In the last couple of months you may have been hearing about an SEC probe of Chinese companies that are listed on the New York Stock Exchange. Since 2004 more than 350 Chinese companies have listed on American stock exchanges through a process called reverse merger. In a reverse merger a company takes over a defunct company that is already listed and then begins trading shares without having to go through the IPO process. A reverse merger takes only about three months and costs under $1 million dollars and allows a company to start trading without undergoing the scrutiny involved if they were to start trading under their own name. Additionally, Chinese companies are not regulated by the SEC because their assets are not in the U.S.
Investors looking to profit off China’s booming growth are pouring billions into these companies, but unfortunately some of them are losing their shirts in the process. The SEC and Congress have started to investigate these companies and have found instances of auditors signing off on companies without actually investigating them and many instances of fraudulent accounting.
Investors looking to get rich quick will always be a juicy target for fraudsters. Often lacking the sophistication of seasoned investors, their greed and impatience cause them to turn a blind eye to red flags and potential illegalities in the hopes of turning a fast profit. However, it’s not just greedy rubes that are investing in these companies, major players are also sinking money into them.
Investors considering Chinese companies or funds should protect themselves by doing thorough due diligence prior to investing. As we learned from the Madoff scandal, personal references or recommendations from financial professionals are not enough. At a minimum, due diligence prior to investing in a foreign company should answer the following:
1. How did the company come to be listed on its exchange? Was it a reverse merger or did the company go through an IPO?
2. Have there been any scandals involving the company or its executives?
3. Where are the company’s assets? Do they actually exist?
4. Is it clear what the company does and where it operates?
5. Has the company been audited by a known accounting firm?
6. Is the company being investigated by the SEC or Chinese regulatory agencies?
Due diligence on this level may cost of bit of money and time, but a small investment up front can help to mitigate your risk so that you can take advantage of investment opportunities with foreign companies without blindly rolling the dice.