(Bloomberg News) The Securities and Exchange Commission's probe into auditors of China-based companies listed on U.S. share exchanges is a signal for investors to approach these stocks with caution, said International Strategy & Investment Group.

The SEC on Dec. 21 sanctioned a California audit firm for signing off on fraudulent financial statements made by a Chinese energy company. Auditors have come under scrutiny for signing the financial statements of China-based firms accessing U.S. markets through reverse mergers, in which a closely held company acquires a publicly traded company and can then sell shares without an initial public offering.

"This is the ultimate 'buyer beware' sector of investing," said Donald Straszheim, director of China research at ISI, who was ranked first in the Macro and Economics categories in Institutional Investor magazine's 2009 survey. Individual investors "would perhaps be well served to just stay away. Even the most sophisticated institutional investors in the world often avoid the opacity and risks," he said.

Straszheim, who is based in Los Angeles, estimates there are "hundreds of tiny companies in China" that have sold shares in the U.S. through reverse mergers, aiming to tap into booming demand from U.S. investors who want access to the Chinese economy.

Xia Lihua, a spokeswoman at the China Securities Regulatory Commission, declined to comment on the SEC probe.

SEC Claims

Moore Stephens Wurth Frazer & Torbet LLP of Orange County, one of several firms that have fallen under the SEC's scrutiny, "did not exercise professional skepticism and due professional care" in audits of China Energy Savings Technology Inc., which was ordered to pay about $35 million in March 2009 for overstating revenue, the SEC said in a statement on Dec. 21.

China Energy Savings has been delisted. Calls to the company's Hong Kong office weren't answered.

Dean Yamagata, the partner in charge of the audit, was barred from practicing as an accountant for at least two years. Frazer and Yamagata didn't admit or deny the allegations. To settle the SEC's claims, Frazer and Yamagata agreed to pay $129,500 and retain an independent consultant for training in fraud detection, auditor independence and other duties related to auditing functions.

The SEC has identified "hundreds" of such small companies "where about 100%, not 95%, 100% of the operations are in the People's Republic of China" and the financial statements are signed by a small U.S. auditor, Wayne Carnall, chief accountant of the SEC's division of corporation finance, said at a Public Company Accounting Oversight Board meeting in April.

Legal Requirements

"It's more of those accounting firms' own issues and problems," said Hubert Tse, a partner at law firm Boss & Young in Shanghai. "It's their job and responsibility to work that out and to make sure the IPO applicants comply with all relevant U.S. legal and listing requirements."

The PCAOB, which was created by the Sarbanes-Oxley Act in 2002 to oversee auditors of public companies, is looking for ways to hold U.S. auditors accountable for work they outsource to China-based audit firms.

"The news about SEC investigations is not surprising," said Michael Yoshikami, who oversees about $1 billion at Walnut Creek, Calif.-based YCMNet Advisors. "Standards for transparency have a way to go to reach a level where one can expect accuracy. Still, this does not change our view that Chinese companies will account for a growing percentage of IPOs."

'Frothy Levels'

At a time when China's government is trying to keep the economy from overheating, a record number of its companies are selling stock in the U.S. Forty-one Chinese companies have sold shares through initial offerings in the U.S. this year, capping a record year that exceeded the 37 transactions in 2007, data compiled by Bloomberg show.

Investor demand for emerging-market shares, including those from China, will remain in "frothy levels," said Yoshikami, who was named by Barron's as one of the Top 100 Independent Financial Advisors for 2009. "The business opportunity is simply too great to ignore."

China's gross domestic product will by expand by 9.2% this year, according to the median estimate of 17 economists surveyed by Bloomberg News, poised to overtake Japan as the world's second-largest economy. The People's Bank of China has raised the amount of reserves banks should set aside, including ordering an increase on Dec. 10, the third time in five weeks, to rein in inflation and avert asset bubbles.

Stock Pressure

Alexander Potter, an analyst at Piper Jaffray Cos, expects pressure on stocks whose companies went public via "back door" methods such as reverse mergers.

The Bank of New York Mellon China ADR Index, which comprises American depositary receipts of Chinese and Hong Kong companies, gained 0.4 percent yesterday, taking its climb this year to more than 12%. China's Shanghai Composite Index fell 0.6 percent as of 9:57 a.m. local time. The gauge has slumped 13% in 2010.

"Investigations like this inevitably cast a shadow that is broader and wider than the particulars of the case itself," Straszheim said. "I doubt that it will cause any lasting damage to the broad investor interest in China's overall economy."