FTI: Scaling the Great Wall of Accounting issues in chinese reverse mergers

Scaling the Great Wall of Accounting Issues
in Chinese Reverse Mergers
By John J. Huber and Jennifer A. Hull∗
December 5, 2011
∗
John J. Huber is a Senior Managing Director and Jennifer A. Hull is a Senior Director in the Forensic and Litigation Consulting
practice of FTI Consulting, Inc. in Washington, DC. The views expressed herein are those of the authors and do not necessarily
represent the view of FTI Consulting, Inc. or its other professionals. Copyright for this article is retained by FTI Consulting, Inc.

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I. Introduction
In a speech to the Institutional Investor Conference in Washington on April 4, 2011,
Commissioner Luis Aguilar focused public attention on what has become known as Chinese reverse
mergers.1
The term “Chinese reverse merger”2
describes a Chinese private operating company being
acquired in a merger with a shell company3
which is publicly traded in the United States, typically over
the counter in the Pink Sheets.4
Even though the Chinese company merges with and into the public shell
company, there is a change of control of the shell. The shareholders and management of the Chinese
company gain voting and operating control, take over the board of directors and management and acquire
“a large majority of the shares”5
of the shell company.
Typically, the merger is not the subject of a Form S-4 registration statement filed at the SEC
under the Securities Act of 1933 (the “Securities Act”). So, nothing has to be declared effective by the
staff of the Division of Corporation Finance (the “Staff”) before the merger is consummated. Rather, the
completed merger is reported on a Form 8-K under the Exchange Act.6
Thus, the Staff is unable to stop
the merger.7
Since a vote in favor of the merger is a foregone conclusion at both the Chinese and shell
company levels, the merger is consummated and the Chinese company, the acquirer for accounting
purposes, becomes a reporting company under the Exchange Act.8
Although public attention may only have been raised this spring, Chinese reverse mergers have
been occurring with some frequency since the early 2000’s.9
The financial crisis of 2008 and the Great
Recession which followed did not adversely affect the trend of Chinese companies going public through
reverse mergers with public shells in the U.S. The underlying reasons for the estimated 15910
Chinese
reverse mergers occurring from 2007 to March 2010 may be traced to:
1
Speech by Commissioner Luis A. Aguilar of the Securities and Exchange Commission (“SEC”), Facilitating Real Capital
Formation, at the Council of Institutional Investors Spring Meeting, Washington, D.C. (April 4, 2011) at
http://www.sec.gov/news/speech/2011/spch040411laa.htm.
2
Chinese reverse mergers and the company that survives the transaction are sometimes referred to herein as “CRMs.”
3
As described by the SEC in an Investor Bulletin on reverse mergers, a “shell company” is “a public reporting company with few
or no operations.” Office of Investor Education and Advocacy, SEC, Investor Bulletin: Reverse Mergers, (June 2011) at
http://www.sec.gov/investor/alerts/reversemergers.pdf (hereinafter “SEC Investor Bulletin”). Rule 12b-2 under the Securities
Exchange Act of 1934 (the “Exchange Act”) defines a shell company as a registrant with no or nominal operations and either: no
or nominal assets; assets consisting of cash or cash equivalents; or assets consisting of any amount of cash, cash equivalents and
nominal other assets. See also Release No. 33-8587 (July 15, 2005) http://www.sec.gov/rules/final/33-8587.pdf.
4
Office of Research and Analysis, Public Company Accounting Oversight Board, (“PCAOB”) “Activity Summary and Audit
Implications for Reverse Mergers Involving Companies from the China Region: January 1, 2007 through March 31, 2010,
footnote 1 at 1, Research Note #2011-PI (Mar. 14, 2011) at
http://pcaobus.org/Research/Documents/Chinese_Reverse_Merger_Research_Note.pdf (hereinafter “PCAOB Research Note”).
5
SEC Investor Bulletin at 1.
6
Item 5.06 of Form 8-K requires disclosure of the material terms of a completed transaction that has the effect of causing the
shell company to cease being a shell company as defined in Rule 12b-2. Meredith Cross, Director of the SEC’s Division of
Corporation Finance, stated that the Staff is reviewing all of these Forms 8-K. “Court Denies Motion to Dismiss Lawsuit Against
PRC-Based Reverse Merger Company” Sec. Reg. & L. Rep., Vol. 43, No. 34, at 1765 (Aug. 22, 2011).
7
According to Meredith Cross, “We don’t have a way to say ‘you can’t do reverse mergers.’ . . . Because the issue of whether
someone can merge is not an SEC question, but a matter of state law, it’s not something where we could just wave a magic wand
and say, ‘we’re not going to let reverse mergers happen anymore.’” Remarks of Meredith Cross reported in “Where was SEC as
trouble festered at Chinese companies?” Reuters, (July 10, 2011) at
http://www.reuters.com/article/2011/07/10/us-china-accounting-enforcement-idUSTRE7692I820110710
8
PCAOB Research Note at 1, footnote 1.
9
While the reported number of CRMs differ depending on the time period measured and source, the Washington Post found
more than 300 CRMs since 2004. Steven Mufson, “How this guy knocked down a $150 million Chinese company with one
blow,” Washington Post at G1 (Aug. 28, 2011) (hereinafter “Post Article”).
10
PCAOB Research Note at 1.

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• the world focus on BRIC countries (Brazil, Russia, India and China) as the engines of growth, as
demonstrated by the percentage increase in China’s GDP far outpacing that of the U.S.;11
• historically low interest rates pushing investors into equities, particularly of BRIC countries, in
search of higher returns on investment;
• investment banks requiring more due diligence to underwrite a traditional IPO causing
management of certain Chinese companies to search for a quicker, cheaper and less restrictive
alternative;12
• Chinese companies being audited by:
o small U.S. accounting firms with limited resources that were not always able to comply
with applicable accounting or auditing standards or to perform sufficient due diligence
and basing their audit opinion on the work of another firm in China or using Chinese
assistants outside the firm13
or
o Chinese accounting firms which may be registered with the PCAOB, but which may not
be familiar with accounting and auditing principles for SEC registrants;14
and
• management of Chinese companies selling restricted securities acquired in the reverse merger via
Rule 144 under the Securities Act into the U.S. trading market or engaging in follow-on
secondary public offerings resulting in receiving substantial profits from the increase in shell
stock prices caused by the “buzz” in the marketplace of a shell company acquiring a Chinese
operating company.
The technique of going public through a shell is not new,15
is still being used and is not limited to
Chinese companies.16
In fact, it has long been the case that such transactions were viewed with suspicion
by regulators and investors alike. Often, the shell company had a checkered track record or had
undisclosed liabilities resulting in it being referred to as a “dirty shell.” Often, the company merging into
the shell had tried to go public through a traditional IPO only to fail and pursue a reverse merger as an
alternative. In the past, the reasons for not being able to conduct a traditional IPO ranged from legitimate
issues, such as cost and timing, to more questionable reasons, such as concerns about experience or
integrity of management, accounting irregularities, not fulfilling the business plan and puffery about
future prospects. While these reasons may or may not be present in today’s reverse mergers, there is a
significant difference -- this new wave of reverse mergers is about China!
11
China’s annual GDP growth rate at September 30, 2011 was 9.1% compared to 1.5% for the U.S. for the same period. Trading
Economics estimates that the Chinese economy will be bigger than the U.S. economy around 2050. Trading Economics at
http://www.tradingeconomics.com/gdp-growth-rates-list-by-country.
12
SEC Investor Bulletin at 1.
13
PCAOB, Staff Audit Practice Alert No. 6, Auditor Considerations Regarding Using the Work of Other Auditors and Engaging
Assistants From Outside the Firm, (July 12, 2010) (hereinafter “Alert No. 6”) at http://pcaobus.org/Standards/QandA/2010-07-
12_APA_6.pdf. Small audit firms are only inspected by the PCAOB once every three years.
14
There are 110 auditing firms in China and Hong Kong that are registered at the PCAOB. PCAOB Announces Some Progress
in Impasse Over Audit Oversight in China, Sec. Reg. & L. Rep., Vol. 43, No. 33, 1720 (Aug. 15, 2011). U.S. registered firms
audited 74% of the Chinese reverse merger companies with the remainder being audited by Chinese and Hong Kong registered
firms. PCAOB Research Note at 1.
15
Reverse mergers have been traced to the mining boom in Colorado in the 1950’s. Nanette Bynes and Lynnley Browning,
“Special Report: China’s Shortcut to Wall Street” reported by Reuters (Aug. 1, 2011) at
http://www.reuters.com/article/2011/08/01/us-shell-china-idUSTRE7702S520110801 (hereinafter “Reuters Report”).
16
See, e.g., Green Star Energies, Inc., trading on the Pink Sheets, announced a reverse merger with Questus Energy LLC, a
privately held oil and gas company in Texas. “Green Star Energies Enters Into an Agreement for a Reverse Merger with Questus
Energy, LLC,” Marketwire (August 22, 2011) at http://www.marketwire.com/press-release/green-star-energies-enters-into-
agreement-reverse-merger-with-questus-energy-llc-pinksheets-gsre-1552027.htm. This announcement followed a press release
by Green Star on April 18, 2011 that it will not timely file its 2010 Annual Report on Form 10-K and another press release on
July 5, 2011 that Green Star engaged a new audit firm. See, generally, Green Star website at www.greenstarenergies.com.

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Market prices initially rose after completion of the reverse mergers. Market declines occurred17
after issues were raised by: short sellers research reports; auditor resignations;18
concerns voiced by U.S.
creditors,19
hedge funds20
and investors, such as John Paulson and Maurice “Hank” Greenberg, resulting
in litigation; and regulatory action, such as delisting of securities on exchanges.21
While these events
could occur individually, they typically occur in combination.
While the SEC, PCAOB, U.S. exchanges and Canadian regulators and exchanges22
have taken
actions, and private plaintiffs have filed lawsuits in the U.S. and Canada, the SEC’s equivalent in China,
the China Securities Regulatory Commission (“CSRC”) has not taken enforcement action to date.23
Perhaps the lack of action in the home country is due to: the primary trading market for these companies
17
The aggregate market capitalization of 122 CRMs is reported to have declined by $18 billion from their respective market
highs to July 10, 2011. The Reuters Report. “Hundreds of stocks that were never attacked by short-sellers have fallen in
sympathy.” Alfred Little, “Short and Sweet” China Economic Review (June 1, 2011) at
http://newcer.chinaeconomicreview.com/en/content/short-and-sweet. The Washington Post has estimated the market
capitalization of “small-to-medium-size Chinese companies listed on U.S. exchanges” as being about $20 billion. Post Article at
1. Presumably, this includes CRMs and non-CRMs.
18
In a two month period in 2011, 24 companies doing business in China (which includes both CRMs and non-CRMs) reported
auditor resignations. See Press Release from Senator Charles E. Schumer, “Schumer to U.S. Audit Watchdog: To Protect U.S.
Investors, Bar Chinese Accounting Firms That Resist Oversight” (Nov. 22, 2011) setting forth the letter from Senator Charles E.
Schumer to the Honorable James R. Doty, Chairman, PCAOB (hereinafter the “Schumer Letter”).
19
For example, after ShengdaTech, Inc. (“ShengdaTech”) missed an interest payment on outstanding bonds, the principal amount
was accelerated under the terms of the bond indenture. Lazard pursued the company for repayment causing ShengdaTech to file
for bankruptcy. The missed interest payment followed the resignation of KPMG LLP (“KPMG”) after the auditor was unable to
opine on the company’s 2010 financial statements due to “serious discrepancies regarding bank balances” and “unexplained
issues” in the company’s books. Naomi Ravnick and Daniel Ren, “Lazard chases debt as ShengdaTech files for bankruptcy in
US,” Business, page 1, South China Morning Post (Aug. 22, 2011). http://topics.scmp.com/news/china-business-
watch/article/Lazard-chases-debt-as-ShengdaTech-files-for-bankruptcy-in-US (hereinafter “China Morning News”). In June
2011, the company’s common stock was delisted from the NASDAQ Global Market. In August 2011, the NASDAQ Listing and
Hearing Review Council affirmed the delisting decision by the NASDAQ Listing Qualification Panel, “ShengdaTech Receives
NASDAQ Listing and Review Council Decision,” PR Newswire (Aug. 26, 2011).
20
An example is Kerrisdale Capital, a $20 million hedge fund run by a 2003 Yale graduate, Sahm Adrangi, who: applied the age
old adage of common sense investing – “if it’s too good to be true, it probably isn’t true” and concluded that the numbers
reported at the SEC “didn’t add up.” According to Mr. Adrangi, “[M]ost of these companies are making something, but they’re
just overstating their numbers.” Post Article at 5; hired researchers to visit plants, stores and other facilities of Chinese
companies, make observations, take pictures, make videos, compare the results to the disclosure in the CRM’s reports filed with
the SEC; compared the results described by the CRM at the SEC with what the CRM, or its operating company, reported to the
Chinese State Administration of Industry and Commerce (the “SAIC”); and compared reported results of the CRM to the results
of comparable companies in the same industry. Kerrisdale Capital has been so successful that in the second quarter of 2011 it
“returned 54 percent (before fees) against 0.1 percent for the S&P 500.” Id. Starting with China Education Alliance, Inc.,
Kerrisdale Capital found, researched and sold short, at least four other CRMs: China Biotics, Inc.; China Marine Food Group
Ltd.; ChinaMedia Express Holdings, Inc.; and RINO International Corporation (“RINO”) since 2009. Id.
21
See, e.g., “SEC probe of U.S.-listed Chinese firms hits Great Wall,” Petroleum News Vol. 05, No. 28 (July 14, 2011) at
http://www.petroleumnews.com/mnarch/05-28-4.html (hereinafter “Petroleum News”).
22
On August 26, 2011, the stock of Sino-Forest Corp. was suspended from trading on the Toronto Stock Exchange for 15 days
by the Ontario Securities Commission (“OSC”). In addition, the OSC ordered the resignations of five executive officers of Sino-
Forest including Mr. Alan Chan, Chairman of the Board and Chief Executive Officer, who misrepresented revenues and
exaggerated the timber holdings of the company. The OSC action followed a Muddy Waters LLC research report in June 2011,
the allegations of which were denied by the company. A report commissioned by an independent committee of the board to
review the allegations has been delayed “due to data collection challenges,” “Sino-Forest Officers Ordered to Resign,” Wall
Street Journal (Aug. 26, 2011). On August 28, 2011, Sino-Forest disclosed the resignation of Mr. Chan and the temporary
suspension of three employees of the company. See, e.g., “Sino-Forest CEO Gives Up Position,” Wall Street Journal (Aug. 29,
2011) and “Regulators blow whistle on reverse takeovers,” The Toronto Star at B1 (Aug. 30, 2011). On September 26, 2011,
two institutional investors, Northwest & Ethical Funds Investments LP and Comité Syndical National de Retraite Bâtirente Inc.
filed a class action lawsuit in Canada against Sino-Forest and also named two auditors and 15 underwriters as defendants. Drew
Hasselback, “Sino-Forest saga a winner for lawyers; Class-action suit will attract all the big guns,” Edmonton Journal (Alberta),
at C7 (Sept. 29, 2011).
23
Although the CSRC has stated it is working with the SEC on investigating CRMs, a senior U.S. diplomat has been quoted as
saying “[T]here has not really been a lot of co-operation.” China Morning News.

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being in the U.S.; the companies being incorporated outside China, either in the U.S. or elsewhere, such
as the Cayman Islands or the British Virgin Islands;24
and the companies not raising capital in China.
Consequently, the U.S. courts may be the focus of litigation concerning CRMs. Perhaps the lack of
action is also attributable to a difference in approach between Chinese and U.S. regulators.25
Chinese reverse mergers raise many issues for managements, directors, accounting firms and their
respective advisors as well as regulators, creditors and investors. Many of the same issues can to any
Chinese operating company or any company doing business in China, whether or not it was formed as the
result of a reverse merger26
. While due diligence applies to any capital raising or acquisition transaction,
the different culture, business practices and traditions in China can pose challenges. The rule of law, so
common and well-established in developed countries, is still only emerging. State secrets laws may
collide with transparency principles. Business practices can be affected by the Foreign Corrupt Practices
Act and piracy issues. Given the significance of family relationships and personal networks, corporate
governance may not differentiate between board membership and management. Corporate structures are
frequently complex and include related party transactions that are not readily identifiable or reported.
Assets, such as cash, inventories, contracts and/or receivables can be misstated either through
inadvertence, lax internal controls, or intentional wrongdoing. Therefore, Chinese operating companies,
including those formed by reverse mergers, require special skills and capabilities in conducting due
diligence, investigations and crisis management.
24
The Commerce Ministry of the Chinese government has announced that it is considering regulations that would affect the
structure of US-listed Chinese companies. Chinese law prevents or imposes severe restrictions on foreign ownership of Chinese
businesses. To comply with Chinese law, companies use a variable interest entity (“VIE”) structure in which an offshore holding
company, typically incorporated in the Cayman Islands, has contractual agreements with the Chinese operating company
resulting in the holding company having effective control over the Chinese operating company which runs the business and has
the licenses, permits, and business in China. Chinese management of the operating company is also the management of the
offshore holding company which is then able to sell securities to citizens outside China. After years of having the VIE structure
thread a regulatory needle between Chinese law and off-shore investors in Chinese companies, the Commerce Ministry has
determined that the VIE structure is not governed by any Chinese “law, regulation or policy.” Dinny McMahan and Owen
Fletcher, “China Studies Foreign IPOs,” Wall Street Journal. C3 (Sept. 21, 2011).
25
After meetings in Beijing in July between representatives of the SEC and PCAOB with representatives of the Ministry of
Finance (“MOF”) and the CSRC to reach a bilateral agreement for the PCAOB to conduct inspections of auditing firms in China,
(see PCAOB News Release, Statement on Delegation to China (July 6, 2011)), it appears that “the situation with China has hit
new bumps in the road.” Keynote Address of James R. Doty, Chairman, PCAOB, “A Fresh Look at Auditing,” to the National
Association of State Boards of Accountancy, (“NASBA”), p.8, (Oct. 24, 2011) at
http://pcaobus.org/News/Speech/Pages/10242011_DotyNASBA.aspx (hereinafter “Doty Keynote”). Instead of continuing the
meetings, the Chinese “put off” a meeting scheduled for October in Washington, D.C. Id. Progress at the PCAOB-CRSC level
may also be affected by macro-political issues between the United States and China, such as the yuan currency legislation
pending in Congress. He Ning, director-general of the Department of American & Oceanian Affairs with China’s Ministry of
Commerce has stated: “[I]f it eventually passes, and becomes law, we cannot ignore it and will definitely reciprocate in kind.”
Ding Qinfen, “US currency bill would see ‘retaliation,’” China Daily (November 2, 2011) at http://usa.chinadaily.com.cn. The
lack of movement in discussions between the PCAOB and Chinese authorities over the auditor inspection issue over a six year
period was noted by Senator Schumer in his letter to Chairman Doty. Schumer Letter at 3.
26
On September 2, 2011, Silvercorp Metals, Inc., a Canadian company traded on the Toronto Stock Exchange and the New York
Stock Exchange (“NYSE”), formed under the British Columbia Company Act and doing business in China, announced receipt of
an anonymous letter dated August 29, 2011, from a short-seller. The letter, addressed to the OSC, alleged accounting
irregularities and that the grade of the company’s silver deposits was “too good to be true.” More specifically, the letter stated
that the $66 million net profit Silvercorp reported to the SEC for 2010 exceeded the $0.5 million loss reported to the SAIC and
the company’s cash position was overstated. In response, Silvercorp issued a press release and documents including its SAIC
reports at http://wznj.saic.gov.cn, its bank records with the Bank of Montreal and other documents in an effort to refute the
allegations. The company also announced the formation of a “task force of independent directors” to “investigate and discover
the identity of the party behind these allegations.” “Silvercorp Notes Large Short Position in Stock and Receipt Of An
Anonymous Letter Attempting to Discredit The Company And Manipulate The Share Price,” (Sept. 2, 2011) at
http://silvercorpmetals.com/news/index.php?&content_id=304. On October 24, 2011, Silvercorp Metals, Inc., announced its
receipt of a “clean forensic accountants report.” http://silvercorpmetals.com/news/index.php?&content_id=324

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This outline first describes the regulatory response, from the SEC, PCAOB, and the self-
regulatory organizations (“SROs”), before discussing litigation, accounting and auditing issues and
concluding with Rules of the Road that apply to the publication of a research report sponsored by a short
seller concerning a CRM.
II. SEC and PCAOB Initiatives
A. The SEC has been investigating CRMs since at least the summer of 2010. Commissioner
Aguilar acknowledged an internal task force in his speech. Also in April 2011, Chairman Mary
Schapiro sent a letter to the U.S. House Committee on Oversight and Reform noting that the SEC
had launched a “proactive risk based inquiry” in the summer of 2010 into U.S. auditing firms that
have a significant client base of companies with their principal operations located outside the
U.S.27
1. Chairman Schapiro’s letter stated that at least 24 China-based companies have
filed reports on Form 8-K disclosing auditor resignations, accounting problems or both.28
2. The SEC Investor Bulletin described five companies with trading suspensions.29
3. The SEC has reportedly launched investigations into 17 CRMs.30
4. The SEC’s Division of Corporation Finance (“Corp Fin”) has published Staff
observations on the Form 8-Ks filed by CRMs.
31
The guidance describes common
comments given by Corp Fin’s review staff including:
a. The merger of a shell company with a Chinese company will trigger
Instruction 2 to Item 2.01 of Form 8-K, which defines “acquisition.” As such,
Item 2.01, Completion of Acquisition of Disposition of Assets and Item 5.01,
Changes in Control of Registrant of the Form 8-K require the former shell
company to include all the information that would be required by Form 10 in the
Form 8-K;
b. Item 9.01, Financial Statements and Exhibits, of Form 8-K requires up to
two years of audited financial statements and stub period unaudited for smaller
companies and up to three years of audited financial statements and stub period
unaudited of the acquired company as well as proforma financial information in
the initial Form 8-K; and
27
April 27, 2011 letter from the Hon. Mary L. Schapiro, SEC Chairman, to the Hon. Patrick T. McHenry, Chairman of the House
Committee on Oversight and Government Reform. http://s.wsj.net/public/resources/documents/BARRONS-SEC-050411.pdf.
28
Id, page 2.
29
SEC Investor Bulletin: 1. Heli Electronics Corp.; 2. China Changjiang Mining & New Energy Co.; 3. RINO; 4. HiEnergy
Technologies, Inc.; and 5. Digital Youth Network Corp.
30
See, http://sec.gov/litigation/admin.shtml: 1. China Sky One Medical; 2. Fuqi International; 3. RINO; 4. China Green
Agriculture; 5. Duoyuan Printing; 6. China Century Dragon; 7. China Intelligent Lighting & Electronics; 8. China Expert
Technology, Inc.; 9. China 9D Construction Group; 10. China Media1 Corp.; 11. China Digital Media Corporation; 12. China
Mineral Acquisition Corp.; 13. China Technology Global Corp.; 14. China Yuchai International Limited; 15. Greater China
Corp.; 16. China Continental, Inc.; and 17. China Energy Savings Technology, Inc. As shown by ShengdaTech receiving a
subpoena from the SEC on August 22, 2011, the list is growing. “ShengdaTech Wins Court Order Barring Management from
Obstructing Probe, RTT News (United States) (Aug. 25, 2011).
31
CF Disclosure Guidance: Topic No. 1 Staff Observations in the Review of Forms 8-K Filed to Report Reverse Mergers and
Similar Transactions (Sept. 14, 2011) at http://www.sec.gov/divisions/corpfin/guidance/cfguidance-topic1.htm.

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c. Staff comments on CRM Form 8-Ks that cite Form 10 are the same as
Staff comments on Form 10 for non-CRM filings. For example, Item 401(f) of
Regulation S-K which is included in Form 10 requires disclosure of events over a
ten year period. A Form 8-K of a CRM would also require a ten year disclosure
concerning compensation arrangements for directors and executive officers just
as they would for a Form 10 filing.
d. Where a company’s books and records are in U.S. GAAP, the Staff will
ask the company to describe its controls to ensure that the activities it conducts
and the transactions it consummates are recorded in GAAP. Where a company
does not keep its books and records in U.S. GAAP, the Staff will ask the
company to explain what it does to convert them to U.S. GAAP for SEC
reporting and to describe the controls it maintains to ensure that it made all
necessary and appropriate adjustments in that process.
e. With respect to the people who prepare the financial statements or are
involved in internal control over financial reporting (“ICFR”), Staff comments
can request disclosure of:
(1) the role each person takes in preparing the financial statements
and evaluating the effectiveness of internal control;
(2) the U.S. GAAP education and ongoing training for such people;
(3) the nature of each person’s contractual or other relationship with
the company;
(4) whether the people hold and maintain any professional
designations; and
(5) the person’s professional experience.
f. Where an accounting firm is retained to prepare the company’s financial
statements or design, monitor or evaluate ICFR, Staff comments can request
disclosure of:
(1) the name and location of the firm;
(2) the qualifications of the firm to prepare financial statements and
be involved in ICFR;
(3) the number of hours spent performing services for the company;
and
(4) how much the company has paid for those services.
g. With respect to audit committee financial experts, Staff comments can
request disclosure of:
(1) his or her qualifications, including the extent of his or her
knowledge of U.S. GAAP and internal control over financial reporting;

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(2) the extent of the audit committee’s U.S. GAAP knowledge,
where a company does not identify an audit committee financial expert;
and
(3) the extent of the board of directors’ knowledge of U.S. GAAP
and ICFR, where a company does not have a separately created audit
committee.
4. Senator Schumer has requested that the SEC “require up front disclosure by
public companies that use China-based audit firms . . . .32
B. The PCAOB’s Response
1. Alert No. 633
discussed audits of financial statements for issuers with
substantially all of their operations outside of the U.S. where factors, such as the
following, may have a negative impact on conducting the audits:
a. The need to understand the local language;
b. Use of the local audit firms or assistants from an outside firm to
complete a portion of the audit work;
c. Additional travel time and expense necessary to complete an audit; and
d. The need to understand the local business environment in which the
client operates.
2. The PCAOB Research Note applied Alert No. 6 to China. The PCAOB
reiterated its concern that some U.S. registered accounting firms may not be conducting
audits of companies with operations outside the U.S. in accordance with PCAOB
standards. Violations of audit standards may occur as a result of audits ineffectively
performed by another firm or by consultants. Specific concerns include:
a. The U.S. firm’s personnel do not travel to China during the audit;
b. Substantially all of the audit documentation is maintained by the firm in
China;
c. The U.S. auditor has inadequate information about the knowledge, skill
and ability of the outside consultants in China engaged by the U.S. auditor;
d. Whether the U.S. auditor is able to plan and supervise the work of the
outside consultants engaged by the U.S. auditor;
e. Whether the auditing procedures performed by the outside consultants in
combination with the auditor’s own work provides sufficient competent
evidential matter for an audit opinion;
f. Whether the outside consultants have the appropriate language skills; and
32
Schumer Letter at 3.
33
According to the Schumer Letter, “[T]he alert appears to have been prompted by the increasing number of companies based in
China and Hong Kong accessing U.S. markets via reverse mergers.” Id.

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g. Whether the auditor would have the ability to comply with the PCAOB’s
documentation requirements.34
3. In an effort to focus attention on “heightened fraud risk” in audits of “companies
based in certain large emerging markets in Asia,” the PCAOB published Staff Audit
Practice Alert No. 8.35
While not specifically focused on CRMs, Alert No. 8 appears to
focus primarily on companies with their principle place of business in the People’s
Republic of China (“PRC”). In addition to listing the conditions and situations that
indicate heightened fraud risk, which may also indicate illegal acts,36
Alert No. 8 gives
examples of how an auditor can understand the culture and environment in which the
company operates.37
In discussing the auditor’s response to fraud risks, Alert No. 8
focuses both on substance, such as auditing variable interest entities, as well as
procedure, such as an auditor’s responsibility for “local accountants” who participate in
the audit but who may be affiliates of or independent from the principal audit firm.38
4. This year the PCAOB announced one settled disciplinary action against an audit
firm, Chisholm, Bierwolf, Nilson & Morrill, LLC (“CBNM”) and two of its associated
persons for, improper audits of two Chinese reverse merger companies.39
The action is
an example of how the PCAOB applies Alert No. 6 and the PCAOB Research Note.
CBNM’s registration with the PCAOB was revoked and the individuals were barred from
being associated persons of a registered accounting firm. The Chisholm Order found
that:
a. CBNM’s audits of Hendrx Corp.’s (“Hendrx”) 2006 and 2007 financial
statements were inadequate.
(1) Audit field work occurred primarily at the issuer’s main
operating facility in China. The engagement partner, who does not speak
or understand Chinese, inappropriately relied on assistants with Chinese
language skills to identify audit issues, communicate with management
and third-parties, and analyze documents provided by the issuer.
34
PCAOB Research Note at 8; See also Auditing Standard No. 3 Audit Documentation at
http://pcaobus.org/Standards/Auditing/Pages/Auditing_Standard_3.aspx.
35
PCAOB, Staff Audit Practice Alert No. 8, Audit Risks in Certain Emerging Markets, (Oct. 3, 2011) (hereinafter “Alert No. 8”)
at http://pcaobus.org/Standards/QandA/2011-10-03_APA_8.pdf.
36
Among the 16 examples listed in Alert No. 8 are the following:
“Auditor difficulties in confirming cash balances, . . . ;
Irregularities in sales contracts, . . . ;
Recognizing revenue from contracts or customers whose existence could not be corroborated;
Undisclosed material facts surrounding acquisition transactions, sales transactions, and off-balance sheet transactions
with related parties;
Recording of assets for which evidence of control, ownership, or title is either unclear or difficult to corroborate; and
Significant unexplained discrepancies between amounts included in the financial statements in SEC filings and
amounts included in financial reports to other regulators, such as local authorities.”
Id. at 3-4. These indications are similar to the accounting issues discussed in IV. and V., infra.
37
“For example, companies in emerging markets may be subject to rapidly changing or less consistent regulatory oversight and
reporting requirements . . . .” Id. at 6.
38
Id. at 17-20.
39
In re Chisholm, Bierwolf, Nilson & Morrill, LLC, Todd D. Chisholm, CPA, and Troy F. Nilson, CPA, Order Instituting
Disciplinary Proceedings, Making Findings, and Imposing Sanctions, PCAOB Rel. 105-2011-003 (April 8, 2011)
http://pcaobus.org/Enforcement/Decisions/Documents/Chisholm.pdf (hereinafter the “Chisholm Order”).

| P a g e 10
(2) CBNM failed to perform sufficient audit procedures to determine
whether management had appropriately tested goodwill for impairment.
CBNM relied exclusively on management representations about
goodwill and failed to follow the guidance prescribed in AU Section 342,
Auditing Accounting Estimates.
(3) Hendrx relied on a report prepared by a Chinese firm to appraise
and assess the fair market value of its patents. CBNM failed to perform
sufficient audit procedures to determine whether Hendrx’s reliance on
the report was sufficient. In short, CBNM did not follow the audit
guidance from AU Section 336, Using the Work of a Specialist.
(4) The engagement team failed to maintain control over the
confirmation process and instead relied on the issuer’s Chinese operating
subsidiary’s personnel to receive responses directly from the intended
recipients and forward them to CBNM by email. CBNM took no steps to
assure that the confirmations responses it received were accurate and
failed to follow the guidance in AU Section 330, The Confirmation
Process.
b. CBNM’s audit of Jade Art Group, Inc.’s 2008 financial statements was
improper.
(1) Audit planning consisted of little more than referring CBNM’s
assistants to standardized audit programs and checklists.
(2) To test the amounts recorded as fair value of distribution rights,
CBNM relied on unverified, unsigned documents they understood to be
translations of reports originally prepared by a Chinese appraisal
organization. Once again, CBNM did not follow the guidance from AU
Section 336, Using the Work of a Specialist.
5. The Schumer Letter urges the PCAOB “to take immediate disciplinary actions
against Chinese audit firms” that have not permitted the PCAOB to inspect them.40
PCAOB Chairman Doty gave a speech on December 1, 2011 titled “Auditing in the
Decade Ahead: Challenge and Change”. In his speech, he noted that the PCAOB’s
inability to conduct joint inspections of all non-U.S. registered audit firms weakens
investor protections in the U.S. and abroad. Mr. Doty stated “I hope Chinese authorities,
40
Schumer Letter at 2. In citing “reverse merger scandals,” the Schumer Letter states that the PCAOB’s “failure to scrutinize
Chinese audits can cost U.S. investors billions” and may be just “the tip of the iceberg.” Id. Noting that the PCAOB has been
negotiating with China for over six years, the Schumer Letter asserts that “the Chinese government is acting to obstruct the
Board’s inspection of registered Chinese audit firms.” Id. While urging the PCAOB to take disciplinary action, the Schumer
Letter may be putting the PCAOB in an even more difficult position, one that does not further U.S. investors’ interests. If a
Chinese audit firm’s registration is suspended or revoked, how can a U.S. multi-national company with operations and/or sales in
China obtain an audit of its financial statements for its Chinese business? Not being able to have the Chinese audit consolidated
with other world-wide audits could result in the U.S. audit firm not being able to sign a consolidated audit opinion for inclusion
in the multi-national’s Annual Report on Form 10-K. If an audit opinion is not included, the Form 10-K is deficient under SEC
rules. Moreover, PCAOB disciplinary action may result in actions by Chinese regulatory authorities that only cause less not
more cooperation between Chinese and U.S. regulators. See Section IV, E., infra.

| P a g e 11
like other countries, will also embrace joint inspections. I view this as an urgent
matter”.41
III. The Reaction From U.S. Exchanges
A. Recent market halts by the NYSE and the Nasdaq Stock Market (“NASDAQ”), resulted
from uncertainty over whether the security continued to meet the exchange’s listing standards.
B. The SEC and the exchanges have suspended or halted trading in more than 35 companies,
including CRMs, because of inadequate current information.42
C. Often, the chain of events that resulted in a trading halt began with the publication of a
research report written by or sponsored by a self-disclosed short seller. “On the heels of the
research being disseminated, the market surveillance arms of NASDAQ and the NYSE began
focusing on the trading of the target company, as both exchanges commonly do for any irregular
trading. This usually includes a referral to the exchange that, in turn, often contacts senior
management of the subject issuer directly, seeking additional information about the underlying
facts alleged in the research, as well as knowledge management may have about the trading in
question.”43
D. On November 9, 2011 the SEC approved rule changes submitted by the NYSE, Nasdaq
and Amex44
that prohibit listing of a reverse merger company unless it has completed a one year
seasoning period of trading after the reverse merger, has filed all required reports with the SEC
and has maintained the minimum share price required by the exchange for 30 of the 60 days
before the date that listing begins. There are exemptions if the reverse merger occurred in
connection with a substantial firm commitment underwritten public offering as well as an
exemption that grandfathers reverse mergers that occurred so long ago that the company has been
able to file four years of annual reports at the SEC.45
While the new rules represent a significant
tightening of trading for CRMs, time will tell how effective these rules will be if trading occurs
outside the exchanges.
IV. Litigation Involving CRMs
A. At least 30 CRMs have been the subject of class action lawsuits filed between April 2010
and June 2011.46
The lawsuits are most often against the CRM, its management and directors.
The class action lawsuit is filed as part of what has become a familiar pattern:
1. A negative research report from a self-described short seller or person retained by
a short seller is published which raises questions about the CRM’s business and/or
describes accounting irregularities. The stock price drops as a result.
41
Speech by Chairman James R. Doty of the PCAOB, “Auditing in the Decade Ahead: Challenge and Change”, at
http://pcaobus.org/News/Speech/Pages/12012011_DotyKeynote.aspx,
42
Release 2011-235, “SEC Approves New Rules to Toughen Listing Standards for Reverse Merger Companies,” (Nov. 9, 2011)
at http://www.sec.gov/news/press/2011/2011-235.htm.
43
Jason S. Frankl and John J. Huber, “Short Sellers and Trading Halts: How to Navigate Regulatory and Short Selling Storms
and Survive” at http://www.fticonsulting.com/global/resources/documents/fti3246-insite-summer-nl-v13-final.pdf.
44
SEC Listing Release including Release No. 34-65710, File No. SR-NYSE Amex-2011-55 (Nov. 8, 2011); Release No. 34-
65709, File No. SR-NYSE-2011-38 (Nov. 8, 2011); and Release No. 34-65708, File No. SR-NASDAQ-2011-073 (Nov. 8, 2011).
45
Id.
46
During this period, there were at least four filings against Chinese companies that are not CRMs: 1. Duoyuan Printing, Inc.; 2.
Duoyuan Global Water, Inc.; 3. Longtop Financial, Inc.; and 4. A-Power Energy Generation Systems, Ltd.

| P a g e 12
2. Interested parties ask management to address the issues raised in the short seller’s
report. Interested parties can include the CRM’s investors, creditors, independent
directors, such as members of the audit committee of the board of directors, the SEC, the
PCAOB, the exchange on which its stock trades, and/or its independent auditors.47
3. The audit committee of the CRM may initiate a special review or investigation
into the allegations and/or restate its financial statements, retaining independent counsel
and forensic accountants.
4. If action is not taken or answers to the research report’s allegations are
unsatisfactory or insufficient to address concerns, auditors may resign, investors and/or
creditors can raise additional concerns, such as failure to pay interest on debt, the
exchange may halt trading in the CRM’s stock, independent directors may resign, and a
class action lawsuit can be filed. The stock may eventually be delisted.
5. Litigation is filed, typically in a US federal district court.
B. Examples of this pattern include Orient Paper, Inc., China Integrated Energy, Inc., and
China MediaExpress Holdings. AutoChina International Limited is an example of a CRM that is
restating its financial statements, but not as the result of a research report sponsored by a short
seller:
1. In December 2007, Orient Paper, Inc. became a Nevada corporation with equity
traded on the NYSE AMEX through a reverse merger.48
a. Orient Paper had been in the business of producing corrugated paper,
offset paper and writing paper in China since 1996.
b. Orient Paper was controlled by Zhenyong Liu (“Liu”) who became the
public company’s chief executive officer, chairman of the board of directors and
owner of over 33% of its common stock after completion of the reverse merger.
c. Orient Paper is a holding company with a wholly-owned subsidiary
incorporated in the British Virgin Islands that has the contractual rights to the
production of Hebei Baoding Orient Paper Milling Company Limited (“HBOP”).
The equity of HBOP is owned by the directors of Orient Paper.
d. According to the 48-page detailed Amended Complaint, Orient Paper:
did not disclose or adequately account for related party transactions between Liu
and a supplier that was 70% owned by Liu;49
overstated revenue by 25% to 50%
in 2008 and 2009;50
did not have the customers it claimed to have;51
hired an
47
See footnote 74, infra, and accompanying text.
48
The facts in this outline are derived from the Amended Complaint in Henning v. Orient Paper, Case No. 2:10-CV-05887-
VBF-AJW, filed in Central District of CA on Jan. 28, 2011 and in the denial of the Defendant’s Motion to Dismiss the Plaintiffs’
Amended Complaint by US District Court Judge Valerie Baker Fairbank, Civil Minutes – General, Case No. CV 10-5887-VBF
(AJWx) (C.D.CA. July 20, 2011) (hereinafter “Motion to Dismiss”).
49
The per year amounts are alleged to be: $31 million in 2009; $28 million in 2008; $15.9 million in 2007; and $14.6 million in
2006. Amended Complaint at 3.
50
Id.
51
Id.

| P a g e 13
auditor that had been disbarred from the PCAOB;52
misstated other accounting
issues such as profits and cost of goods; and did not have effective internal
controls.
e. The plaintiffs retained their own investigator, Muddy Waters LLC,53
which publicly issued a report in June 2010 causing a 40% decline in market
price in three days of trading.54
Other reports followed from Muddy Waters and
another research firm.
f. Although Orient Paper denied the charges, the audit committee of the
board of directors retained a law firm and an accounting firm to conduct an
independent investigation which was favorable to Orient Paper. However,
neither firm “issued any signed statement attesting to the tasks they had
performed in assisting the audit committee with its investigation.”55
While the
audit committee apparently was satisfied that there was no fraud, there were
inconsistencies between Orient Paper’s SEC reports and HBOP’s annual filings
to the SAIC concerning revenues, profits, assets and cost of goods sold.
g. In what is reportedly the first time plaintiffs have survived a dismissal
motion involving a Chinese reverse merger company,56
Judge Fairbank ruled that
the “[P]laintiffs adequately plead a securities violation with particularity under
Section 10(b),” Rule 10b-5 under the Exchange Act, Section 20(a) of the
Exchange Act, and the “heightened standard of the Private Securities Litigation
Reform Act.”57
2. China Integrated Energy, Inc. (“CBEH”) consummated a reverse merger in
October 2007.
a. On March 16, 2011, a short seller sponsored a research report with the
following accusations:
(1) CBEH transferred $23 million of shareholder funds to the son of
the chief executive officer through the acquisitions of a biodiesel plant
and a gas station, both acquired in October 2010.
(2) CBEH acquired companies with minimal assets, revenue and
profit as shown in the SAIC filings. As with Orient Paper, there were
discrepancies between the SAIC reports and the SEC reports.
(3) CBEH overpaid for 13 retail gas stations which had no listed
addresses.
52
Id. at 9; see also PCAOB Release No. 104-2008-050A. Orient Paper retained “an auditor based out of Cedar Rapids, Utah,
three flights from China, who has been disbarred for (among other things) not being independent of its client.” Amended
Complaint at 21.
53
The name “Muddy Waters” is derived from a “Chinese proverb, ‘muddy waters makes it easy to catch fish.’” Post Article at 5.
54
Amended Complaint at 28.
55
Id. at 30.
56
“Court Denies Motion to Dismiss Lawsuit Against PRC-Based Reverse Merger Company” Sec. Reg. & L. Rep., Vol. 43, No.
34 at 1765 (Aug. 22, 2011).
57
Motion to Dismiss at 11.

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(4) Reported interest income on the balance sheet appeared low for
the $80 million of cash reported on the balance sheet. Because of the
low amount of reported interest income, the research report questioned
the existence of cash on the balance sheet.
(5) CBEH’s variable interest entity corporate structure was designed
to hide something.
(6) CBEH’s biodiesel segment’s revenue and earnings were greatly
overstated. The research report included pictures of a “rail tanker” which
was actually a passenger train next to rail tanker loading equipment at
CBEH’s Tongchuan biodiesel facility. Rather than rail tankers, CBEH
had asserted that biodiesel was shipped on trucks. The research report
asserted that trucks only appeared when potential investors were visiting
the facility.
(7) The business model of CBEH’s wholesale business segment was
too good to be true.
(8) CBEH raised capital at a low multiple of price to earnings ratio
and low valuation.
(9) CBEH’s former auditor, Sherb & Co., LLP, prepared the
financials for another “highly suspicious” Chinese company.58
b. CBEH responded on March 23, 2011 by denying most of the charges, but
admitting to an undisclosed related party transaction. CBEH admitted that the gas
station it acquired in October 2010 was temporarily owned by the chief executive
officer’s son. CBEH stated that, for Chinese tax reasons, ownership interest must
first transfer to an individual. CBEH and the chief executive officer’s son
intended to transfer ownership to CBEH after transfer of title, related permits and
licenses.
c. The complaint in the class action lawsuit filed on March 25, 2011
focused on the undisclosed related party transaction and on the other allegations
described in the research report.
d. On March 28, 2011, CBEH announced that the audit committee of the
board of directors authorized retention of attorneys and forensic accountants to
help conduct an independent investigation of the allegations raised in the short
seller’s report.59
e. NASDAQ halted trading on April 20, 2011.
f. The company’s independent auditors, KPMG, resigned on April 26, 2011
citing “inconsistency between management’s representation to us that it will fully
cooperate with the special investigation requested and authorized by the Audit
Committee and the manner of management’s conduct during the investigation
58
CBEH letter to shareholders (Mar. 23, 2011).
59
CBEH Current Report on Form 8-K (Mar. 30, 2011).

| P a g e 15
raises doubts about management’s representations provided to us in connection
with out 2010 audits. . . .”60
g. Three months after publication of the research report, NASDAQ delisted
the stock on June 15, 2011. CBEH is now trading on the Pink Sheets. CBEH
stock opened at $5.95 per share on March 16, 2011, the day the research report
was published. On December 2, 2011, CBEH closed 93% lower, at $0.42 per
share.
3. Another example is China MediaExpress Holdings (“CCME”) which listed it
shares through a reverse merger in October 2009.
a. On January 31, 2011, an analyst firm published a report alleging that
CCME misrepresented, among other things:
(1) the scope of the company's operations;
(2) its financial performance; and
(3) the extent of the company's claimed strategic partnership with a
government-affiliated entity.
b. Other research reports followed and a class action lawsuit was filed on
February 10, 2011. The complaint repeated allegations from the research reports.
c. On March 11, 2011, CCME trading was halted on NASDAQ.
d. On that same day, the company’s auditors, Deloitte Touche Tohmatsu
(“DTT”), resigned. DTT informed CCME in its resignation letter that it was no
longer able to rely on the representations of management and that it had lost
confidence in the commitment of the board of directors and the audit committee
to good governance and reliable financial reporting. Prior to its resignation, DTT
also had requested that issues encountered during the audit, including issues
related to the reliability of the bank confirmation process, be addressed by an
independent forensic investigation. DTT stated in its resignation letter that, in its
view, the company was not in good faith willing to proceed with the course of
action requested by DTT.61
e. The chief financial officer resigned on March 13, 2011.
f. Later that same week, Starr Investments Cayman II, Inc., a firm
associated with former AIG chief Maurice Greenberg, sued CCME, its chief
executive officer, former chief financial officer, and DTT. The plaintiff accused
CCME of being “an international fraud on the market in both the United States
and China.”
g. The stock was delisted on May 19, 2011. CCME is now trading on the
Pink Sheets. CCME stock opened at $20.86 per share on January 31, 2011, the
publication date of the research report. On August 1, 2011, CCME closed 95%
60
CBEH Current Report on Form 8-K (May 2, 2011).
61
CCME Current Report on Form 8-K (Mar. 17, 2011).

| P a g e 16
lower, at $1.13 per share. By November, Pink Sheets had discontinued the
display of CCME quotes because the stock was labeled “buyer beware.”
4. AutoChina International Limited (“AUTC”) completed its reverse merger in
April 2009.
a. The terms of the business combination included an Earn-out Share
Provision (“Earn-out”). Pursuant to the Earn-out, AUTC was required to issue
between 5% and 20% of the number of ordinary shares outstanding as of
December 31 of the fiscal year immediately prior to each Earn-out issuance date
that it achieved certain EBITDA thresholds in each of the five years following
the business combination. An entity affiliated with AUTC’s chief executive
officer was entitled to receive any shares issued pursuant to the Earn-out.62
b. AUTC’s original accounting treatment recorded the Earn-out shares,
upon issuance, as an adjustment to the par value of ordinary shares and additional
paid-in capital and included the shares in the calculation of earnings per share
from the date of issuance.63
c. AUTC sought guidance from the SEC’s Office of the Chief Accountant
(“OCA”) regarding the Earn-out’s accounting treatment. While the Staff of OCA
agreed that the Earn-out did not constitute compensation, the Staff did not agree
with AUTC’s past accounting for the shares issued pursuant to the Earn-out as
stock dividends. Instead, the Staff believed the Earn-out should be treated as a
derivative financial instrument. As a result, a liability should have been initially
recorded at its fair value at the time of the business combination. Thereafter, any
gain or loss in the fair value of the derivative would have been recorded in
AUTC’s income statement at the end of each reporting period.64
d. After the markets closed on June 30, 2011, AUTC announced that it was
being investigated by the SEC and that it might have to restate its previously
issued financial statements to recognize a derivative liability relating to the Earn-
out. AUTC also stated that it anticipated further discussion with the Staff
because AUTC believed that the restatement was not warranted.65
e. AUTC replaced its independent auditor on September 16, 2011.66
f. AUTC’s common stock was delisted on October 4, 2011 and is now
trading on the Pink Sheets. AUTC stock opened at $29.19 on July 1, 2011, the
date of the press release about the possible restatement. AUTC filed its restated
audited financial statements on November 30, 2011, and on December 2, 2011,
AUTC closed 32% lower, at $19.75 per share.
C. The lessons of case law and administrative proceedings involving US-listed Chinese
companies may be helpful to CRMs.
62
AUTC Current Report on Form 6-K (June 30, 2011).
63
Id.
64
Id.
65
Id.
66
AUTC Current Report on Form 6-K (Sept. 27, 2011).

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1. In her Memorandum and Order, Judge Miriam Goldman Cedarbaum granted a
motion by defendants to dismiss a lawsuit against China North East Petroleum Holdings
Limited (“China North East”).67
a. The lawsuit was filed after a February 23, 2010 company disclosure of
bank transfers that had been made to officers. In the following months, further
disclosures were made, the NYSE halted trading on May 25, 2010 and when
trading resumed on September 9, 2010, the stock price initially dropped, but then
rebounded for a short period before declining again.
b. In the first dismissal of a complaint against a US-listed Chinese
company, Judge Cedarbaum cited Dura Pharmaceuticals, Inc. v. Broudo, 554
U.S. 336 (2005) which held that a plaintiff does not “satisfy the economic loss
element of a 10b-5 claim under the fraud-on-the-market theory simply by
alleging that the plaintiff purchased securities at an inflated price.”68
Since the
plaintiff could have avoided any loss and could have sold at a profit by selling
during the brief rebound after September 9, 2010, the plaintiff could not
“logically ascribe a later loss to devaluation caused by the disclosure.”69
2. In addition to bringing lawsuits, the SEC can bring administrative proceedings to
revoke or suspend registration of a company’s securities under the Exchange Act70
for
not complying with the federal securities laws, such as the requirement to file periodic
and current reports.71
a. On November 10, 2011, the SEC’s Division of Enforcement charged
Longtop Financial Technologies Limited (“Longtop”) with failure to file current
and accurate financial reports with the SEC.72
b. Filing of the administrative proceeding followed Longtop’s failure to file
an annual report on Form 20-F for the year ended March 31, 2011 which was due
at the SEC at the end of September 2011. Longtop’s auditor had resigned in May
2011.73
D. The scope of claims, counterclaims and responses by CRMs.
1. CRMs may threaten to sue short sellers for libel. For example, SkyPeople Fruit
Juice, Inc. (“SPU”) sued the hedge fund Absaroka Capital Management, alleging that a
report the firm published accusing the Chinese fruit juice maker of fraud was libelous and
injured the company.74
2. Another CRM is accusing short sellers of market manipulation. DEER Consumer
Products, Inc. (“DEER”) was the subject of negative research reports written by self-
disclosed short sellers. DEER fought back. In a press release, the company stated that
67
In re China North East Petroleum Holdings Limited Securities Litigation, 10 Civ. 4577 (MGC) (S.D.N.Y. Oct. 6, 2011).
68
Id. at 3.
69
Id. at 6.
70
Section 12(j) of the exchange Act.
71
Section 13(a) of the Exchange Act.
72
Order Instituting Administrative Proceedings and Notice of Hearing Pursuant to Section 12(j) of the Securities Exchange Act
of 1934, In the Matter of Longtop Financial Technologies Limited, Release No. 34-65734, File No. 3-14622 (Nov. 10, 2011).
73
See Section IV. E. infra.
74
SPU Current Report on Form 8-K (July 8, 2011).

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“During the months of March and April 2011, the Company believes that an attempted
market manipulation scheme by illegal short sellers acting in collusion caused DEER’s
share price to plunge. . . .” DEER also stated that it will seek sanctions if the class action
complaint is not withdrawn.75
3. The plaintiff was successful in including the former independent auditors of
China Expert Technology, Inc. (“CXTI”) as defendants in a class action lawsuit that was
originally filed in November 2007.76
4. Some CRMs accessed U.S. markets through a simultaneous reverse merger and
private placement.77
Still others made a secondary offering of securities after completion
of the reverse merger. Thus, it would not be surprising to see plaintiffs include
underwriters in their amended class action complaints.
5. Likewise, related litigation may result from investors suing their brokerage firms
for performing inadequate due diligence prior to recommending a CRM’s stock.
6. The officers of a CRM may be sued by the members of their board of directors.78
E. The challenge and response posed by the SEC’s subpoena to Deloitte Touche Tohmatsu
CPA Ltd. (“Deloitte Shanghai”) and the response from the MOF and the CSRC
1. On May 27, 2011, the SEC served Deloitte Shanghai’s US counsel with a
subpoena In the Matter of Longtop Financial Technologies Limited (“Longtop”), SEC
File No. HO-11698, requesting documents concerning its activities as the auditor of
Longtop from January 2007 to the date of the subpoena. Deloitte Shanghai had resigned
on May 22, 2011 because “it had identified numerous indicia of financial fraud at
Longtop and it further indicated that D&T Shanghai’s prior year audit reports for
Longtop could no longer be relied upon by investors.”79
2. Deloitte Shanghai refused to comply with the subpoena on July 8, 2011 after
receiving an extension to do so. The SEC then brought an action to enforce the subpoena
in District Court for the District of Columbia.80
The Department of Justice (“DOJ”)
reportedly is “close” to the SEC’s position on subpoena enforcement.81
75
DEER Current Report on Form 8-K (May 4, 2011).
76
But see footnote 40, supra.
77
For instance, China Century Dragon Media, Inc. (“CDM”) went public using the “WestPark Reverse Alternative Senior
Exchange Process.” The method, created by WestPark Capital (www.wpcapital.com), merges a private company into a non-
trading shell, arranges private placement financing, and then takes the company public through a traditional IPO.
78
For example, the chief executive officer and largest shareholder of ShengdaTech was sued by some of the directors of the
board to prevent him from regaining control of the company, obstructing the investigation of the company’s finances and trying
to terminate a chief restructuring officer after the company filed for bankruptcy. Subsequently, the U.S. Bankruptcy Court for the
District of Nevada granted a temporary restraining order preventing any change in the composition of the special committee of
the board of directors or the chief executive officer. See, “CEO sued by board in Chinese reverse merger case,” China Economic
Review – Daily & Industry (Aug. 23, 2011) and “ShengdaTech Wins Court Order Barring Management from Obstructing Probe”
RTT News (United States) (Aug. 25, 2011).
79
Declaration of Lisa Deitch, Deloitte Shanghai included in the Form 6-K filed by Longtop on May 23, 2011 and quoted in the
Application for Order to Show Cause and For Order Requiring Compliance with a Subpoena Filed in SEC v. Deloitte Touche
Tohmatsu CPA Ltd. (DCDC, Sept. 8, 2011).
80
Id.
81
Remarks of Denis McInerney, Chief, Fraud Section, DOJ at American Bar Association Criminal Justice Section Conference,
Washington, D.C. (Oct. 27, 2011) (hereinafter “ABA Criminal Justice Section Conference”) reported in “DOJ Tackling
Document Production Issues Regarding PRC-Based Firms, Official Says,” BNA Sec. Reg. & L. Rep. 2288 (Nov. 7, 2011)
(hereinafter “Nov. 7, 2011 BNA”).

| P a g e 19
3. The SEC’s action has resulted in media attention both in favor of as well as
opposed to the SEC’s action.82
4. The response from the MOF and the CSRC apparently has been to request
accounting firms in China to report to the Chinese government whether the firms had
provided audit workpapers, correspondence or other documentation concerning their
audits of Chinese companies to overseas regulators.83
Whether the Chinese position will
become cooperative with U.S. subpoena enforcement or not will be a question for
regulators, accounting firms, companies and investors into 2012.84
5. As described by Chairman Doty in his Keynote Address to the NASBA, “[P]ress
accounts now say the Chinese authorities have called in the heads of the global firms to
lay down the law and seem to suggest that they are prohibiting the firms from bringing
out of China summaries of audit results. If true, that, of course, would go well beyond
keeping PCAOB inspectors out of China. It would be a long-arm interdiction of the
global firm’s maintenance of its own work papers.”85
By doing so, the PCAOB would
have less information about audits conducted by Chinese affiliates of U.S. audit firms
than the PCAOB has now.
F. In an example of how U.S. affiliates of Chinese accounting firms may face liability for
the actions by the Chinese affiliate, Judge Alvin K. Hellerstein denied a motion to dismiss by the
U.S. accounting affiliate, PKF Certified Public Accountants (“PKF New York”), of a Chinese
audit firm, PKF Hong Kong, in a case involving China Expert Technology Inc. which had sold
securities in the U.S. with a prospectus containing the PKF audit opinion.86
1. PKF New York had argued under Janus that it was not the “’maker’ of an untrue
statement of a material fact in violation of securities laws.”87
2. Discussing how PKF New York participated in the audit, exercised authority
over the language in the opinion as well as having “final approval” over the opinions
before it was signed and citing language in the engagement letter, Judge Hellerstein
denied the motion. Under Janus, “the maker of a statement is the entity with authority
over the content of the statement and whether and how to communicate it.”88
Therefore,
there were genuine issues of fact as to “whether PKF New York explicitly or implicitly
controlled sufficiently – and thus ‘made’ – the statements in question.89
82
See, e.g., Francine McKenna, Auditors in China: A Whole Lot of Posturing Going On,” Forbes, Oct. 21, 2011.
83
Reuters “China quizzes audit giants on foreign regulator contact” October 19, 2011.
84
See, e.g., remarks of Pamela Rogers Chepiga, Esq., Allen & Overy LLP, at ABA Criminal Justice Section Conference reported
in Nov. 7, 2011 BNA.
85
Doty Keynote at 8-9.
86
Munoz v. China Expert Technology Inc., No. 07 Civ. 10531 (AKH) (SDNY, Nov. 7, 2011) (hereinafter “PKF Order”). The
prior history of the motion to dismiss indicates how courts may apply caselaw to fact patterns involving Chinese companies and
accounting firms. A hand-written note by Judge Alvin K. Hellerstein in Carlos Munoz v. China Expert Technology et al. 07-CV-
10532 (AKH) (SDNY, Aug. 5, 2011) granted a rehearing on a motion to dismiss a shareholder class action by PKF New York.
As a result of a private investigator’s report, plaintiffs had alleged that two units of PKF New York, one in the U.S. and the other,
PKF Hong Kong, had failed to verify the existence of 16 contracts to build government computer systems in China as well as
failing to identify an overstatement of revenue and accounts receivable in the audit. Rehearing was granted on the basis of the
Supreme Court’s decision in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. __, 131 S.Ct. 2296 (2011) at
http://www.supremecourt.gov/opinions/10pdf/09-525.pdf. While plaintiff’s assertion of Janus was sufficient to gain a rehearing,
it did not win the day on the motion to dismiss.
87
PKF Order at 2.
88
Janus, 131 S.Ct. at 2303.
89
PKF Order at 2.

| P a g e 20
V. General Description of Accounting and Auditing Issues Involved in Recent CRM Litigation.
The final chapter has yet to be written for many CRMs that are in the early stages of litigation. The
litigation raises many accounting and auditing issues, the resolution of which may require investigations
and reviews as well as discovery and/or restatements. As a result, the complaint in the lawsuit may be
amended to include additional claims and more defendants. This section describes the accounting and
auditing issues that are the subject of recent litigation. Guidance provided by U.S. Generally Accepted
Accounting Principles (“GAAP”) will be described first, followed by a summary of guidance provided by
U.S. Generally Accepted Auditing Standards (“GAAS”).90
The discussion involving each accounting or
auditing issue concludes with examples of selected CRMs found in SEC filings.
A. The Existence of Cash
1. ASC Topic 305, Cash and Cash Equivalents91
defines cash as including “not
only currency on hand but demand deposits with banks or other financial institutions.
Cash also includes other kinds of accounts that have the general characteristics of
demand deposits in that the customer may deposit additional funds at any time and also
effectively may withdraw funds at any time without prior notice or penalty. All charges
Aand credits to those accounts are cash receipts or payments to both the entity owning the
account and the bank holding the funds. For example, a bank’s granting of a loan by
crediting the proceeds to a customer’s demand deposit account is a cash payment by the
bank and a cash receipt of the customer when the entry is made.”
2. AU Section 330, The Confirmation Process provides guidance for the process by
which an auditor checks with a company’s bank to verify its balance. An auditor is
expected to exercise a heightened degree of professional skepticism, particularly in a
situation where the respondent is the custodian of a material amount of the audited
entity’s assets.92
Under GAAS, the auditor must maintain control over the confirmation
requests and responses to minimize the possibility that the results will be biased because
of interception and alteration of the confirmation requests or responses.93
Also, when an
auditor receives a facsimile or email confirmation, the auditor should consider taking
precautions, such as verifying the source and contents of the response in a telephone call
to the purported sender.94
Finally, if the auditor questions the reliability of the
90
Although the financial statements of Chinese companies may be prepared in accordance with International Financial Reporting
Standards, Chinese Generally Accepted Accounting Principles or U.S. GAAP, this outline focuses solely on U.S. GAAP. For
citations to U.S. GAAP, see FASB Accounting Standards Codification (“ASC”), available through subscription at
http://asc.fasb.org/home. This outline also does not focus on the differences between financial reporting under U.S. GAAP and
the reports filed by the more than 50 million businesses registered with the SAIC in China. Much has been made about the
differences between SAIC and U.S. GAAP. See, e.g., footnote 19, supra. Put simply, differences between SEC filings and SAIC
filings do not mean that the Chinese company’s financial statements prepared in accordance with U.S. GAAP are materially
incorrect. Moreover, neither SEC rules nor China’s State Administration of Taxation require any reconciliation of financial
results.
91
The term “ASC” refers to Accounting Standards Codifications issued by the United States Financial Accounting Standards
Board (“FASB”). ASC Topics represent a collection of related guidance. Topic codes 305-799 exist for financial statement
accounts and Topics are organized in financial statement order - Assets, Liabilities, Equity, Revenue, and Expenses. Cash is
reported first on a balance sheet, and therefore ASC Topic 305 is Cash and Cash Equivalents. ASC Topic 305 contains one
Subtopic. This Subtopic (ASC 305-10) provides implementation guidance on cash on deposit at a financial institution.
92
AU Section 330, The Confirmation Process, at 27.
93
Id. at 28.
94
Id. at 29.

| P a g e 21
confirmation, he or she should consider performing additional tests of details and/or
analytical procedures.95
3. More and more questions are being raised about a CRM’s actual cash balance as
opposed to the cash balance reported in public filings. For example, in September 2010,
China-Biotics, Inc. (“CHBT”) was accused by short sellers in a research report of
falsifying accounting records. The research report pointed to red flags, including an
interest income amount that was irrationally low when compared to the supposed cash
balance that was in excess of $150 million. The resignation letter in June 2011 of
CHBT’s auditors, BDO Limited (“BDO”), implied that CHBT had falsified its
accounting records related to cash. The auditors noted the following:
a. In connection with the review of CHBT’s bank account through the
company’s e-banking system using the company’s computer, BDO was directed
by the company to access a suspected fake website for the bank;
b. A bank advice dated March 21, 2011 documenting a portion of CHBT’s
interest income contained mathematical errors that the company’s management
dismissed as clerical mistakes made by the bank. The company later replaced it
with a “corrected” advice from the bank; and
c. The bank advice dated March 21, 2011 used a deposit interest rate to
calculate the interest income earned by CHBT, which differed from the interest
rate announced by the People’s Bank of China for the relevant deposit period as
referred to in an undated deposit agreement that was presented to BDO to
corroborate the company’s interest income.96
4. Another example is provided by China MediaExpress Holdings (“CCME”). The
company’s independent auditor, DTT, resigned on March 11, 2011. CCME disclosed
that the auditors resigned for reasons that included audit concerns related to the
authenticity of bank statements and a loss of confidence in bank confirmation
procedures carried out under circumstances which the auditors believed to be
suspicious.97
B. Revenue Recognition
1. For many financial statement users, revenue is one of the most important
indicators of the success of a business. ASC Topic 605, Revenue Recognition (“ASC
605”) provides guidance for the amount and timing of revenue to be recognized in
accordance with GAAP. ASC 605 provides guidance for transaction-specific revenue
recognition and certain matters related to revenue-generating activities that are not
addressed specifically in other ASC Topics.98
95
Id. at 33.
96
CHBT Current Report on Form 8-K (June 23, 2011).
97
CCME Current Report on Form 8-K/A (Mar. 29, 2011).
98
Each ASC Topic contains an “Overall” Subtopic that generally represents the pervasive guidance for the Topic. ASC Topic
605 also contains nine additional Subtopics for transaction-specific guidance. The nine Subtopics are: Products (ASC 605-15),
Services (ASC 605-15), Multiple-Element Arrangements (ASC 605-25), Milestone Method (ASC 605-28), Rights to Use (ASC
605-30), Construction-Type and Production-Type Contracts (ASC 605-35), Gains and Losses (ASC 605-40), Principal Agent
Considerations (ASC 605-45), and Customer Payments and Incentives (ASC 605-50). Industry specific revenue recognition
guidance is also contained within ASC Topic codes 905-999. Those Topics relate to accounting that is specific to an industry or
type of activity. Finally, revenue recognition guidance is also provided by the SEC in Staff Accounting Bulletin (“SAB”) Topic

| P a g e 22
2. AU Section 316, Consideration of Fraud in a Financial Statement Audit provides
auditors with examples of audit procedures that might be performed in response to
assessed fraud risks relating to financial reporting. If there is an identified fraud risk that
involves improper revenue recognition, the auditor may consider:
a. Performing substantive analytical procedures relating to revenue using
disaggregated data. For example, the auditor may compare revenue reported by
month and by product line or business segment during the current reporting
period with comparable prior periods;
b. Confirming with customers certain relevant contract terms and the
absence of side agreements, because the appropriate accounting often is
influenced by such terms or agreements; and/or
c. Being physically present at one or more locations at period end to
observe goods being shipped or being readied for shipment (or returns awaiting
processing) and performing other appropriate sales and inventory cutoff
procedures.99
3. There are reported instances of CRMs incorrectly recognizing revenue.
However, accounting issues in CRMs typically don’t result from a misapplication of
complex revenue recognition rules, but may result from apparently fraudulent reporting.
CRM revenue recognition issues may be simple to understand, yet complex to verify,
particularly given the culture and practices of China. For example, some CRMs report
sales that simply do not exist.
a. On November 17, 2010, RINO’s independent auditors delivered a letter
to RINO and each member of its board of directors. The 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. . . . 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.”100
b. There is also evidence that China-Biotics, Inc. (“CHBT”) tried to support
reported revenue by forging sales contracts. As reported by the auditor, “In a
Company sales contract, the purchaser’s chop (i.e. the official signature or seal)
13 Revenue Recognition. SABs are not intended to contradict existing accounting literature and SABs are included in the ASC.
SAB Topic 13 can also be found at http://www.sec.gov/interps/account/sabcodet13.htm.
99
AU Section 316, Consideration of Fraud in a Financial Statement Audit ¶54 at
http://pcaobus.org/Standards/Auditing/Pages/AU316.aspx#au_316.52.
100
RINO Current Report on Form 8-K (November 18, 2010).

| P a g e 23
affixed on the signature page of the sales contract belongs to a different company
than the one named in the sales contract.”101
C. Disclosure of Related Party Transactions
1. GAAP does not require the accounting for related party transactions to be any
different from the accounting for transactions between unrelated parties. Instead,
emphasis is placed on the disclosure of the related party transaction. Guidance is
provided by ASC Topic 850, Related Party Disclosures. Simply put, the financial
statements must disclose material related-party transactions, and must include certain
specific information about the following:
a. The nature of the relationship(s) involved;
b. A description of the transactions, and such other information deemed
necessary to an understanding of the effects of the transactions on the financial
statements;
c. The dollar amounts of transactions; and
d. Amounts due from or to related parties.102
2. Identifying and disclosing related party transactions is ultimately the
responsibility of company management. However, auditors also play a role. Audits
performed in accordance with GAAS are not expected to provide assurance that all
related party transactions will be discovered. However, in accordance with AU Section
334, Related Parties, the auditor must be aware of and perform procedures to uncover the
possible existence of material related party transactions that could affect the financial
statements or require disclosure.
a. The work an auditor must perform to identify parties that are related to
the reporting entity may include:
(1) Evaluating the company’s procedures for identifying and
properly accounting for related party transactions;
(2) Interviewing management about related parties; and
(3) Reviewing stockholder listings of closely held companies to
identify principal stockholders.103
b. The auditor must be on alert for material transactions with identified
related parties, while also being attentive for unidentified related parties. Steps
the auditor should perform include:
(1) Reviewing the minutes of meetings of the board of directors for
information about material transactions authorized or discussed at their
meetings;
101
CHBT Current Report on Form 8-K (June 23, 2011).
102
ASC Topic 850, Related Party Disclosures. See ASC 850-10-50-1.
103
AU Section 334, Related Parties ¶7 at http://pcaobus.org/Standards/Auditing/Pages/AU334.aspx.

| P a g e 24
(2) Reviewing the extent and nature of business transacted with
major customers, suppliers, borrowers, and lenders for indications of
previously undisclosed relationships;
(3) Reviewing accounting records for large, unusual, or
nonrecurring transactions or balances, paying particular attention to
transactions recognized at or near the end of the reporting period;
(4) Reviewing confirmations of loans receivable and payable for
indications of guarantees.104
3. CBEH is an example of a CRM failing to disclose material related party
transactions. On March 16, 2011, short sellers accused CBEH of concealing a host of
transactions between the company and its officers and directors that had the effect of
funneling cash to these officers and directors. CBEH responded by issuing a letter to its
shareholders. In the letter, CBEH acknowledged one undisclosed related party
transaction and committed to the independent investigation into all issues raised by the
short seller.105
D. Loan Transactions with Related Parties
1. ASC Topic 470, Debt provides guidance for accounting for debt in accordance
with GAAP.106
Personal loans to executive officers or directors either directly or
indirectly by an issuer violate Section 402 of the Sarbanes-Oxley Act of 2002 (“SOX”)
unless they comply with an exception specified in Section 402(b) of SOX.
2. The auditor must follow the guidance in AU Section 334, Related Parties.
3. NIVS Intellimedia Technology Group, Inc. (“NIVS”) became a public company
in July 2008 through a simultaneous reverse merger and private placement.107
a. The acquiring company in the reverse merger was a British Virgin
Islands company that had three subsidiaries, including a 97.5% owned subsidiary
that had borrowed money from Mr. Li, the NIVS founder, principal shareholder,
chief executive officer and chairman of the board of directors. In these
transactions, the subsidiary borrowed money from Mr. Li and then loaned the
funds to six other entities that were controlled by Mr. Li.108
b. As a public company in July 2008, NIVS became subject to Section 402
of SOX. However, only four months later, it was discovered that 47 additional
loans were made to companies controlled by Mr. Li. The accounting records
reflected a “Due to Shareholder” amount of $7.8 million at December 31,
2008.109
In March 2009, the debt was converted into shares of NIVS.110
104
Id. at 8.
105
CBEH May 23, 2011 letter to shareholders.
106
470 also contains five additional Subtopics for transaction-specific guidance. The five Subtopics are: Debt with Conversion and
Other Options (ASC 470-20), Participating Mortgage Loans (ASC 470-30), Product Financing Arrangements (ASC 470-40),
Modifications and Extinguishments (ASC 470-50), and Troubled Debt Restructurings by Debtors (ASC 470-60).
107
NIVS Form 10-K for the fiscal year ended December 31, 2009, pages 38 and 47.
108
Id. at page 52.
109
Id., pages 47 and F-24.

| P a g e 25
c. There is a possibility that the illegal loan transactions continued. The
auditors were unable to complete the 2010 audit and resigned on March 25, 2011.
The auditors cited forged accounting records and bank statements in their
resignation letter.111
E. Subsidiary Ownership
1. ASC Topic 810, Consolidation provides guidance for consolidating financial
statements in accordance with GAAP.112
Consolidated financial statements present the
financial position and results of operations of a parent and all of its subsidiaries as if they
were one economic entity.
2. AU Section 326, Audit Evidence requires the auditor to obtain sufficient
competent evidential matter to afford a reasonable basis for an opinion regarding the
financial statements under audit. Evidential matter is obtained through inspection,
observation, inquiries, and confirmations.113
If management asserts that a subsidiary is
wholly-owned, then the auditor must review corroborating information available to him,
such as ownership agreements and minutes of shareholder meetings.
3. PUDA Coal, Inc. (“PUDA”), through two wholly-owned subsidiaries, owned
90% of the only operating company. Ming Zhao, the co-founder and chairman of the
operating company owned the other 10%.114
a. On April 8, 2011, a short seller accused Chairman Ming Zhao of illegally
transferring the ownership of the operating company to himself during 2009. In
2010, Ming Zhao sold 49% and pledged the other 51% to a Chinese private
equity fund. If the allegations are true, the financial statements included in the
Form 10-K for the years ended December 31, 2009 and 2010 were improperly
prepared on a consolidated basis.
b. PUDA’s independent auditors resigned in July 2011, citing
“representations are materially inconsistent with the alleged unauthorized
transfers of subsidiary ownership by the company’s chairman, Mr. Ming Zhao,
which are currently subject to the investigation by the Audit Committee.”115
110
Id. at page F-24.
111
NIVS Current Report on Form 8-K (Mar. 25, 2011).
112
810 also contains two additional Subtopics for transaction-specific guidance. The two Subtopics are: Control of Partnership and
Similar Entities (ASC 810-20), and Research and Development Arrangements (ASC 810-30).
113
Guidance is also provided by PCAOB Auditing Standard No. 15, Audit Evidence
http://pcaobus.org/Standards/Auditing/Pages/Auditing_Standard_15.aspx.
114
PUDA Form 10-K for the fiscal year ended December 31, 2010.
115
PUDA Current Report on Form 8-K (July 14, 2011).

| P a g e 26
F. Subsequent Events
1. ASC Topic 855, Subsequent Events defines subsequent events as events or
transactions that occur after the balance sheet date but before financial statements are
issued or are available to be issued. There are two types of subsequent events:
a. Events or transactions that provide additional evidence about conditions
that existed at the date of the balance sheet, including the estimates inherent in
the process of preparing financial statements; or
b. Events that provide evidence about conditions that did not exist at the
date of the balance sheet but arose subsequent to that date.116
2. AU Section 560, Subsequent Events provides audit guidance for dealing with
events or transactions that occur after the balance-sheet date but prior to the issuance of
the financial statements. These events or transactions have a material effect on the
financial statements and therefore require adjustment or disclosure in the statements.
Auditing procedures for the purpose of ascertaining the occurrence of subsequent events
may include:
a. Comparing the most recently prepared financial statements with those
being reported upon;
b. Making inquiries of the people having responsibility for financial and
accounting matters as to whether any substantial contingent liabilities or
commitments existed at the date of the balance sheet or at the date of inquiry and
whether there was any significant change in the capital stock, long-term debt, or
working capital to the date of inquiry;
c. Reviewing the available minutes of meetings of stockholders, directors,
and appropriate committees. If the minutes of a meeting are not available, the
auditor should inquire about the matters that were dealt with at such meeting;
d. Making inquiries of the company’s legal counsel concerning litigation,
claims, and assessments; and
e. Obtaining a letter of representation, dated as of the date of the auditor’s
report, from the company as to whether any events have occurred subsequent to
the date of the financial statements being reporting on by the independent
auditor.117
3. China Natural Gas, Inc. (“CHNG”) is an example of a CRM having to restate its
financial statements due in part to an undisclosed subsequent event. CHNG entered into
a material bank loan on February 26, 2010, but did not disclose the loan in the December
31, 2009 Form 10-K filed on March 10, 2010. The new bank loan caused a default under
another borrowing. Because of the default, CHNG misclassified debt as long term
liabilities, rather than short term liabilities. On August 20, 2010, CHNG restated the
116
ASC 855-10-25, Recognition.
117
AU Section 560, Subsequent Events ¶ 12 at http://pcaobus.org/Standards/Auditing/Pages/AU560.aspx.

| P a g e 27
financial statements for the fiscal year ended December 31, 2009 and the quarter ended
March 31, 2010.118
G. Fraud
1. Accounting irregularities can lead to accusations of fraud. At least 30 class
action lawsuits involving CRMs were filed from April 2010 to June 2011. Since many of
these cases are still in the early stages of litigation, it is too early to determine how many
instances of fraud occurred. There are some issues concerning fraud; however, that have
come to light:
a. In 2007, the shareholders of CXTI sued the company over an alleged
$132 million fraud committed by the company. CXTI never responded to the
investor group and was found to be in default in 2008. In July 2011, it was
announced that the investor group is suing CXTI’s independent auditors.
b. Tongxin International Ltd. announced in December 2010 that it
commenced legal proceedings against its former chief financial officer and chief
accounting officer after an internal investigation uncovered the wrongful transfer
of funds as well as other questionable actions.119
c. On April 29, 2011, the SEC announced that it obtained a court order to
freeze the assets of China Voice Holding Corp. The SEC alleges that the
company, its co-founder and his two associates were operating an $8.6 million
Ponzi scheme.120
d. In June 2011, the SEC filed complaints against CDM and CIL, and
accused both companies of forging bank statements.
VI. Rules of the Road
The following Rules of the Road may be helpful in responding to a research report either written
by or sponsored by a short seller which causes a material decline in the stock price. Following some of
the precepts of these rules may also be helpful in avoiding the unpleasantness of a short seller’s raid in the
first place. Of course, every situation is different, but some common rules include the following:
A. Don’t dismiss an adverse research report prepared by or for a short seller out of hand.
While they may have an ulterior motive, even short sellers can make valid points about
accounting issues, financial statements, business operations and future prospects.
B. An ounce of prevention is worth a pound of cure. The best antidote to a research report
prepared for or by a short seller is to have already done your homework before the report appears.
Homework runs the gamut from due diligence, internal controls, tone at the top to corporate
governance, transparency in the public disclosure and effective shareholder relations.121
Taking
preventative measures can result in avoiding even the possibility of having a short seller’s report
118
CHNG Form 10-K/A for fiscal year ended December 31, 2009 (Aug. 20, 2010).
119
Current Report on 6-K (December 13, 2010).
120
See, press release at http://www.sec.gov/news/press/2011/2011-101.htm.
121
As with U.S. companies, corporate governance issues for CRMs can include the experience of the directors as well as the
number of boards a director is a member of. Mike Tarsala and Rachel Armstrong, “Lots of boards, little time for some China
directors, Reuters News (Sept. 1, 2011).

| P a g e 28
being published about your company. And, if one is published, you are better able to accurately
and completely respond promptly after publication.
C. Don’t underestimate the importance of the basics, such as understanding the language,
customs, culture and local practice. While China has great potential, the Far East often resembles
the Wild West. Given the different culture and practices, don’t assume that what is an effective
response to an issue in the U.S. will be effective or work the same way in response to the same
issue during the same time period in China.
D. Take your time in crafting your initial response. A quick reaction that publicly denies the
allegations without having sufficient basis for the statements made may need to be followed by
corrective disclosures resulting in taking one step forward and two steps back from a legal as well
as a market perspective.122
E. Once a short seller or an investor or creditor makes allegations or the outside auditor
raises concerns, be proactive. The audit committee of the board of directors should be put in
charge and given authority by the board to retain independent counsel and forensic accountants to
conduct a review which may result in an investigation of accounting irregularities and possibly a
restatement of financial statements.123
F. Given the elementary nature of many of the accounting issues in Chinese reverse
mergers, forensic accountants can be of great assistance. Rather than understanding the rocket
science of derivative accounting, CRM accounting issues are typically not complex in theory, but
are difficult to track down in terms of factual evidence. Thus, the accounting principle may be
easy to understand, but the work needed to arrive at the correct amount may present practical
difficulties. Having competent, experienced forensic accountants who know the issues, speak the
language and are trained how to identify and track down accounting issues, can be an efficient,
cost effective way for a company, director or management to respond to a short seller’s
accusations. For example, verifying cash on hand on the balance sheet can involve labor
intensive work by a forensic accountant, but not the same level of accounting expertise as
applying short cut or long haul accounting for derivatives.
122
At a conference call on July 14, 2011, the former chief executive officer of Sino-Forest stated: “I personally stand by and
guarantee that the audited financial statements in the reports filed are accurate, and any material connected parties’ transactions
have been disclosed in our management discussions and analysis.” CNN Money Article. Subsequent events showed that that
wasn’t the case and the OSC required his resignation. See footnote 21, supra.
123
The number of restatements increased from 683 in 2009 to 735 in 2010. The number of restatements during 2009 and 2010 is
still lower than each of the years between 2003 and 2008, which was a period when the average number of restatements per year
was 1,206. According to Audit Analytics, 2010 Financial Restatements, A Ten Year Comparison (May 2011), the per year
numbers are as follows: 2003: 814; 2004: 945; 2005: 1,550; 2006: 1,795; 2007: 1,215; and 2008: 920 restatements. In both 2009
and 2010, the accounting issue restated with greatest frequency was related to errors or irregularities in approach, theory or
calculation associated with the recording of debt or equity accounts. Debt or equity issues appeared in 119 restatements during
2009 and 160 restatements during 2010. Another accounting issue restated with greater frequency during 2010 was related to
errors, omissions or irregularities associated with disclosure about related, alliance, affiliated and/or subsidiary entities. Related
party issues appeared in 41 restatements during 2009 and 61 restatements in 2010. The adverse effects of restatements during
recent years were less severe than historical restatements. The average income adjustment per restatement between 2003 and
2006 was $30.1 million whereas the average income adjustment per restatement between 2007 and 2010 was $6.6 million.
Companies do not have to look as far into the past in order to correct previous financial statements. An average of 635 days was
restated per restatement between 2003 and 2008, whereas an average of 494 days was restated per restatement during 2009 and
2010. The average number of issues identified in the restatements has declined to a current low of 1.48 issues per restatement.
The number of days needed to investigate and calculate a restatement dropped from approximately 20 days in 2009 to
approximately five days in 2010. The decrease in number and severity of restatements may be due to improved internal control
over financial reporting under Section 404 of SOX, something that many CRMs are not subject to.

| P a g e 29
G. A review or an investigation can be time consuming, expensive and divert management’s
attention. So don’t be penny wise and pound foolish. Understand that cooperation and
transparency, rather than denial and placing blame, can make the review or investigation more
cost efficient and effective. And make sure the outside advisors conducting the
review/investigation sign their reports.
H. Keep your eyes open to other issues identified during a review/investigation that can
relate to or be separate from the allegations in the short seller’s report. Identifying separate issues
can result in a determination that financial statements are required to be restated for different
reasons than those raised in the short seller’s report. Have an open door policy for employees to
report issues, irregularities and possible wrongdoing. Don’t “shoot the messenger” when
something is reported.
I. Throughout the process, management, the audit committee and the board of directors
should be transparent with outside auditors, counsel, other advisors, regulators and the
marketplace.
J. Remember the Chinese proverb: “if a lawyer can understand an accounting issue, like
misstating cash on the balance sheet, so can a federal district court judge as well as a jury.”

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