Struggling to see the wood for the trees

Mounting losses for American investors in Chinese companies have prompted claims of fraud. Stephen Foley reports

Regulators in North America are trying to clean up the auditing of Chinese companies that list on their stock markets, after a string of scandals that have left Western investors – from retail traders to famed hedge fund managers – nursing huge losses.

In the latest and most spectacular blow-up, the chief executive of theChinese forestry company Sino-Forest quit after being accused of fraud by Canada's Ontario Securities Commission (OSC).

Meanwhile, shares in dozens of smaller companies remain suspended as the US Securities andExchange Commission pursuesinvestigations of their auditing practices, and the stock prices of those that remain keep plunging because investors fear the next revelations. The parade of dreadful headlines threatens to undermine Chinese companies' attempts to tap developed world markets and to sour Western investors' love affair with the world's second largest economy.

Allen Chan, a popular Hong Kong newspaper columnist who turned himself into a forestry company boss when he set up Sino-Forest in 1994, submitted his resignation on Sunday night, just as the company's independent directors placed three other executives on administrative leave.

The development heaps further potential embarrassment on the Western investors and business leaders who have supported Sino-Forest. They include the hedge fund legend John Paulson, who lost around $500m before selling out of the plunging shares, and Simon Murray, the British adventurer and serial executive who currently chairs Glencore and who is a non-executive at Sino-Forest.

The OSC demanded resignations after ruling that the company's bosses appeared to be engaging in "acts they know or reasonably ought to know perpetuate a fraud", although the regulator also admitted it did not have the power to force them out.

A board committee has beenexamining allegations of fraud since June, when a swashbuckling hedge fund manager called Carson Block published a research note alleging that the company has been lying about the size of the forest land it actually owns in China and fiddling its revenues numbers too. Both the company and Mr Chan have been denying the accusations.

Sino-Forest was worth about C$4.7bn (£2.9bn) before doubts emerged, and was one of the most popular stocks trading in Canada and in the over-the-counter market in the US. When trading was suspended by the OSC last Friday, it had fallen to just C$700m.

The company manages tree plantations in China, and sells logs, standing timber and manufactured engineered-wood products. It has more than 150 subsidiaries and owns a majority stake in Greenheart, a Hong Kong-traded company involved in logging with assets in Suriname and New Zealand, whose shares were also suspended yesterday.

Mr Block's fund is called Muddy Waters Research. "The Chinese have an old proverb, muddy waters make it easy to catch fish," it explains. "In other words, opacity creates opportunities to make money. This way of thinking has been part of Chinese culture for centuries. Western investors and their regulatory systems are inherently unprepared for muddy waters environments. Moreover, Harvard-educated Chinese analysts based in New York usually have little more in common with Chinese company managers than you do. As a result, many sub-par Chinese companies find ways to game the system and trade at inflated values."

It is an insight to which otherinvestors, and now regulators, are waking up. More than 40 Chinese companies listed in the US haveeither had their shares suspended or seen them tumble sharply after disclosing the resignation of their auditors or other accounting questions.

The SEC is particularly concerned about companies which arrived on US exchanges via reverse takeovers, the practice where a pre-listed shell company buys the Chinese firm so that the firm bypasses the expense and the scrutiny of publishing a prospectus and offering sharesdirectly to investors.

For the past few months,enforcement officers at the US regulator have been examining the small US audit firms that certify thesereverse takeover company accounts, and the regulator has also been lobbying for new access to Chinese audit offices, so it can assess whether the quality of their work is up to US standards. There are also expected to be new rules to make such takeovers harder.

Meanwhile, the bad headlines keep coming, and august US investors keep getting burnt. CV Starr, the investment vehicle of the former AIG boss Hank Greenberg, was a top 10 shareholder in China MediaExpress, a reverse takeover company that provided advertising for the sides of Chinese buses, whose shares were suspended following the resignation of its chief financial officer and audit firm, Deloitte Touche Tohmatsu.

And earlier this month, Nasdaq called a halt to trading in SinoTech Energy, a Beijing-headquartered oil services company, pending answers to some of the exchange's concerns.

Chinese investors' losses prompt protests

It is not just Western investors at risk of losing their shirts in the mania for Chinese stocks on North American markets. In China, too, growing numbers of small investors have been drawn to companies that promise to strike it rich with a flotation in the US – and examples of disappointment and fraud arepiling up and provoking street protests.

A wheelchair-bound retiree called Lu Yafang has become a folk-hero to these investors, after organising a string of protests in Shanghai aimed at getting more than 1,000 supporters their money back. She first became an activist after investing her and her sister's money in a Shaanxi drugmaker in 2005 when she was approached by a stock promoter who suggested it would soon be listed in the US. "We weren't cheated by an individual, it was an organised scheme," Ms Lu told reporters at one protest in June, as she handed out leaflets that said: "Made our money with toil and ready to die to get it back."

There are around 400 Chinese companies which have listed in North America via reverse takeovers by pre-listed shell companies, but many others promising such deals do not make it.