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China Security Memo: Looking into “Reverse Mergers” on Wall Street

July 16, 2011

The saying goes that you can learn something new every day. If you're paying attention that is – and more importantly if you know where to look. Today I was getting my morning fill of geopolitical intel from my friends over at STRATFOR (on everything from personal security to country economic profiles) and stumbled onto their weekly China Security Memo, this particular edition on "Looking into Reverse Mergers on Wall Street." Is this another head-scratcher in the less-than-conventional foreign policy coming from China, or a regulatory end-around by some enterprising Chinese companies?  Take a few minutes to read this report, which also goes through everything that happened in China this week that matters.

This article discusses the SEC's ongoing investigation of the "reverse mergers," where questionable Chinese auditing allowed companies to list on U.S. stock exchanges despite their fraudulent accounts. The report is a superb example of the detail and insight STRATFOR gives its customers. If you're into the idea of learning something new on a daily basis (the desire grows with age, I believe) you'll enjoy learning about the current state of Chinese regulations (or lack thereof) for companies that list on US stock markets, state-owned enterprises (SOEs) that compete with American businesses, recent bank robberies, tensions with the Catholic Church, and bottled water contaminated with E. coli. In other words, you'll definitely meet your novel-knowledge quota for the day, all while getting the deepest insight on the security situation in China.

And if you're interested in getting more than just an occasional note and article from me every now and then, I've procured a nice discount of 63% on a STRATFOR subscription. It's one of the smartest sources I read every morning – a great investment, in my humble opinion.

John Mauldin, Editor
Outside the Box

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China Security Memo: Looking into "Reverse Mergers" on Wall Street

July 13, 2011

What is a Trade Secret Now?

Members of the U.S. Securities and Exchange Commission and the U.S. Public Company Accounting Oversight Board (PCAOB) went to Beijing for meetings July 11-12 with the Chinese Ministry of Finance and the China Securities Regulatory Commission. The meetings were prompted by a series of accounting scandals that involved Chinese companies being listed on U.S. stock exchanges through “reverse mergers.” This is a process in which companies enter an American exchange not by an initial public offering but by acquiring a shell company that is already publicly traded on the exchange.

The United States allows foreign companies to gain access to its markets if approved by foreign auditors, and the PCAOB is responsible for accrediting the foreign auditors. But if the auditors fail to perform due diligence they can allow fraudulent accounting to affect American markets — hence the need for the PCAOB to conduct investigations abroad.

For years the Chinese government has rejected American appeals to investigate 110 Chinese auditing companies on the basis of preserving its sovereignty over China’s business practices. The latest scandals have resulted in the U.S. suspension of 24 Chinese-listed companies that had already been reviewed by the approved auditing companies. This has had a significant impact on the markets, so there is renewed market pressure for U.S. authorities to gain access to Chinese books. STRATFOR sources say the most recent round of negotiations was preliminary and that it will be a long time before the two countries agree on a solution, such as raising standards for accreditation or allowing joint U.S.-China inspections on Chinese soil.

Chinese auditors have reportedly denied giving American investigators access to their books, claiming that to do so would be to violate China’s state-secrets law. STRATFOR sources believe this reference to the state-secrets law is a smokescreen for firms that do not want to provide transparency or cooperate with American authorities. Therefore, entirely aside from the stock scandals and financial regulatory negotiations, this incident has again brought up the issue of China’s state-secrets laws.

The question comes down to whether auditors in China can legally be allowed to give information to U.S. regulators or whether such information can be designated as state secrets. The current state-secrets law, which was updated in 2010, theoretically gives the Chinese government less flexibility in prosecuting such cases, but it does not make it impossible. The reality is that taking action under the new law — trying to prosecute a case — is the only way to assess how the new law will be interpreted.

One criterion for information to qualify as a state secret would have to be whether it is related in any way to state-owned enterprises (SOEs). The rules set in April 2010 by China’s State-Owned Assets Supervision and Administration Commission (SASAC), which manages SOEs, and the state secrets law that went into effect in October 2010 provided some clarity on this issue. Any commercial information from “central enterprises,” which are identified as 120 companies overseen by the SASAC, could be considered a state secret. None of the Chinese companies that have been publically identified so far in the recent accounting scandals is an SOE, so information on these companies is not clearly defined as state secrets. But if any of the companies being audited has major business dealings with SOEs, or if SOEs are stakeholders in these companies, such information could be so defined.

Another criterion would be whether the information is related to any “strategic sectors” defined by Beijing or whether it would be in the interest of national security. This is the part of the law that gives Beijing flexibility, and any information relevant to the U.S. investigation could be considered a state secret. An example of this would be the prosecution of Xue Feng, who collected public information on oil reserves, which relate to an industry classified as a strategic sector. This also ignores the whole concept of commercial secrets, which could more clearly be applied to the companies in question. While not as serious as a state secrets prosecution, commercial secrets are also protected under Chinese law, a charge Stern Hu also faced, but was not convicted of, in the 2009 Rio Tinto scandal.

The redefinition of SASAC rules and the new state-secrets law came after Hu’s case, in which he was originally accused but not prosecuted for violating the previous law. The new law broadened the potential classification for information related to state-owned companies but not private ones. If what Chinese authorities consider important auditing information is exposed during the U.S. investigation, they may use the same tactics they used in the Hu case. Chinese authorities have created a culture of fear around the issue, making it difficult to move forward with proper due diligence for fear of prosecution.

The problem faced by Chinese companies, and more broadly the Chinese government, is this: To be listed on U.S. stock exchanges, Chinese companies have to make their financial information public. The companies and their Chinese auditors may be trying to hide behind the threat of state-secrets prosecution in order to hide their own problems. The Ministry of Finance may also be bringing up the importance of “national economic information,” as Reuters reported July 6, to deter Chinese companies and auditors from revealing too much.

In the end, Beijing may decide that the release of information by the Chinese companies being investigated could reveal state secrets and threaten national security. However it chooses to handle the situation will be telling. If the Chinese government prosecutes auditors for handing over their books, the message will be clear: China’s state-secrets law is incompatible with American expectations regarding foreign access to U.S. equity markets. If no auditors hand over their books, it will reinforce the assumption that they are using their fears to hide fraudulent accounting.

(click here to view interactive map)

July 6

  • The Nanjing Public Security Bureau announced it was looking for two suspects in a local robbery in Jiangsu province. The two suspects followed a woman after she withdrew 500,000 yuan (about $77,000) from a China Merchants Bank branch in Gulou district and stole her bag. They dropped the bag as they were being chased by the woman and bystanders.
  • A man was arrested in Taixing, Jiangsu province, after falsely claiming there was an explosive device on a subway car in Shanghai. The man was arguing with a real estate broker when he shouted, “There is a bomb on the train,” indicated the broker was carrying it and escaped in the rush of passengers getting off the train. He was tracked down and arrested that day.
  • An accountant and her husband were sentenced to death and life imprisonment, respectively, for embezzling 70 million yuan (about $10.8 million) of public funds from Jiangxi Guixi Electric Co. in Yingtan, Jiangxi province.
  • Three gunmen in Cangshan, Shandong province, attacked 200 villagers staging a protest over a demolition dispute. The police issued a warrant for the gunmen’s arrest.
  • A spokesman for the Higher People’s Court of Yunnan province in Kunming city announced that a convicted murderer and rapist could be retried after a public outcry over his sentencing. He was originally sentenced to death, but after an appeal he received a two-year reprieve.

July 7

  • The Beijing Public Security Bureau announced it had detained a man for sending phishing messages through the microblogging service Sina Weibo that automatically made any receiver of the messages a follower of his microblog when they clicked on a link and forwarded the messages to other users.
  • Hong-Kong based media outlet Mingpao reported that thousands of people protested water shortages July 5 in Chongqing during a heat wave in the area. Three protestors said they had drinking water only from 2 a.m. to 6 a.m. each day.
  • The Beijing Transport Commission said that all 1,331 escalators and elevators used in the city’s subway system had been checked for faults. The announcement followed an accident when an escalator reversed direction and the resulting crush of people killed a 13-year-old boy.

July 8

  • China’s Ministry of Land and Resources announced that 73 officials from city- and county-level posts were recently punished for illegal use of agricultural land for development purposes. The officials received warnings and demotions.
  • Beijing authorities halted the sale of 31 brands of filtered water after it failed safety tests. The water, commonly used in water coolers, was found to have high levels of bacteria, including E. coli.
  • Su Jinsheng, the former chief engineer of the Ministry of Industry and Information Technology, was fired from his job and expelled from the Communist Party for corruption, the Ministry announced.
  • A former Hunan Provincial People’s Congress deputy was sentenced to 20 years in prison in Xiangtan, Hunan province, for involvement in organized crime. The man, also the general manager of real estate development company Hunan Zhongyi Group, was convicted of organizing rape, assault, racketeering, illegal imprisonment and gun smuggling.

July 10

  • AsiaNews reported that three Catholic bishops in China loyal to the Vatican were recently detained in the cities of Jiangmen, Meizhou and Zhanjiang, all in Guangdong province. Another bishop from Guangzhou, in Guangdong province, is missing. The four bishops may have refused to participate in the ordination of Haung Binzhang, which they were scheduled to attend July 14 in Shantou. Tensions have been high between the Catholic Church and the Chinese government following the ordination of a Chinese bishop in November 2010 without the permission of the Vatican, which excommunicated him in May 2011.

July 11

  • Journalist Qi Chonghuai was convicted of extortion and blackmail and sentenced to eight years in prison after completing a four-year sentence in Tengzhou, Shandong province, on the same charges. Qi reported various instances of corruption, unemployment, labor violations and illegal demolitions. Authorities say he took hush money not to report certain illegal acts, but his wife claims that he was forced to accept the money. She attempted to commit suicide by jumping off of a bridge after the second sentence was announced.

July 12

  • Zhang Chunjiang, the former deputy manager of China Mobile, went on trial in Cangzhou, Hebei province. Zhang has been under investigation for bribery since before January 2010, when he was removed from his post.
  • A court in Zengcheng, Guangdong province, sentenced six people to prison terms for their involvement in protests over three days in June. The longest sentence, three and a half years, was given to Li Zhonghuang for leading a group that threw rocks at police and set their vehicles on fire. Others were sentenced to prison terms ranging from nine months to two years for engaging in violence during the protests.
  • Radio Free Asia reported that Urumqi police intercepted 13 to 15 Uighurs who were bringing leaflets to the city from Aksu July 1 calling for the independence of Xinjiang. The leaflets have reportedly already been circulating in Aksu, where police are said to be at a higher level of alert.

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