Questions Hedge Fund Managers Need to Consider Prior to Making Investments in Chinese Companies

The negative publicity surrounding Chinese companies listed in the United States seemingly has reached a fevered pitch.  In April 2011, the Securities and Exchange Commission, or SEC, acknowledged that it had established a task force to address what it deemed to be abuses by Chinese companies accessing the U.S. markets through the use of reverse merger transactions.  SEC Commissioner Luis Aguilar referred to the proliferation of these companies as a “disturbing trend that seems to have challenging implications for capital formation and investor protection.”  In addition to the SEC, the U.S. national stock exchanges have been taking more aggressive actions against Chinese companies.  During 2011, almost two dozen Chinese companies have seen trading in their securities halted or have been delisted in large part due to accounting irregularities.  Against this backdrop, it has become increasingly difficult for investors in this space to separate the undervalued from the fraudulent.  In a guest article, Cavas S. Pavri, a Member in the Business Law Department of Cozen O’Connor, discusses areas that hedge fund managers should focus on in performing their due diligence on investments in Chinese companies.  Specifically, Pavri discusses, among other things: relevant PCAOB guidance; specific factors to consider in evaluating a Chinese company’s accounting firm; specific factors to consider in assessing a Chinese company’s chief financial officer and accounting staff; what to look for when evaluating the corporate governance of a Chinese company; considerations in connection with “variable interest entity” structures; local financial reporting; SAFE registration; the importance of a prior underwritten offering; and insurance considerations.

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