting investors at risk.

For instance, the American Stock Exchange, which has since merged with the New York Stock Exchange, took all comers during the most recent bubble. That included reverse mergers and "special purpose acquisition companies, which are also shells with zero operating history, zero revenue, no profits, and no staff. Just a hope and a prayer to buy a U.S. company to pour into the shell.

The Big Board and Nasdaq at that time shunned them, but the Amex took them on to boost listing revenues, letting SPACs acquire something, anything, as long as a year and a half away, among other watery rules. So much for Sarbanes-Oxley.

The evil twin to SPACs are the companies that got a lease on life through a reverse merger. Chinese companies like Bodisen Biotech of Xi'an and Tiens Biotech Group USA of Tianjin. Dont be fooled by their high falutin bio-tech sounding names. Bodisen actually manufactured fertilizer and pesticides, and was subsequently delisted. Tiens sold nutritional supplements. A company calling itself China Natural Gas was a pink sheet, Amex wannabe, but it wasnt a BP (NYSE:BP) or an ExxonMobil (NYSE:XOM): China Natural Gas ran nine gas stations in Xi'an.

Surprisingly, 16 of the 27 Chinese companies Disclosure examined were not reverse mergers, an area of recent market focus. And more than half, 56%, of the Chinese companies got its worst rating of being a High Risk investment. That compares with only 6% of non-Chinese companies rated "High Risk by Disclosure, out of a coverage library of 1,484 companies, Gavin said in a statement.

Which companies did Disclosure Insight list as high risk? Chinese solar companies, and China Eastern Airlines and China Life Insurance Co. to name a few.

Disclosure Insights Gavin also says the analysis shows a pattern of significant, chronic, and disproportional risk from companies listing here from China, spanning many industries, and included some of the larger and betterknown names.

He added: Since we first started producing D.I. Reports in 2009, our risk profiling discipline has consistently compelled us to assign negative ratings to the vast majority of Chinese companies that we have reviewed. And he said: Upon updating our reports through this spring and summer, ratings for some of the companies have deteriorated as fraud allegations, auditor resignations, and other negative events have been reported."

Here are details behind some high-risk names -- the info is directly from Disclosure Insights report -- and the full list of the 24 companies Disclosure Insight flagged is at bottom:

Canadian Solar Inc. (CSIQ $9.63 Mkt Cap $419 Mil).Check out this companys pretty website, showing a canoe on a mountain lake somewhere, and also its contact list showing it supposedly has offices in Canada, Japan, Germany and Italy, the  U.S., Korea and China. You may not get the impression this is a Chinese company. But Discclosure notes that this is from the Canadian Solar 20F filed 17May11 for the year ended 31Dec10: " We are a Canadian company with substantially all of our manufacturing operations in China. " Our principal executive office is located at 650 Riverbend Drive, Suite B, Kitchener, Ontario, Canada N2K 3S2. " Our principal place of business is at No. 199 Lushan Road, Suzhou New District, Suzhou, Jiangsu 215129, Peoples Republic of China.

D.I. PROFILE: An ongoing SEC investigation; insider ownership; concentrated revenue; executive suite turnover; debt covenant violations; related party transactions; and the chairman and CEO positions being held by one person. In Jun10, CSIQ announced that it received a subpoena from the SEC requesting documents from the company relating to certain sales transactions in 2009. As of May11, the SEC investigation was ongoing. As of Mar11, Chairman, CEO & President Shawn (Xiaohua) Qu held 30% of the company's outstanding shares. One customer accounted for 11% of 2010 net revenue. There have been 3 CFOs since the companys IPO in Nov06. CSIQ had 2 debt covenant violations, which resulted in borrowings being due and payable and therefore classified as shortterm. The present status of the covenant violations and shortterm debt is not clear. In 2010, CSIQ outsourced module processing services to a joint venture (Suzhou Gaochuangte New Energy) established by the company, which purchased module products from the company and sold finished products back to the company after completion of the processing services. (Note: Related-party transactions like these are often a red flag). There were $2.1 million module products sold to Gaochuangte in 2010 for further processing and $2.1 million in finished goods purchased back from Gaochuangte. Chairman & CEO Dr. Qu fully guaranteed a oneyear RMB250 million loan facility from the Bank of Communications in 2010. Amount drawn down from the facility at Dec10 was $38 million. Founder Dr. Shawn (Xiaohua) Qu has served as both Chairman & CEO since Oct01.

China Natural Gas, Inc. (CHNG - $3.13 Mkt Cap - $67 Mil ) (Note: This is a reverse merger (2005).

D.I. PROFILE: Turnover in the CFO position; board departures; 3 auditors; internal controls issues; 16 amended filings; 5 delayed filings; and the chairman and CEO positions being held by one person support our opinion of a High Risk rating on CHNG. There have been 6 CFOs. Current CFO Bode Xu was appointed in Dec-10. CFO changes in Oct-08, Apr-09, Jan-10, and Dec-10 were each followed by the filing of an amended 10-K in Dec-08, Jul-09, Aug-10, and Jun-11, respectively. Of the 3 director departures, 2 were audit committee chairmen. The company has had 3 auditors. The current auditor, Friedman LLP, was appointed in Dec-10. CHNG disclosed that its internal controls were ineffective as of 31-Dec-08 due to a material weakness related to insufficient accounting personnel with U.S. GAAP expertise as well as a significant deficiency related to insufficient resources to properly perform internal audit functions. Additional deficiencies relating to the financial closing and reporting process and the treasury cycle were identified as of 31-Mar-09. Internal controls were reported effective as of 31-Dec-09. However, in the 2Q10 10-Q, the company disclosed that its internal controls were ineffective as of 31-Dec-09 due to a material weakness related to 3 transactions entered into by key executives without prior board approval. CHNG continued to disclose a material weakness relating to the disclosure of such transactions in the 10-K filed 14-Mar-11. Further, in the 1Q11 10-Q, the company reported that it had identified a material weakness relating to insufficient accounting personnel with U.S. GAAP expertise. The weakness was later disclosed to have been present since at least 1-Oct-10. Qinan Ji has been Chairman since Dec-05 and CEO since May-06. On 30-Jun-11, Ji announced that he had entered into an exclusivity agreement to formulate a proposal to acquire the outstanding shares of CHNG at a price of $4.25 per share as part of a going private transaction.

China Automotive Systems, Inc. (CAAS $8.28 Mkt Cap $233 Mil) (Note: This is a reverse merger (2003).)

D.I. PROFILE: Related party transactions; concentrated revenue; insider ownership; an auditor resignation; delays in filing the 2010 10K and 1Q11 10Q; and a forthcoming restatement support our opinion of a High Risk rating for CAAS. From 2006 through 9M10, sales to related parties totaled $25.7 million, purchased materials from related parties totaled $44.8 million, technology purchased from related parties totaled $1.5 million, and equipment purchased from related parties totaled $10.6 million. During the 9 months ended Sep10, the companys 10 largest customers accounted for 76.3% of its consolidated net sales, with two customers accounting for 15.3% and 11.7% of sales. Members of the companys management beneficially owned approximately 73.5% of the outstanding shares of its common stock as of 9Nov10 with CAAS chairman and his wife controlling almost 55.5%. In Dec10, CAAS auditor since May03, Schwartz Levitsky Feldman, resigned. PwC was appointed as the new auditor. On 17Mar11, CAAS disclosed that it expects to restate 2009 and 2010 results due to errors in accounting for convertiblenotes. The review of the accounting errors and pending restatement precipitated delays in filing the 2010 10K and 1Q11 10Q.

China Eastern Airlines Corp. Ltd. (CEA $23.79 Mkt Cap $1663 Mil)

D.I. PROFILE: Controlled company status; related party transactions; at least 10 instances where trading in the stock was suspended; the Jan10 Shanghai Airlines acquisition; onetime items; and director turnover support our opinion of a High Risk rating on CEA. The company is majority owned by China Eastern Air Holding Company, a stateowned enterprise incorporated in China. As of the general meeting held 18Feb11, CEA Holding and CES Global, its wholly owned subsidiary, controlled 59.9% of CEAs voting rights through a combination of Class A and Class H shares. In 2010, CEA purchased RMB764 million in goods and services from CEA Holding and its affiliates. Trading in CEA stock has been suspended at least 10 times in the last 5 years, most recently for one day on 27 May10. The company requested all of the suspensions. The lengthiest were from 22May07 to 3Sep07 and from 8Jun09 to 13Jul09. The company acquired Shanghai Airlines in Jan10 for RMB9.1 billion, resulting in RMB11.3 billion of goodwill. Onetime items include impairment charges each year since 2007 totaling RMB3.6 billion. There have been 9 director departures, including a chairman change.

JA Solar Holdings Co. (JASO $5.02 Mkt Cap $858 Mil)

D.I. PROFILE: Insider ownership; related party transactions; executive suite turnover; board turnover; and onetime items support our opinion of a High Risk rating for JASO. As of 31Mar11, Chairman Baofang Jin beneficially owned a 22.7% stake in JASO through Jinglong Group Co., Ltd. (for which Chairman Baofang Jin is the sole director and has a 32.96% economic interest). In Jul10, JASO acquired Shanghai Jinglong Solar Technology Co., Ltd. from Ningjin Jinglong PV Investment Co., Ltd. (a company controlled by Chairman Jin) for RMB199 million. In Jul11, JASO announced a definitive agreement to acquire Silver Age Holdings Limited (which owns Solar Silicon Valley Electronic Science and Technology Co., Ltd.) for $180 million. Silver Age Holdings Limited is 70% owned by Jinglong Group. JASO has longterm supply contracts with Hebei Jinglong and Solar Silicon Valley Electronic Science and Technology for silicon wafers, for which JASO made payments of RMB1.6 billion. Hebei Jinglong is 100% owned by Jinglong Group. JASO is in the process of acquiring Solar Silicon Valley Electronic Science and Technology. There have been 3 CEOs, 4 COOs, and 4 CFOs. Jian Xie has served as acting COO since Jun09 and COO on a permanent basis since Jan10. Peng Fang has served as CEO since Jan10. In Jul11, CFO Anthea Chung resigned and was replaced by Min Cao. There have been 7 director departures. Since JASOs IPO in Feb07, the company has recorded RMB333 million in charges for inventory valuation and RMB65 million in impairments of property.

Company     Ticker 3SBio, Inc. SSRX AsiaInfo-Linkage, Inc. ASIA Canadian Solar, Inc. CSIQ China Agritech Inc. CAGC China Automotive Systems, Inc. CAAS China Distance Education Holdings Ltd. DL China Eastern Airlines Corp. Ltd. CEA China Green Agriculture, Inc. CGA China Life Insurance Co. Ltd. LFC China MediaExpress Holdings, Inc. CCME China Natural Gas, Inc. CHNG China Pharma Holdings, Inc. CPHI China Southern Airlines Co. Ltd. ZNH China TransInfo Technology Corp. CTFO China-Biotics, Inc. CHBT Harbin Electric, Inc. HRBN JA Solar Holdings JASO LDK Solar Co. Ltd. LDK Longtop Financial Technologies Ltd. LFT, Inc. NTES Shanda Interactive Entertainment Ltd. SNDA Synutra International Inc. SYUTUTStarcom, Inc. UTSI Xinyuan Real Estate Company Ltd. XIN