Monday, November 29, 2010

The Farce of Small U.S. Auditors in China

By Eric Jackson
RealMoney Contributor

11/29/2010 2:30 PM EST
Click here for more stories by Eric Jackson

Over the last two weeks, a huge drama has been playing out with a small-cap China stock called RINO International (RINO - commentary - Trade Now). The wastewater filtration equipment provider to the Chinese steel industry was accused by Muddy Waters LLC of fraud earlier this month. RINO said nothing in response, dragged its feet and then released the following baffling 8-K last week:

On November 17, 2010 Frazer Frost, LLP, the independent auditors of RINO International Corporation (the "Registrant"), delivered a letter (the "Auditor's Letter") to the Registrant and each of its directors. The Auditor's Letter states in part:

In a telephone conversation on November 16, 2010, Mr. Zou Dejun, the Chief Executive Officer of the Company, informed Ms. Susan Woo of our firm, in substance, that as to the six RINO customer contracts discussed in the recent report of Muddy Waters LLC, the Company did not in fact enter into two of the six purported contracts, and a third contract among the six was explainable. When Ms. Woo inquired about the Company's other contracts, Mr. Zou said he was not sure, but there might be problems with 20 - 40% of them. Assuming that these statements were reasonably accurate, it appears that our reports would have been affected if this information had been known to us at the date of our reports, although the effect on the financial statements is currently unknown and cannot be quantified without a thorough investigation. We further note that in a conversation the following day, November 17, 2010, involving Ms. Woo, several directors of the Company, Company counsel, and Mr. Zou, Mr. Zou stated that he was not sure the day before and went back to look into some things, and found that apart from the two problematic contracts, all other contracts are legitimate and can be verified.

The auditing standards of the Public Company Accounting Oversight Board provide procedures to be followed by an auditor to prevent continued reliance on audit reports in such circumstances. In view of the information provided by Mr. Zou Dejun, we hereby advise the Company to promptly notify any person or entity that is known to be relying upon or is likely to rely upon our audit report(s) for the periods ended December 31, 2008 and December 31, 2009 and reviewed quarterly financial statements for periods between March 31, 2008 to September 30, 2010 that they should no longer be relied upon, and that revised financial statements and revised auditor's report(s) will be issued upon completion of an investigation.

Obviously, RINO's management deserves condemnation and criticism. Hopefully, the rapid disintegration of a company that came into this month with a market capitalization of nearly half a billion dollars will serve as a cautionary tale to other Chinese small-caps that think they can pull one over on U.S. investors with the help of complicit U.S. pre-IPO investors, law firms, auditors and IR firms.

As you might expect, since the RINO scandal unraveled (the stock has now been halted for a week, and there's no word on when the Nasdaq will see it resume trading), many investors have paid attention to RINO's auditor, Frazer Frost. Citron Research published a great post yesterday titled "Dude, Where's My Auditor? The Curious Case of Frazer Frost," outlining the many questions surrounding what this firm actually did as an auditor to deserve its fee.

In my experience meeting with China-based, U.S.-listed companies and investors, Frazer Frost is a very lax audit firm. As many people have pointed out, since RINO admitted fabricating customers, Frazer Frost announced it would not proceed with its previously announced merger with another audit firm called Moore Stephens Wurth Frazer & Torbet. If anyone thinks this is a coincidence, I have some swampland in Florida to sell you. I fully expect there are more bodies buried under the offices of both these firms and others like them.

Some investors, in RINO's wake, have speculated that Frazer Frost's other clients, such as Harbin Electric(HRBN - commentary - Trade Now), Fushi Copperweld (FSIN - commentary - Trade Now) and China Valves (CVVT - commentary - Trade Now), are good possible shorts. "If Frazer signed off on one fraud, why not another?" the thinking goes.

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