[Flashback] The dozy watchdogs

Posted by NG Sin Ying, Year 4 undergrad at the School of Accountancy, Singapore Management University


Some 13 years after Enron, auditors still can’t stop managers cooking the books. Time for some serious reforms

NO ENDORSEMENT carries more weight than an investment by Warren Buffett. He became the world’s second-richest man by buying safe, reliable businesses and holding them for ever. So when his company increased its stake in Tesco to 5% in 2012, it sent a strong message that the giant British grocer would rebound from its disastrous attempt to compete in America.

But it turned out that even the Oracle of Omaha can fall victim to dodgy accounting. On September 22nd Tesco announced that its profit guidance for the first half of 2014 was £250m ($408m) too high, because it had overstated the rebate income it would receive from suppliers. Britain’s Serious Fraud Office has begun a criminal investigation into the errors. The company’s fortunes have worsened since then: on December 9th it cut its profit forecast by 30%, partly because its new boss said it would stop “artificially” improving results by reducing service near the end of a quarter. Mr Buffett, whose firm has lost $750m on Tesco, now calls the trade a “huge mistake”.

No sooner did the news break than the spotlight fell on PricewaterhouseCoopers (PwC), one of the “Big Four” global accounting networks (the others are Deloitte, Ernst & Young (EY) and KPMG). Tesco had paid the firm £10.4m to sign off on its 2013 financial statements. PwC mentioned the suspect rebates as an area of heightened scrutiny, but still gave a clean audit.

PwC’s failure to detect the problem is hardly an isolated case. If accounting scandals no longer dominate headlines as they did when Enron and WorldCom imploded in 2001-02, that is not because they have vanished but because they have become routine. On December 4th a Spanish court reported that Bankia had mis-stated its finances when it went public in 2011, ten months before it was nationalised. In 2012 Hewlett-Packard wrote off 80% of its $10.3 billion purchase of Autonomy, a software company, after accusing the firm of counting forecast subscriptions as current sales (Autonomy pleads innocence). The previous year Olympus, a Japanese optical-device maker, revealed it had hidden billions of dollars in losses. In each case, Big Four auditors had given their blessing.

And although accountants have largely avoided blame for the financial crisis of 2008, at the very least they failed to raise the alarm. America’s Federal Deposit Insurance Corporation is suing PwC for $1 billion for not detecting fraud at Colonial Bank, which failed in 2009. (PwC denies wrongdoing and says the bank deceived the firm.) This June two KPMG auditors received suspensions for failing to scrutinise loan-loss reserves at TierOne, another failed bank. Just eight months before Lehman Brothers’ demise, EY’s audit kept mum about the repurchase transactions that disguised the bank’s leverage.

The situation is graver still in emerging markets. In 2009 Satyam, an Indian technology company, admitted it had faked over $1 billion of cash on its books. North American exchanges have de-listed more than 100 Chinese firms in recent years because of accounting problems. In 2010 Jon Carnes, a short seller, sent a cameraman to a biodiesel factory that China Integrated Energy (a KPMG client) said was producing at full blast, and found it had been dormant for months. The next year Muddy Waters, a research firm, discovered that much of the timber Sino-Forest (audited by EY) claimed to own did not exist. Both companies lost over 95% of their value.

Of course, no police force can hope to prevent every crime. But such frequent scandals call into question whether this is the best the Big Four can do—and if so, whether their efforts are worth the $50 billion a year they collect in audit fees. In popular imagination, auditors are there to sniff out fraud. But because the profession was historically allowed to self-regulate despite enjoying a government-guaranteed franchise, it has set the bar so low—formally, auditors merely opine on whether financial statements meet accounting standards—that it is all but impossible for them to fail at their jobs, as they define them. In recent years this yawning “expectations gap” has led to a pattern in which investors disregard auditors and make little effort to learn about their work, value securities as if audited financial statements were the gospel truth, and then erupt in righteous fury when the inevitable downward revisions cost them their shirts.

The stakes are high. If investors stop trusting financial statements, they will charge a higher cost of capital to honest and deceitful companies alike, reducing funds available for investment and slowing growth. Only substantial reform of the auditors’ perverse business model can end this cycle of disappointment.

Born with the railways

Auditors perform a central role in modern capitalism. Ever since the invention of the joint-stock corporation, shareholders have been plagued by the mismatch between the interests of a firm’s owners and those of its managers. Because a company’s executives know far more about its operations than its investors do, they have every incentive to line their pockets and hide its true condition. In turn, the markets will withhold capital from firms whose managers they distrust. Auditors arose to resolve this “information asymmetry”.

Early joint-stock firms like the Dutch East India Company designated a handful of investors to make sure the books added up, though these primitive auditors generally lacked the time or expertise to provide an effective check on management. By the mid-1800s, British lenders to capital-hungry American railway companies deployed chartered accountants—the first modern auditors—to investigate every aspect of the railroads’ businesses. These Anglophone roots have proved durable: 150 years later, the Big Four global networks are still essentially controlled by their branches in the United States and Britain. Their current bosses are all American.

As the number of investors in companies grew, so did the inefficiency of each of them sending separate sleuths to keep management in line. Moreover, companies hoping to cut financing costs realised they could extract better terms by getting an auditor to vouch for them. Those accountants in turn had an incentive to evaluate their clients fairly, in order to command the trust of the markets. By the 1920s, 80% of companies on the New York Stock Exchange voluntarily hired an auditor.

Unfortunately, Jazz Age investors did not distinguish between audited companies and their less scrupulous peers. Among the miscreants was Swedish Match, a European firm whose skill at securing state-sanctioned monopolies was surpassed only by the aggression of its accounting. After its boss, Ivar Kreuger, died in 1932 the company collapsed, costing American investors the equivalent of $4.33 billion in current dollars. Soon after this the Democratic Congress, cleaning up the markets after the Great Depression, instituted a rule that all publicly held firms had to issue audited financial statements. Britain had already brought in a similar policy.

Just what that audit should entail, however, remained an open question. Some legislators proposed that the newly formed Securities and Exchange Commission should conduct audits itself. However, Congress decided to let accountants determine for themselves what their reports would contain. That ill-fated choice paved the way for a watering-down of the audit report that plagues markets to this day.

Even in the age of voluntary audits, accountants were rarely held accountable for their clients’ sins. As a British judge declared in 1896, “An auditor is not bound to be a detective…he is a watchdog, not a bloodhound.” The advent of mandatory audits exacerbated this hazard, because auditors no longer needed to provide value to investors in order to induce companies to buy their services. Without any external rules on what the profession had to verify, it quickly began reducing its own responsibility. Having once offered a “guarantee” that statements were correct, auditors soon moved on to mere “opinions”.

The modern audit does not even provide an opinion on accuracy. Instead, the boilerplate one-page pass/fail report in America merely provides “reasonable assurance” that a company’s statements “present fairly, in all material respects, the financial position of [the company] in conformity with generally accepted accounting principles (GAAP)”. GAAP is a 7,700-page behemoth, packed with arbitrary cut-offs and wide estimate ranges, and riddled with loopholes so big that some accountants argue even Enron complied with them. (International Financial Reporting Standards (IFRS), which are used outside the United States, rely more on broad principles). “An auditor’s opinion really says, ‘This financial information is more or less OK, in general, so far as we can tell, most of the time’,” says Jim Peterson, a former lawyer for Arthur Andersen, the now-defunct accounting firm that audited Enron. “Nobody has paid any attention or put real value on it for about 30 years.”

Although auditors cannot hope to verify more than a tiny fraction of the millions of transactions their clients conduct, in order to comply with the standards they physically count inventories, match invoices with shipments and bank statements, and consult experts on the plausibility of management’s estimates. Most firms’ records are at least tweaked during the process. And even though private businesses do not have to undergo audits, most mid-size firms buy one anyway, because banks rarely lend to unaudited borrowers. The recent spate of frauds in China, where auditing practices are far laxer, shows that markets are right to assign a premium to companies that receive a Western accountant’s approval.

Those conflicts of interest

Even so, the misaligned incentives built into auditing all but guarantee that accountants will fall short of investors’ needs. The beneficiaries of the service—current and prospective shareholders—pay for it indirectly or not at all, while the purchasers buy it only because they are required to. As a result, companies tend to select auditors who will provide a clean opinion as cheaply and quickly as possible. Similarly, accountants who discover irregularities may be better off asking management to make minor adjustments, rather than blowing the whistle on a mis-statement that could embroil their firm in costly litigation.

The audit industry cites four main factors that counteract this conflict of interest. One is the separation of the audit committee from management. Ever since the Sarbanes-Oxley corporate-governance reform of 2002, American auditors have been chosen not by CEOs or CFOs but by a subcommittee of the board of directors. In theory, this should ensure they are selected and compensated with shareholders’ interests in mind. In practice, audit committees are easily captured by management. One academic study found that companies with a senior executive previously employed by a member of the Big Four are far more likely to be audited by that firm than its competitors. The head of Tesco’s audit committee once worked at PwC.

Another potential defence against conflict is reputation: an auditor known for shoddy work will lose business, because investors will not believe its reports. That may have been true long ago, when companies could choose among many accountants. But today only the Big Four have the scale to audit giant multinationals; together, they audit firms that make up 98% of the value of American stockmarkets. And since all of them have approved statements later revealed to be incorrect, none enjoys a reputation much above the others. Companies do not drop Big Four auditors just because the firm failed to catch an error at a different client.

A potentially stronger deterrent is legal risk. Ever since a 1969 Supreme Court case found auditors liable for failing to detect fraud, accountants have feared litigation from shareholders. Those concerns were vindicated when Arthur Andersen, a peer of the Big Four, was brought down by lawsuits related to the Enron scandal. But it took the biggest accounting failure in history to overcome the legal protections auditors enjoy. Short of an Enron-scale disaster, the Big Four have generally beaten back suits or settled them for affordable sums. In America, plaintiffs have to demonstrate intentional recklessness by the accountants in order to reach trial. And in 2005, the Supreme Court ruled that shareholders must prove a direct causal link between a defendant’s activity and a declining stock price in order to claim damages. Despite the auditors’ abysmal performance before the financial crisis, legal claims against them have been modest: this April an arbitration council ruled that EY was not at fault in Lehman Brothers’ bankruptcy.

That leaves only one truly effective force: regulation. In 1933, during a hearing on a law that helped establish mandatory audits, an industry spokesman told Congress that auditors were fully independent from the accounting staffs of their clients. “You audit the controllers?” a sceptical senator inquired. “Who audits you?” “Our conscience,” came the meek reply.

If there was any doubt that this was an insufficient safeguard, the Enron scandal eliminated it. In response, the Sarbanes-Oxley act limited the consulting work American accounting firms could do for audit clients, and set up the Public Company Accounting Oversight Board (PCAOB), a non-profit intended to play Big Brother to the Big Four. James Doty, its chairman, says that “We see [auditors] as professional people subject to pressures to compromise their independence.” In 2004 Britain established a similar watchdog, which is part of the Financial Reporting Council.

These bodies have audited the auditors with gusto. They check the most delicate sections of risky audits; prepare reports on each accounting firm; and levy multimillion-dollar fines when displeased. Last month the PCAOB announced that of the 219 audits of financial statements for 2013 it had reviewed, 85 required more work and should not have been approved. Since the board’s creation, restatements have declined significantly. The PCAOB “is what’s on the mind of the everyday auditor today”, says Joe Ucuzoglu of Deloitte. “Their work is going to have to stand up to inspection scrutiny. High-quality work is rewarded, but lapses can have severe consequences for their compensation.”

Improving the bite

The PCAOB is rightly proud of the improvements in audit quality on its watch. But the regulators themselves admit that though government inspections may help reduce gross negligence, they cannot convert auditors into the trusty allies against rogue management that shareholders need. For that, only structural reform will do.

The easiest improvement would be an expansion of the audit report. Britain has already replaced the single-page pass/fail statement with a more detailed summary of auditors’ activities and areas of focus. Bob Moritz, the chairman of PwC’s American arm, says that reports would be more useful if accountants audited a wider range of “value drivers”, such as drug pipelines for pharmaceutical companies or oil reserves for energy companies.

Another help would be greater competition. Because the Big Four specialise in different industries in each country, many companies have only two or three candidates to audit them. High concentration has also hamstrung the courts: in 2005 America’s Justice Department agreed not to prosecute KPMG for marketing illegal tax shelters, largely because the government feared that a conviction would destroy the firm and further reduce the numbers in the oligopoly. But antitrust action against the Big Four would make matters worse: breaking one up would leave even fewer firms with the necessary scale. Ironically, the way to increase competition would be for a group of weaker networks to consolidate into a new global player. However, even KPMG, the smallest of the Big Four, is larger than the next four firms combined.

Proposals to modify how auditors are chosen or paid invariably involve trade-offs. The simplest would be to shield the audit committee even more from management influence, by having it nominated by a separate proxy vote rather than the board of directors. Whether arm’s-length shareholders would know enough to do so is debatable. But the change would reduce the risk of the CFO suggesting an auditor to a committee member on the golf course.

Some critics suggest taking the selection of auditors away from companies entirely. One model would hand that responsibility to stock exchanges. However, exchanges might be more interested in using lax audit rules to induce companies to list than in courting investors by marketing themselves as fraud-free platforms. To avoid that risk, many pundits suggest that government should appoint auditors instead—or even that the profession should be nationalised. “Do people panic when the IRS descends on them, or when your friendly neighbourhood auditor that you pay does?” asks Prem Sikka of the University of Essex. “Companies should be directly audited by an arm of the regulator.” Small-government types hate either prospect.

The most elegant solution comes from Joshua Ronen, a professor at New York University. He suggests “financial statements insurance”, in which firms would buy coverage to protect shareholders against losses from accounting errors, and insurers would then hire auditors to assess the odds of a mis-statement. The proposal neatly aligns the incentives of auditors and shareholders—an insurer would probably offer generous bonuses for discovering fraud. Unfortunately, no insurer has offered such coverage voluntarily. New regulation may be needed to encourage it.

Finally, the answer for free-market purists is to scrap the legal requirement for audits. Today accountants enjoy a captive market, and maximise profits by doing the job as cheaply as possible. If clients were no longer forced to buy audits, those rents would disappear. In order to stay in business, the Big Four would then have to devise a new type of audit that investors actually found useful. This approach would probably yield detailed reports designed with shareholders’ interests in mind. But it would also allow hucksters to peddle unaudited penny stocks to gullible investors. Whether government should protect people from bad decisions is a question with implications far beyond accounting.


In China, Detecting Fraud Riskier Than Doing It

It can be very risky to do things in China that are taken for granted in other countries.

Kun Huang, a Chinese-born Canadian citizen, is back in Vancouver after spending two years in a Chinese jail. His crime was contributing to research that led his employer to recommend short sales of Silvercorp Metals, a silver producer that is based in Canada but does its mining in China.

Mr. Huang, now 37, returned to his native China in 2006 after graduating from the University of British Columbia with a degree in commerce. His parents immigrated to Vancouver in 1997, when he was 20 years old, and he became a Canadian citizen in 2002.

His job was to research Chinese companies, which were beginning to list on stock markets in the United States and Canada. He had been hired by Eos, a hedge fund run by Jon Carnes, a Canadian money manager, to “go through all the financial records in Chinese, talk to management and customers and suppliers,” he said in an interview.

Kun Huang, a Canadian citizen born in China, was arrested there after researching a Vancouver silver-mining company. Credit Kim Stallknecht for The New York Times

Mr. Huang had worked on some of those reports but had no run-ins with the Chinese authorities until 2011. In June of that year, he was asked to look into Silvercorp. He said he found that some Silvercorp reports to the Chinese government showed its mines were not doing as well as they were in reports that the company issued in Canada.

He sent associates to the Ying Mine, Silvercorp’s largest operation, in Henan Province, about 500 miles southwest of Beijing. They filmed trucks leaving the mine with ore and picked up samples of the ore that fell off trucks.

In September, an Alfred Little report questioned whether Silvercorp had exaggerated the mine’s production. It said the samples it had picked up had substantially less silver in each ton of rock than the company claimed and that the volume of truck traffic was too light to account for all the ore Silvercorp said it had mined.

The company responded indignantly and demanded investigations into those who had attacked it.

Mr. Huang was arrested on Dec. 28 when he tried to fly to Hong Kong from Beijing. A police officer from Luoyang, the city closest to the mine, warned him that if he did not cooperate he could spend four or five years in jail. The officers questioning him took frequent calls — Mr. Huang says he believes they were from Silvercorp officials — and then demanded such information as “the password to the Eos mail server.”

Within a few days, Mr. Huang was released on bail, prohibited from leaving China. But that status ended abruptly in July 2012 after a column I wrote for The New York Times appeared, quoting Mr. Carnes as saying the Luoyang police “arrested, terrorized and forbid my researchers from communicating with me or performing any further research on Chinese companies.”

Mr. Huang was rearrested, he told me, with police officers making clear that action was “directly in retaliation” for the column. He spent the next two years in the Luoyang detention center, in a 300-square-foot cell that held as many as 34 other prisoners, according to a lawsuit Mr. Huang filed this month against Silvercorp in Vancouver.

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In September, The Globe and Mail of Toronto published a long article on Mr. Huang and Silvercorp, including statements Mr. Huang had made during an interview while he was out on bail. That made the police even angrier, Mr. Huang said in his lawsuit. He was required, according to the suit, “to scrub the sick bay using his bare hands.”

Mr. Huang told me the Luoyang detention center “is the most unbearable imprisonment in China.” He has not seen most Chinese jails, of course, but he said it was much worse than the Beijing detention center, the other one he has seen.

Finally, in June 2013, he was charged with criminal behavior and convicted in a one-day private trial in September. He was fined 500,000 renminbi, about $80,000, and sentenced to two years in prison. He was given credit for the time he was jailed after his second arrest and was released and deported in July.

What was his crime? An appeals court decision that rejected his appeal said he committed “the crime of impairing business credibility and product reputation,” according to a translation of the decision provided to me by Silvercorp. He was acquitted of the second charge, that of illegal use of spy equipment — the cameras that filmed the trucks leaving the mine. He had not been the one who bought the cameras or did the filming. Nor had he written the reports, although he did provide information for them.

The appeals court ruling sounds as if simply selling stocks short is a crime under Chinese law. “This court has determined that Huang Kun clearly knew that the purpose of gaining production information and pictures of the said Chinese enterprises, as requested by Carnes, was to short the stocks,” the judges wrote.

Silvercorp’s efforts to sue people involved in the reports in Canada and the United States have not been fruitful, but last December the British Columbia Securities Commission did file fraud charges against Mr. Carnes, saying that he published his original report in part because put options he had purchased on Silvercorp were about to expire.

It said he made millions of dollars on those options as a result of the report. Mr. Carnes denied the allegations, and a hearing is scheduled for this year.

A Silvercorp official declined to discuss the cases with me, and the police in Luoyang did not respond to calls and faxes seeking comment.

Meanwhile, business has declined at Silvercorp. Last year it said there was fraud at the Ying Mine, committed by contract miners who were paid by the ton of rocks they dug out. The company said the miners had mixed in refuse to get paid more. The amount of silver produced by Silvercorp fell from 5.6 million ounces in the 2012 fiscal year ended in March, to 4.9 million ounces in 2013 and 3.85 million ounces in 2014, according to Chris Thompson, an analyst at Raymond James in Canada. He said production of lead, zinc and gold also declined.

But the company said this month that results improved in the first quarter of the 2015 fiscal year, which ended in June, although silver sales were lower than they were in the period a year earlier.

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Continue reading the main story

The company’s stock price, which peaked at $15 in April 2011, was below $8 when the first report from Mr. Carnes was released. Now it is about $1.85. Part of that decline was caused by falling silver prices, but Silvercorp shares have underperformed those of other silver producers.

Mr. Huang is still working for Eos and says he still wants to be a stock analyst. “It is what I learned in school,” he said, adding that he believes he is good at it. He won’t be able to visit China while conducting his research.

China remains a closed society in some ways, too big for foreigners to ignore but with a language few of them can master. Many of the frauds that have come to light in recent years have involved lies that would have been obvious if documents filed with Chinese government agencies had been analyzed by underwriters, auditors and analysts involved with the companies. But China has shown more hostility to those who found the frauds than to those who committed them and has been reluctant to share information with investigators for the Securities and Exchange Commission.

Mr. Carnes says seven companies he identified as frauds have been delisted in the United States. The S.E.C. has filed fraud suits regarding three of the companies.

It may be that China’s government is especially resentful of those Chinese who returned after moving overseas, as Mr. Huang did. Early this month, Yu Yingzeng, a Chinese-born United States citizen, was convicted, with her husband, Peter Humphrey, of violating Chinese law in investigating a former employee of GlaxoSmithKline at the request of the pharmaceutical company. She was sentenced to two years in prison, the same sentence that Mr. Huang received.


China to Wall Street: The Side-Door Shuffle

IT was the hot new thing on Wall Street — one of those exotic investments that seem to promise untold riches for the lucky few.

And, like so many hot new things, it went cold fast.

Such was the fabulous stock-market flameout of a company called Rino International, an untested enterprise that, until recently, would have raised nary an eyebrow in the United States.

But over the last few years, Rino International and scores of other young Chinese companies slipped into the United States stock market through the back door. Rino’s American stockholders later lost hundreds of millions of dollars when accusations surfaced that the company had fudged its books. All told, investors’ losses on these Chinese ventures have stretched into the billions.

How companies like Rino wormed their way into the temples of American capitalism is a story for these financial times. Even amid the wreckage of the 2007-8 financial collapse, an ecosystem of Wall Street enablers — bankers, lawyers, entrepreneurs, auditors — spirited Chinese companies to the United States. With some deft financial maneuvers, these businesses essentially went public while sidestepping the usual rules. Before long, many were trading on the Nasdaq stock market, alongside the likes of Google.

It was all perfectly legal. With bankers’ help, the Chinese companies executed what are known as reverse mergers. They bought American companies that were merely shells and assumed those companies’ stock tickers — sort of the Wall Street equivalent of “Invasion of the Body Snatchers.” The strategy let them avoid reviews with state and federal regulators that are normally required for initial public stock offerings.

At issue now is who should bear responsibility for the bursting of yet another Wall Street bubble. Should it be the Chinese executives and their bankers, who engineered the deals and celebrated these companies? Or should it be the investors, who bought these stocks when, in hindsight, the risks seemed clear enough? The lawsuits are flying.

Next to Bernard L. Madoff and the sins of the subprime era, the supposed shenanigans of a few Chinese companies might seem like small beer. But the developments underscore fundamental questions that came to the fore in the financial crisis: What do the people who create and sell investments owe to those who buy the investments? And where, if anywhere, are the regulators?

Dozens of Chinese companies that, like Rino, entered the United States market via reverse mergers have since been accused of fraud or shoddy accounting. The shares of at least 19 of them have been suspended or delisted by Nasdaq, wiping out billions of dollars in stock market value. Shares of Rino, which were flying high at $35 in 2009, have been removed from the exchange.

Laurence M. Rosen, whose law firm has filed a class-action suit against Rino International, says Rino’s bankers failed investors. Wall Street didn’t do its homework, he says.

“This is egregious,” Mr. Rosen says. “They said they did due diligence but were fooled — but they weren’t doing any solid due diligence.”

Rino has been accused of creating phony business contracts and wildly inflating its sales, among other things. Executives at Rino International, which is based here in Dalian and makes industrial pollution control systems, declined to comment, beyond saying that it is conducting business as usual.

THERE is not much to see outside the headquarters of Rino International here. The company resides in a bland corporate park that is home to a number of other Chinese businesses. A guard stands watch at the gated entrance. Inside, workers load steel beams onto trucks. The bang and hum of factory work rises from workshops.

Dalian, a seaport city in northeastern China with a population of about six million, in recent years has developed into a fast-growing hub of machine manufacturing, petrochemicals, oil refining and electronics. Driving this growth have been companies like Rino, whose name means “green promise” in Chinese.

For international investors, Rino was an alluring equation: “China” plus “environment” equals profit. Like many other Chinese companies, Rino faced obstacles in borrowing money from the state-owned banks that dominate the country’s economic life. It also confronted hurdles in going public on stock markets in Shanghai or Shenzhen, where share prices have gyrated wildly.


Rino’s Reverse Merger


And so the entrepreneurs behind Rino — Zou Dejun and his wife, Qiu Jianping — turned to Wall Street.

The matchmaker in this transcontinental deal was an American, Chris Bickel, who earned handsome finder’s fees for bringing Chinese companies to the attention of investment bankers and lawyers back in New York. Working from China with a small New York financial advisory firm, Douglas Financial, Mr. Bickel helped package Rino International for its Wall Street debut.

“We determined at the time that this was a significant market and they had the technology,” Mr. Bickel recalls, adding that any possible improprieties arose later.

As part of the plan, Rino got new handlers in New York: a law firm, an investor relations firm, a new auditor. To complete the package, the company named as its chief financial officer Bruce Richardson, an American businessman who had spent more than a decade in Shanghai. Mr. Richardson declined to comment.

To gain entry to an American stock market without an I.P.O., Rino needed to find an American shell. Enter Glenn A. Little, a Texas entrepreneur who specialized in buying up defunct companies and selling them in reverse mergers.

In 2002, Mr. Little paid about $100,000 to buy Jade Mountain, a failed medical devices company that had once been publicly traded. Jade Mountain, based in Nevada, had no business operations, no debt, no liabilities. What it had was a current stock registration.

Mr. Little himself was so enamored with Rino that rather than take payment in cash, he asked for shares in Rino. The bankers’ pitch seemed irresistible, he recalls, all the more because several big institutions, including Bank of America, were investing in Rino, too.

“They gave me a book and it had the two most exciting words you could hear: ‘China’ and ‘pollution,’ ” Mr. Little says. “They had audited financials, big-name lawyers and Bank of America.”

In October 2007, soon after Rino acquired Jade Mountain, Bank of America and about a dozen other investors, including Alder Capital, a hedge fund, bought Rino shares in what is known as a private placement. That sale raised $25 million. Before long, Rino stock was trading on the over-the-counter market for about $4.50 a share.

Over the next several years, Rino reported ever-higher quarterly profits. It expanded its business and its product line. Word spread on Wall Street: Rino was a company to watch.

David N. Feldman, a New York lawyer and the author of “Reverse Mergers and Other Alternatives to Traditional I.P.O.’s,” says that such reverse mergers reflected a confluence of two powerful forces. One the one hand, Chinese companies were desperate to raise capital. On the other, American investors were desperate to tap into China’s fast-growing economy. “A lot of this is about access to capital,” Mr. Feldman says.

Founded in 2002, Rodman has carved a niche for itself as the Goldman Sachs of private placements — sales of new stocks or bonds that circumvent the public markets. The hurdles for these private sales are lower than for public offerings, the theory being that the buyers — large, supposedly sophisticated investors — can do their own homework.

Like many investors, Rodman smelled opportunity in China, and in 2009, when Rino wanted to raise more money in the United States, the bank gave the Chinese company a prominent place at its gala. The presentation served as Rino’s splashy debut before thousands of investors.

A few months later, Rodman helped Rino raise $100 million in a deal that valued the Chinese company at nearly $1 billion. From there, however, Rino’s stock price began to decline. In November 2010, it fell off a cliff.

That month, Muddy Waters Research, a firm that has grabbed Wall Street attention by digging up dirt on Chinese companies, released a scathing report on Rino. It said Rino had vastly overstated its revenue, fabricated contracts and diverted tens of millions of dollars to its own executives.

Rino later owned up to some of the findings and cautioned that its financial statements from 2008, 2009 and early 2010 “should no longer be relied upon.” Eventually, the S.E.C. suspended trading in its stock.

Representatives of Rodman & Renshaw, which itself went public by assuming the ticker of a defunct company, declined to comment.

WHEN it comes to China, the question on many investors’ minds is how fast its economy can keep growing. Beijing has been trying to head off a new surge in inflation.

Back in the United States, there has been an explosion of class-action lawsuits, many of which are aimed at auditors and investment banks that brought Chinese companies to American markets. Everyone is pointing fingers at everyone else: lawyers are blaming the bankers, and the bankers are blaming the auditors, and the auditors are blaming executives in China.

Fanning the flames is an army of private investigators, bloggers and Wall Street short-sellers that hope to profit from the stock-market implosions, like Muddy Waters. In the aftermath of the China meltdown, reverse mergers have slowed sharply, and the Securities and Exchange Commission has warned investors of risks associated with such deals. S.E.C. officials met Chinese regulators two weeks ago in Beijing to discuss auditing rules for such companies.

Chinese regulators are worried. “I hate these scandals; everybody hates them,” Liu Qingsong, deputy director of the research center of the China Securities Regulatory Commission, said this month at a conference in Singapore, as reported by Reuters. “The scandals are very damaging to the reputation of all Chinese companies in the U.S.” Yet, for many, China seems irresistible, with money to be made and, invariably, lost. Since 1990, the benchmark stock index on the Shanghai exchange has soared 27-fold, despite a crash in 2008 and a lot of ups and downs in between.

One question that won’t go away is whether investors can really trust the numbers in China. Even investors like John A. Paulson, the hedge fund manager who made a killing on the subprime collapse, have lost big in China.

Michael Licosati, a founder of Alder Capital, bought shares in Rino. Today, convinced that fraud is rampant in China, he is betting against such stocks.

“You cannot compare the capitalist system in the U.S. with the capitalist system in China,” he says. Bank of America, another early Rino investor, declined to comment.

In Dalian, Ms. Qiu, Rino’s chairwoman and the wife of its C.E.O., says only that it is business as usual at the company. “What I can tell you is that our company is doing well and the operation has been very normal,” she says.

Inside the gated compound, workers in tarred jerseys and goggles weld and drive screws. Back in New York, Rino’s shares are frozen at 40 cents.


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