2nd UPDATE: SEC's Aguilar Sounds Alarm On Backdoor Mergers

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The U.S. Securities and Exchange Commission is investigating the "disturbing trend" of Chinese and other companies registered through backdoor mergers with dormant shell companies, an SEC commissioner said Monday, confirming recent reports about the inquiry.

In prepared remarks at an investors conference, Luis Aguilar said the inquiry comes amid increasing concerns about the proliferation of small private companies that elect to merge with public shell companies in lieu of more rigorous methods of becoming public, such as a traditional initial public offering.

"While the vast majority of these companies may be legitimate businesses, a growing number of them have accounting deficiencies or are outright vessels of fraud," Aguilar said at a Council of Institutional Investors conference here.

Since January 2007, there have been 600 backdoor registrations, with more than 150 from in and around China, Aguilar said.

Aguilar noted that two companies, the jewelry manufacturer Fuqi International and the equipment maker RINO International, were once highly ranked by Investors Business Daily as top investments. But Fuqi had to restate its earnings and was delisted last week while RINO admitted that at least two of its manufacturing contracts didn't exist, Aguilar said.

He also noted that the SEC on Friday suspended trading in another Chinese company, China Changjiang Mining & New Energy Co., that became public in the U.S. through a Nevada-based shell.

In addition, Nasdaq and the American Stock Exchange have recently suspending trading in a number of these companies, he said. The SEC's enforcement and corporation-finance divisions have established a task force to conduct a wide- scale investigation into how networks of U.S. accountants, lawyers and bankers have helped bring scores of Chinese companies onto the U.S. stock markets, people familiar with the situation have said.

Aguilar acknowledged the task force in his remarks, saying it has already produced results and would continue to do so. The use of backdoor mergers by Chinese companies has raised at least two issues, Aguilar said.

First, he noted that there appears to be "systematic concerns" with the quality of the auditing of the firm's financial reporting. Citing a study by the Public Company Accounting Oversight Board, Aguilar said many U.S. accounting firms appeared to signing off on accounting opinions based solely on work performed by Chinese audit companies, without independent work to ensure the Chinese information is reliable.

Secondly, even though these foreign companies are registered in the U.S., Aguilar warned there are limitations on the ability of regulators to enforce the securities laws and for investors to recover losses tied to fraudulent disclosures.

PCAOB Chairman James Doty, who also spoke at the conference, said there are " significant risks" associated with audits of operations of U.S. companies in China, which fail to adhere to "even simple audit maxims."

"If Chinese companies want to attract U.S. capital for the long term, and if Chinese auditors want to garner the respect of investors, they need the credibility that comes from being part of a joint inspection process that includes the U.S. and other similarly constituted regulatory regimes," Doty said. "In light of these risks, the PCAOB's inability to inspect the work of registered firms from China is a gaping hole in investor protection."

Concerns about backdoor IPOs come as lawmakers worry it is increasingly difficult for small businesses to raise capital.

A bill introduced last month by Rep. David Schweikert (R., Ariz.) aims to assist small businesses in raising money by authorizing the SEC to increase an existing exemption for small securities transactions that can be offered to the public with simpler filings and without audited financial statements.

The cap would be raised to deals of up to $50 million, from $5 million.

"Many companies, especially those in the high-tech sector, require more capital upfront to make their ventures successful," Schweikert said in a statement. "At a time when so many small businesses are in need of capital, this is a commonsense proposal that will make our capital markets more vibrant and competitive."

But opponents warn the measure would only encourage securities fraud. At a hearing on the bill last week, Damon Silvers, policy director and special counsel to the AFL-CIO, quipped that the bill ought to be called "The Promote Penny Stock Fraud Act."

-By Andrew Ackerman, Dow Jones Newswires; 202-569-8390; andrew.ackerman@ dowjones.com

(END) Dow Jones Newswires

04-04-111530ET

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