By Benjamin Wey

China is one market that is often undervalued because of these fears. Investors often mistrust Chinese companies’ transparency or misjudge the Chinese government’s ability to fine-tune its economy, thus impacting the greater markets valuation.

While it is not a completely unfounded concern, it can be easily disproven with a mild assessment of the company of interest. That is to say that any company is capable of releasing false information, but due diligence and quality control can quickly sort the quality companies from the “bad seeds.” Unfortunately, recent investor attitudes have shown that one sour grape can spoil the bunch, but that needs not be the case.

Consider, for example, Rino International (OTC: RINO). The company’s suspicious activity raised red flags not just among its investors, but across the board – its contracts and earnings just did not add up. What followed was an investigation that halted the company, revealed misstated numbers and led to them being delisted from NASDAQ.

Shareholders suffered a loss of roughly 80% of their investment. At this cost, investors may now proceed with extreme caution, if at all. While this is one way to avoid risk, it is also a way to neglect tremendous opportunity. At an annual GDP growth of more than 9% in the last 30 years in a row since 1980, China’s GDP has doubled every 7 years.

Additional factors that have led to undervaluing of Chinese stock are the misunderstood macro economy. An example of such is that “naysayers” of China have been anticipating China’s sudden economic meltdown in the last twenty years. Reality is that China’s GDP has more than tripled in the last two decades. As China’s economy continues to expand and its population continues to grow wealthier, significant China domestic demand for goods and services naturally turn the country into a huge domestic consumer market – with a population about 5 times as many as in the United States.

Much of such negative perception towards China stems from North American institutional investors’ detachment from China – its language, its culture, and the face-to-face interaction with its companies. A lack of information and the mentioned concerns over transparency and credibility of a company can lead to mispricing.

The opportunity pool in BRIC markets for foreign investors is simply too large to dismiss on weary assumptions.

To mitigate risk and keep the door to China-based opportunities open, consider using the subsequent three tools when considering an investment:

1. Comparison

A starting point for investors interested in the large return potential of China-based companies is to compare how the company is trading between the U.S., Hong Kong and mainland China.

For example, there are a number of companies that are trading at 5 times their earnings in the U.S., while companies in the comparable industries in China are trading at 50 times their earnings. It reflects the need for U.S. sources to gain a better understanding of China’s macro economy and the underlying segments, but – for the investor – it can be a good litmus test for determining which company is a wise investment with a strong potential for future value growth.

2. Research and Due Diligence

Stand-alone, top-line research is not enough when it comes to any form of due diligence, but especially when applied to BRIC investments. Brazil, Russia, India, and China are all hosts to rapid economical growth, flourishing consumer markets, and foreign interest. They are not, however, without risk – as are most companies with a high ROI.

To mitigate loss and maintain a stable, lucrative portfolio, investor institutions must look beyond balance sheets and earning statements. And, therein lies the crux of local-to-foreign investments. One way to determine whether a retail company’s earnings are accurate and whether sales are as promising as stated is to look to its value chain. Is the company ordering quantities of material that agree with its announced sales? Local knowledge and cultural familiarity are often critical to successful due diligence.

3. Counsel

When self-conducted research hits a ceiling and doubt is not completely removed, there are external resources – dealmakers, consulting and advisory firms, and target market experts – to help. Without language barriers, they can speak to the company directly and gain a sense of trust or suspicion. Without culture barriers, they understand the local business, financing and accounting process and can relay the true value to foreign investors.

The emerging markets present tremendous growth opportunities for financial institutions and individual investors alike. It is never too late to travel to some of these countries and experience first-hand what those exciting growth markets are about.

Mr. Benjamin Wey is the President and a founding partner of New York Global Group (“NYGG”), a leading middle market advisory firm on Wall Street specialized in executing China related transactions.

On the contrary, it is highly unusual and it should cause real concern to investors if SAIC filings do match a public company’s SEC filings.

Based on New York Global Group’s 12 year office presence in China and our Chinese language and cultural familiarity, the concerns over SAIC and SEC filing mismatches are overblown and unnecessary. The reason is simple: investors lack basic understanding of China’s corporate registration processes and are comparing very different items. It is important to understand what these documents are, what they are not, and why it would be incorrect and ignorant to allege companies as frauds based on SAIC documents. This article intends to alleviate these concerns based on facts and our extensive knowledge of China.

There are over 60 million registered businesses in China. China’s State Administration for Industry and Commerce (“SAIC”) is not a tax authority.

It is incorrect to refer to SAIC filings as a Chinese company’s “tax authority” and make accompanying accusations regarding tax evasion or derive judgment on a company’s financial status. The SAIC’s main function is like the “Office of the Secretary of State” at the state levels in the U.S., whose primary responsibilities include business registration, issuing permits, and maintaining corporate status of a business. Here is how it works: Chinese companies are required to file annual tax returns with local tax bureaus. The same filing document is copied to the local SAIC branch office within the jurisdiction where a business is physically located. What does the SAIC do with it? It files it away and there is nothing beyond that. The process is a simple formality to show that a registered business has filed its annual tax return, a requirement for a business to maintain good corporate standing. In addition, SAIC has tens of thousands of branch offices across China that each provides varying lengths of information for a locally registered business. There are more than 60 million registered businesses in China and all of them must register with their SAIC local branch offices before they can start doing business.

For a Chinese company, a “Certificate of Tax Completion” is all that is needed to satisfy a company’s tax and filing requirements.

The only Chinese government agency that is in charge of collecting corporate taxes and receiving annual tax filings is the State Administration of Taxation (“SAT”) and its tens of thousands of local branch offices across China. Corporate tax reporting in China is a local event, filed by a business within the jurisdiction of an SAT office where the business is physically located. Once it is filed and accepted by the local SAT, the local SAT issues a Certificate of Tax Completion to the business which is evidence that the business’s tax filings are complete and accepted, and that the business has satisfied all of its tax and financial reporting obligations. Then a copy of such filings is provided to the SAIC office which can provide continued legal registration status to the business. That is the very extent of the SAIC’s involvement in Chinese tax filings.

All of the U.S. listed China based companies are under holding company structures which own multiple subsidiaries in China. Unlike the SEC, the SAT or SAIC does not require a holding company to file consolidated financial statements.

If a company is a holding company that owns multiple subsidiaries or factories that are not all located in the same physical location, then each subsidiary has to file its own tax returns separately with a local tax bureau where the subsidiary is located. Each subsidiary makes its own tax filings independently from other sister businesses as well. There is no such a thing as a consolidated tax return filed with either the SAT or SAIC at the holding company level. Therefore, for a holding company that owns multiple subsidiaries, pulling a tax return on one subsidiary certainly does not represent the holding company’s financials. In the case of U.S. listed China based companies; all of them have multiple subsidiaries located in China. Until all of a holding company’s subsidiaries are consolidated into one financial statement, simply adding up the financials of each subsidiary does not equate to the financials filed by the holding company, represented as an entire organization through its SEC filings.

On the other hand, a holding company’s auditor reconciles tax filings, sales receipts, and other public and nonpublic financial evidence to produce SEC and U.S. GAAP required financial statements. For several decades, experienced auditors in China are well aware of this issue. Thus, SEC filings are indeed the most reliable proxy for a U.S. listed company’s financial performance.

Illegal acts are involved: a company’s tax filings with a local tax authority cannot be obtained by non-related third parties through legal means. By law, business tax filings are not publicly accessible.

It would be impossible for anyone outside a business itself to have legal access to its SAT tax filings since the data is not publicly available and confidentiality is preserved by the Chinese government agency. It is certainly illegal and a criminal act to trade or disperse rumors based on such nonpublic information. Many so-called China “sources”, often backed by stock short sellers, tout their abilities to get SAIC filed financial reports on any U.S. listed China based company. These are illegal claims. Also as discussed earlier, no consolidated financial statements exist for a holding company in China. Even if an SAIC filing is illegally obtained on a subsidiary, it does not reflect the U.S. listed holding company’s consolidated financials.

SAIC filings are not consolidated financial statements and each subsidiary often includes inter-company transactions.

For a vertically integrated manufacturing business as an example, it is common for subsidiaries to transfer revenues and expenses within the same organization for allocating profits to entities that are legally subject to lower tax rates or for the purpose of simply following a manufacturing production process. To avoid double counting, professional auditors consolidate all of a holding company’s subsidiary financials after inter-company transactions are eliminated. A holding company’s financials are filed with the SEC only after such inter-company related transactions are eliminated. Therefore, financial reports obtained from SAIC or SAT are absolutely not a correct reflection of a publicly traded holding company’s financial statements.

SAIC filings have no relevance to the credibility of a company’s public filings filed with the SEC

As long as a holding company structure is involved, SAIC and SEC numbers cannot possibly match except under an extreme circumstance in which a public company has only one wholly owned operating subsidiary and there are no inter-company transactions of any sort, including expenses, different revenue recognition etc. at the parent company level. Presently, no such China based company exists on any U.S. stock exchange.

Any concern over SAIC filings is just one example of the many areas that investors are just beginning to learn about Chinese business practices. Be wary of less professional advice from amateur or anonymous sources that often have untold self-interest behind some seemingly legitimate arguments. There are often stock short sellers behind many “sudden discoveries of fraud” at a legitimate publicly traded China based company. Avoiding fraud involves much more than comparing apples to oranges. Understanding China, learning to speak the Chinese language, gaining better understanding of China’s complex cultural and business aspects are among the right steps one should take.

At New York Global Group, our 16 year experience in executing China related projects has helped us identify traits that are fundamentally critical for strong companies with strong corporate governance. Due to our stringent client acceptance criteria, we accept only 1% of the hundreds of China based companies that we review each year as clients.

Mr. Benjamin Wey is the President and a founding partner of New York Global Group (“NYGG”), a leading middle market advisory firm on Wall Street specialized in executing China related transactions.

Essentially, the world has not changed very much. But we have added the convenience of currency, which then gave birth to the coining of this “currency war” phrase.  If we could think in friendlier terms, the current situation of global trade may be better described as an arm wrestling contest. The judges want to know which nation is strongest, though any victory would be a celebration of human progress and strength.  Whether their strengths are measured by lifting dumbbells, an intermediary object much like currency, the final deciding stage is an arm wrestling match of direct hand-to-hand combat.

In the dumbbell lifting stage, when one player sees the other taking weights off the bar, the others will simply follow. Similarly, currency value fluctuations are simply a tit-for-tat procedure through fiscal policy and cycles of inflation and deflation. Printing money out of thin air is just as artificial as any other maneuver. Money is simply used to buy productivity, whether from a person, idea, or machine. The short term benefits of currency valuation will adjust rather quickly whether for exports, labor costs, or trade balance. Over the long run, the true results depend on the real growth and productivity of nations.

Moreover, we should recognize that every nation is working hard and experiencing their respective difficulties. For every unemployed American there are several underpaid migrant workers operating under very harsh conditions either voluntarily or involuntarily, and for very little amounts of money. A major competitive strength of such emerging markets and their cheap labor force is simply their willingness to undergo such hardships. Often times it may be their only strength and means to survive. Resources are scarce, and those who choose to sacrifice the most will earn them. The bottom line is that no one has invented the free lunch yet.

The emerging nations are far off from America’s leadership in engineering talent, management skills, innovation, infrastructure and natural resources. America also happens to offer great political stability, democracy, and the luxury of freedom and rights.  With such admirable qualities we embody as a nation, it is hard to imagine that other much less developed markets could pose any threat to us. In addition, we are the veterans of capitalism as demonstrated through our rich history of entrepreneurship and contribution to society. We truly have a wide range of advantages that are in place for further success as long as we continue to focus on our own strengths instead of criticizing others’.

China has been the most noted challenger of America’s competitive strength through their last three decades of explosive growth, fueled largely by their stride towards a more capitalistic environment. The unleashing of many years of suppression and struggle is finally taking place. Never has the playing field been more leveled with goods and services flowing both ways, albeit requiring continual rebalancing. The valuation of the Chinese currency, the RMB is a non-issue if we consider that the Chinese people are producing goods and willing to work for less relative to their purchasing power, which is already rather weak. The last place Americans want to end up is in a price war if we just remind ourselves of our many areas of excellence.

More and more U.S. businesses are realizing that there is great opportunity to make profits from China’s booming economy by introducing truly innovative products. The Apple Store in Beijing is very busy. Dell is making a $100 billion push into China. These real economic profits will trickle down much faster than uncontrolled government spending. As businesses continue to globalize and earn money in multiple currencies, the exposure to currency risk will likely diminish over the years.

Going forward, we can expect many other great nations to undergo their golden age as well. The world as a whole will benefit from reduction in poverty, elevated competition, and the resulting progress in science, technology, medicine, healthcare, and universal friendship.  Many parts of the world can still only dream of buying American products. The least we can do is give them and ourselves the chance.

Mr. Benjamin Wey is the President and a founding partner of New York Global Group (“NYGG”), a leading middle market advisory firm on Wall Street specialized in executing China related transactions.

What have Chinese banks done differently from Western banks that brought upon such vast differences – one side churning out profits while the other standing on the brink of bankruptcy? The answer is simple: Chinese banks follow the traditional banking model – a financial institution that takes in deposits and provides loans, a simple business model. The Chinese bankers are the “old fashioned” bankers. Many Western banks however, are interested in pursuing faster and higher risk profits generated from derivatives trading. Many Western banks were not and are still not focused on making money from a conventional business model such as the traditional commercial banking of loaning money to qualified borrowers. In this day and age, it is not difficult to imagine that a prestigious college graduate would refuse a career as a loan officer. The fanfare of fast paced Wall Street deals and deal making continues to attract some of the brightest minds to the industry. In other words, Chinese banks serve the economic need of borrowing and lending money while Western banks serve Wall Street’s forever insatiable appetite and relentless pursuit of profits despite higher risk profiles that have doomed many.

When a Chinese bank approves a loan, the bank carries the note on its books against its own capital thereby reducing its ability to extend more loans since the outstanding loan already counts against its capital reserve. That’s the traditional approach in commercial banking. A Western bank however decides that once a loan is made and fees are collected, it wants to move the loan off its balance sheet so that the bank could provide more loans and collect more fees from new borrowers. That’s when “securitization” comes in – a process in which a loan is divided into pieces and sold to investors just like stocks. These smaller pieces of the same loan are then each separately rated by credit rating agencies and each piece is assigned an investment rating. Investors such as pension funds and other institutions that buy these securitized loan products often require minimum investment grade ratings since it is broadly believed that the due diligence work performed on these products by accredited rating agencies can be trusted. Holders of these securitized products often hold them over time while hoping to receive regular loan interest payments from the underlying loans.

Once a loan is securitized and sold, it no longer stays on a bank’s books as a liability which then allows the bank to make new loans and therefore generate additional fees.  When a bank carries a securitized loan product on its books, it is classified as an asset item which increases a bank’s appearance of size and strength, rather than a pure loan which is a liability. The value of such securitized assets fluctuates according to market prices and mark to market accounting is applied. Each quarter, banks count these securitized products on their books and mark these instruments against market prices at that time. If the market prices are higher than the original value, a bank books a gain which shows an increase in earnings and a bank’s stock could move up. If market prices are below the original value, a bank has to report a loss. Banks record earnings or losses although no products or services have been offered. These paper profits do not serve the real economy, where real people and real businesses depend on capital for growth.

A loan securitization process is highly efficient for money management and can be highly profitable for banks that originate the loans. Banks that originate these loans charge the original borrowers processing fees and charge the investors brokerage fees for underwriting the securitization of the same loan. Once a loan is securitized, it becomes just like a share of a common stock; it can be traded and money can be made. A bank benefits from all of these steps.

Wall Street will always fall in love with a growth story.  Wall Street loves a bank that generates more fees and shuns those that grow earnings slowly, often ignoring the fact that those higher profit potentials are typically associated with higher risks. Since bank executives want to increase shareholder value by means of a higher stock price, market and economic forces naturally drive Western banks to securitize everything possible: from bank loans to mortgages, from student debt to household obligations – all debt of all types can be securitized and sold to investors in pieces.

The world was rosy until the macro economic conditions drastically turned negative in the U.S. when the underlying assets and loans quickly turned into bad assets and underperforming loans. In a bear market during the financial crisis, investors no longer wanted to buy more securitized products in such a nervous market environment. When buyers were not around, market prices for those securitized loans became worthless or their values dropped substantially and as a result, banks had to write off billions of dollars as losses.  This chain reaction is what we experienced in the recent global financial crisis which brought some of the largest global banks to their knees. The unintended consequence of widespread securitization process by Western banks in pursuit of quicker returns on assets hurt the real economy when banks stopped lending and pulled their loans from businesses.  When banks were in trouble, they had to raise new capital by selling new equity to investors in the real economy, which had to put up real money for such investments. The financial tsunami will repeat itself unless Western banks go back to the basics of commercial banking –making loans within their capital allowance and with less securitization.

On the contrary, Chinese banks have grown their businesses the traditional way – taking customer deposits at low rates from savings-conscious Chinese consumers and making loans to qualified borrowers. When the deposit and loan spread is wide, a bank’s profit margins are also fattened.  That’s what has happened in China and is still happening there daily – low deposit rates and high loan rates. Chinese banks enjoy a spread of 4-5%. When many billions of dollars in loans are involved, Chinese banks become very profitable due to significant sizes of their loan portfolios.  Meanwhile, as Chinese consumers get wealthier and a rising middle class wants to enjoy life the American way, China’s economy enjoys tremendous growth – supported by real consumer spending in a real economy. In a fast expanding economy such as China which has grown its GDP on average 9% in the last 30 years, banking activities are strong and consumer loan demand is soaring. These are the reasons Chinese banks have been reporting double digit earnings increases in the last couple of years – all originating from organic growth in a booming Chinese economy.

Have Chinese banks been burned at all during the financial crisis? Many certainly have. Some of the largest Chinese banks suffered tremendous losses buying into toxic Structured Products such as MBS underwritten by Lehman Brothers and other big debt shops on Wall Street.  They also got burned investing in the corporate bonds of Lehman Brothers and GM.

Since the late Chinese leader Den Xiaoping’s declaration of China’s “open door” policy in 1979, China has grown into the 2^nd largest economy in the world. Supported by a growing middle class, expanding economy, Chinese banks stand to gain size and profitability. Today, the banks in China are confident and expanding globally. As long as the Chinese economy continues to self-adjust and remain strong, Chinese financial institutions will have years of prosperity to come.

What are some of the perils in China’s economy and its banking system? My view is plain and simple: two things need to be monitored constantly in the Chinese economy: inflation and unemployment. Real problems in both areas could negatively impact the very foundation of China’s economic growth – political and economic stability.

China’s most senior leadership consists of scholars and experts in law and economics, with many of them holding PhDs in these areas. China’s less open and controversial political system prove to be highly efficient in maneuvering economic activities. While in the U.S., major legislative initiatives by the Administration must pass a complex and long legislation process before they could be implemented, in China, the political and economic policy direction is almost entirely determined by the Central Committee. Once the decision is made, the Chinese government can move the entire country’s resources towards implementing the policy. Such a system proved to be highly productive in time of crisis as evidenced in China’s swift and decisive move to provide US$580 billion toward its economic incentive plan at the height of the global financial crisis in 2009. The Chinese government ordered commercial banks of all levels to quickly extend lending and increase loans. In a short few months, over $150 billion dollars was injected into the Chinese economy toward multi-billion dollar infrastructure projects such as inter-province highways and power plants. Such drastic moves helped China avert a severe downturn for the Chinese economy and set the stage for China’s continued 10% plus GDP growth in 2009 while other developed economies suffered major setbacks.  These effective and bold moves by the Chinese government would not have been possible in a more open society such as the U.S. No matter how controversial the government ruling in China may be, we cannot deny that the strong-handed approach by the Chinese government has worked well economically for the country.

China’s continued growth depends heavily on its political and economic stability. High unemployment or high inflation rates threaten such stability. Therefore, as a matter of national priority, the Chinese government places economic and political stability as the highest priority –to maintain peace on these dual fronts at all costs. Human rights or other social concerns take a back seat when such matters are deemed to harm the stability of Chinese society.

In the last century, China successfully transformed itself from an agriculture based economy to an industrialized world.  In this decade, China has so far successfully advanced itself from an export oriented society to a domestic market driven growth model – the same path the U.S. took during the last century. So far, China has very well managed its inflation expectations as well as unemployment numbers.  The inflation target of around 3% for 2010 appears to be well within control. Unemployment, however, becomes a more serious issue. Thus, as China continues to moving forward towards becoming a more developed society, she must deal with all the social dilemmas that come with it.

Chinese banks are certainly not seeking to be innovators of new exotic products and services for the global banking world. They are conservative, policy driven, and autonomous. China’s four largest banks are all majority owned by the Chinese government. China’s central bank, the People’s Bank of China, is the “brain” and policy think tank for the Chinese government. When inflation picks up, the central bank extracts liquidity from commercial banks through central bank IOUs. Instead of increasing interest rates which are considered drastic and shocking to an economy, China’s central bank can change a monetary policy overnight by ordering banks across the country to increase or decrease loans allowances, provide guidance on which sectors in the Chinese economy banks are allowed to provide loans to, or which sectors are prohibited from being given debt support.

The Chinese government’s tight control and broad intervention of the Chinese economy sometimes can be totally incomprehensible for the Western mind.  However, whether we like it or not, it is the Chinese way and it has been working well for the China economy.

Mr. Benjamin Wey is the President and a founding partner of New York Global Group (“NYGG”), a leading middle market advisory firm on Wall Street specialized in executing China related transactions.

The possibility of surpassing the United States, the world’s current largest economy by as early as 2030, shows that the strong growth in China in the next 20 years is very real. Nominal GDP in 2009 for China was $4.9 trillion, about 8% of global GPD, and in the U.S was $14.3 trillion, about a quarter of the global GDP.

The China market, with its 1.3 billion Chinese consumers, one of the highest savings rate in the world of over 30% of household disposable income, have become an area of opportunity that cannot be ignored by any foreign company that wants to compete in the global platform. Currently the world’s fifth-largest consumer market behind the U.S, Japan, UK, and Germany. China is also the world’s largest exporter and second largest importer of goods. In 2009, China overtook the U.S as the world’s largest auto market selling approximately 13.6 million vehicles. China’s fast growth has also created an abundance of wealth. According to Hurun Rich List in October 2009, China has 130 billionaires, second ranked only second to the U.S by number.

Large U.S companies have definitely not been waiting to grab a piece of China’s fast growth. Companies such as Apple, Ford Motors, Nike, Heinz, and the Gap have all taken actions to expand in China, Starbucks and Coca Cola continue to view China as top growth markets, and General Motors have already invested billions in China since a decade ago. According to the U.S –China Business Council, foreign direct investment (FDI) from the U.S in China was up to $3.6 billion last year from the $2.9 billion invested in 2008. In the first half of this year, total FDI in China has already climbed 20% to about $51.4 billion (China’s Ministry of Commerce).

There are definitely challenges that exist for foreign companies in the China market, including government restrictions on foreign investments, counterfeiting, and fragmented local markets. Thus having the right China approach is critical. But with the regulatory environment in China a lot more transparent that it was 5-10 years ago, it has never been easier for international companies to enter the Chinese market. According to the Beijing Axis, a consulting firm that works with foreign multinationals, there are now a lot more opportunities for small- and medium-sized companies than bigger companies in China.

Why should Chinese Companies get involved in U.S Markets? How would that help the overall economy of the United States?

As Chinese companies mature, they must enter the U.S markets in order to survive and compete globally. Not only is U.S the largest consumer market in the world, it is also the world’s leader when it comes to technology, business practices, talents, and exchange of ideas. Chinese companies have already taken an active role to penetrate the U.S markets. Currently Georgia has about a handful of Chinese ventures; Texas has quite a few Chinese telecommunications and industrial manufacturers; in Rockford, Illinois, Chinese automaker Wanxiang Group is planning to build a solar panel assembly plant, hiring 60 employees and eventually increasing to 200. The states have recognized the needed jobs and investments Chinese companies can bring for the local communities that have been devastated by one of the worse recessions in our history. States are thinking of all kind of ways to attract Chinese companies including monetary incentives. The solar plant built by Wanxiang group is expected to be a total investment of $12.5 million with $5 million in incentives from the city and state.

In 2008, foreign direct investments in the U.S from China totaled $1.24 billion, up three times from 2002, according to the U.S Bureau of Economic Analysis. However, this is still only 0.05% of the total $368.2 billion of 2008 FDI invested in the U.S. As the largest foreign holder of U.S treasuries at $877.5 billion as of February, China definitely sees the U.S as a land of vast opportunities, learning ground, and an important role model whose relationship she is eager to maintain and build upon. According to a City administrator in Rockford, there are over $1.3 trillion in foreign exchange reserve locked up in the Chinese economy that the Chinese government is encouraging its people and companies to place back in the United States.

As two of the largest economies in the world, the U.S and China have the most to benefit from in establishing closer relationships with each other. By being more involved in the world’s fastest large economy, U.S companies can capture the needed growth that can help revitalize our economy. By being more involved in the world’s most mature and advance market, Chinese companies can learn to manage their growth, compete competitively globally, and at the same time contribute to the recovery of the largest economy, thus to the global economy.

Mr. Benjamin Wey is the President and a founding partner of New York Global Group (“NYGG”), a leading middle market advisory firm on Wall Street specialized in executing China related transactions.

Despite a large deal flow, less than 2% of all China based companies reviewed by NYGG have passed the firm’s rigorous client acceptance process. NYGG’s local presence in China provides the firm with the latest intelligence on Chinese companies on an ongoing basis.

The fundamentals of a business and more importantly, the integrity of a management team determine its stock performance over the long run. Can lawyers and accountants give investors assessment on the integrity of a company’s management team? The answer is No. That’s part of what NYGG does –  we bring to our clients the “human due diligence” in addition to extensive accounting and legal reviews  on projects which we support.

Cultural Understanding is Critical to Successful Investing:

NYGG staff meets with several hundred Chinese companies each year across many sectors. Through these meetings, we often gain insightful knowledge in many industries by speaking directly to Chinese CEOs and other leaders. We speak to them in the same Chinese language and we truly understand them since we share the same Chinese culture. Therefore, we believe New York Global Group (NYGG) has the ability to read into the “minds and hearts” of a Chinese CEO and conduct “human” due diligence – far more real and extensive than any desktop accounting or  legal reviews. It is  all about getting to know the people involved.

Peter Siris, a New York based Chinese-English bilingual money manager at Guerilla Capital who has invested in many U.S. listed China based companies, is perhaps one of the few people on Wall Street that have a good understanding of how to invest in small cap growth Chinese companies. He has put it very well in one of his media interviews: ”Most people who own these China stocks don’t go to China, they don’t know thesecompanies, and they don’t speak the language. And so they can be suckered in both long and short.”

NYGG’s Due Diligence Process May Have Uncovered Some Problems Early On:

Significant cultural advantages help NYGG and our clients avoid pitfalls as well as identify undiscovered opportunities in the China investment space. The following are a few examples of some of the recent cases that have confirmed our due diligence results:

Case #1: We suspected China Energy Savings Corporation (“CESV”) could be a problem as early as in 2005. At the request of a multi-billion dollar investment fund – a potential investor in CESV, we conducted a due diligence assignment on this company. Our mandate from the institutional investor was simple: take a final look before he invested. “Our due diligence is 99% done and our legal reviews were conducted by a large global law firm…since you guys are the best in the China space, please help us take a final look before we close the deal…we need your blessing and we only have a few days to wrap it all up”, stated the fund manager to us. Our work at our U.S. and China offices was very efficient. Within days, we advised the fund manager to walk away from CESV. He walked away on our advice and saved his fund at least $20 million from potential losses.  In less than a year, the SEC sued CESV for fraud and the company folded. We later on received sincere gratitude from the fund manager thanking us for our advice.

Case #2: We sensed Rino International (“RINO”) could become a problem for U.S. investors as early as the beginning of  2009. We had learned from several senior executives at large Chinese steel mills at that time that steel mills were not motivated to cut waste gas emissions since those efforts cost money while the steel industry itself was already suffering significant losses. However, the steel mills must meet certain minimal emission reduction standards or face large fines. As a result, steel mills spent as little as possible on pollution control equipment, just enough to get by. Pollution control equipment providers such as RINO’s operating business in China were likely to have a much smaller market size than portrayed publicly and the crowded industry meant that it would have been unlikely for RINO to be as profitable as it claimed to be. In addition, our conversations with the local government officials confirmed our view that RINO was also running low on cash. In order to save the company from potentially a much earlier demise, RINO was in a hurry to raise $100 million in an equity offering in 2009. In late 2010, RINO was subpoenaed by the SEC and its stock was swiftly delisted by the NASDAQ citing accounting concerns at the company. RINO shareholders will most likely recover very little, if at all. RINO’s corporate structure is in the form of a Variable Interest Entity – “VIE”, created by highly “creative” lawyers.

In addition to the above, a few names currently listed on the NYSE and the NASDAQ did not pass our due diligence checks either, with more than half of them having gone public through an IPO. Some investors prefer public companies that have gone public through IPOs. But the reality is that it makes no difference whether the company went public through an IPO or a reverse merger – they go through the exact same level of SEC reviews when a financing related registration statement SEC Form S-1 is submitted to the SEC.

In our view, problematic Chinese companies represent a very small percentage of all China based, U.S. listed companies. The majority of

China based, U.S. stock exchange listed companies are compelling opportunities for investors to tap into the growth of China. Structural changes however, should be made so that the investing public in the U.S. gets as much protection by investing in China names as they invest in U.S. companies. The following are our observations:

China Based Companies with VIE Structures Are the Single Biggest “Time Bombs” in the U.S. Markets:

In a VIE structure, the public shareholders do not own the underlying assets in the operating entity – the actual business that generates revenues and earnings for common shareholders. Instead, all of the sales and  incomes reported by the public company and filed with the SEC are booked through contractual agreements whereby a company’s management and founders agree to transfer their rights to sales and incomes from the operating business to the public company. The original founders retain the ownerships of the underlying tangible hard assets such as  cash, factories, land  use rights, machinery, customers etc. In theory and in reality, company management and founders can choose to walk away and leave the public shareholders with no legal claims to the assets of an operating entity. Doesn’t this sound crazy? It certainly does.

RINO was a good example of a VIE structure. RINO’s market capitalization was at one time approaching $1 billion. Shareholders that bought shares in RINO apparently did not realize the inherent risks  involved since they perhaps  did not bother to read the company’s SEC filings which disclosed risks associated with a VIE deal structure.

In our view, a public company in the U.S. with a VIE structure poses the single biggest risk to U.S. investors. Alarmingly, companies with the VIE structure represent more than 20% of the entire universe of China based, U.S. listed companies listed on U.S. stock exchanges, including almost all of the high flying internet stocks. The vast majority of them have become public companies in the U.S. through IPOS.

In contrast, China’s own domestic stock exchanges do NOT permit listing of any company whose revenues are organized under a VIE structure. The VIE structure was created by global law firms in the early  2000s to intentionally circumvent legal requirements in China that prohibit foreigners from owning shares in China based internet companies. That law is still applicable in China today. However, the “creative” VIE structure has become a main stream listing process for China based companies – with almost all of them listed through IPOs in the U.S. markets. What do shareholders own by buying shares of a company organized under a VIE structure? Legal professionals may argue that shareholders get sufficient protection through those management contracts. The reality is, in today’s China, a VIE structure is nothing but a piece of paper evidencing certain “right” that is next to impossible to enforce under Chinese laws. At New York Global Group, we avoid companies with VIE structures completely.

Companies with “Earnings Make Good Provisions” Pose Significant Risks to Investors:

The typical audience of early investors in U.S. listed China based companies are small hedge funds, those with less than $100 million under management and are never long term holders. The vast majority of them are unwilling to or are unable to perform much due diligence on the target companies in China. A popular mechanism that caters to these types of investors is created, by Wall Street bankers and lawyers and is given the fancy name of “earnings make good provisions.” In this approach, investors demand a company CEO make personal guarantees as well as on behalf of his company that certain minimum net income targets must be met by the company, typically for 3 years in a row from the date of the investment. If the company misses its earnings targets in a particular year, the CEO could lose the majority control of his company to the investors to “make good” on those earnings promises. This financing mechanism is worse than a weather forecast. Unless one can predict weather conditions precisely on a specific date, three years in a row, one may lose control of his company. Such mechanism not only stimulates management fraudulent behavior but also limits the investing public’s upside – earlier investors often sell short against their positions. This is one of the main reasons why many China based, U.S. listed high growth  small cap companies trade at single digit current year multiples and are highly vulnerable to short seller attacks – they fight the short sellers on a daily basis as a result of their previously entered “earnings make good provisions” related financings. We have met with many Chinese company CEOs who complain about these “poison terms”, often sold to them by small investment banks. We are highly concerned that management often expresses their willingness to do “all things possible” to achieve those earnings targets – a high risk endeavor for both the companies and the investing public.

NYGG Follows Strict Client Acceptance Criteria:

NYGG is regularly approached by both institutional investors and companies for our knowledge on the China space and the capital markets. Having worked with more than two dozen U.S. stock exchange listed names, we have gained much experience in identifying quality companies.

As a disciplined equity investor ourselves, we have avoided every single one of those publicly acknowledged problematic China based U.S. listed companies. Here are our “NYGG 10 Commandments” which we strictly follow during our client acceptance process.

Mr. Benjamin Wey is the President and a founding partner of New York Global Group (“NYGG”), a leading middle market advisory firm on Wall Street specialized in executing China related transactions.