Merger of U.S., Chinese firms is cautionary tale

SHENZHEN, China -- For U.S. investors hoping to cash in on China's booming economy, Huiheng Medical once seemed like a smart bet.

A presentation for investors called the firm China's leading domestic developer and provider of gamma-ray technology for fighting cancer. Investors were also told about strong customer orders and a joint venture that would supply Western expertise and boost growth.

But four years after first listing its shares in the U.S., Huiheng trades on the over-the-counter market for $1.60 a share, down from a peak above $13. Net income fell to $2.3 million last year, a fall-off from a 2007 high of $9 million. And sales are so slow, the firm hopes to explore preserving food with radiation — but says it lacks cash to fund the research.

Some of Huiheng's first investors obtained a legal settlement in which the firm bought back their stock after they alleged they'd been duped into buying "essentially worthless" shares.

The firm's latest annual report is so filled with caveats that Michael Santoro, a professor of management and global business at Rutgers University Business School, said a U.S. investor would be hard pressed to "make an intelligent judgment about whether to invest in this company."

"The question for Americans is, does it make sense for a company like this to be accessing our capital markets at all?" asked Santoro, author of China 2020.

Huiheng is one of more than 150 firms based in China or nearby that entered North American securities markets since 2006 through what's called a reverse merger. Though they had no U.S. operations, they took over U.S. shell firms or special-purpose acquisition companies already registered for public stock trading. That enabled them to raise millions in capital without the closer scrutiny focused on more costly initial public stock offerings.

A USA TODAY examination of Huiheng, amid concerns about Chinese reverse-mergers, found:

•The financial backers who helped the firm start trading in the U.S. include father-and-son bankers who have tangled with the federal government and have guided other now-struggling Chinese reverse-merger companies.

•Radiosurgery experts question the firm's effectiveness claims for its technology.

•The company is headquartered in a high-tech area of Shenzhen, one of China's wealthiest cities. But a USA TODAY reporter who observed the five-story building housing its offices from just outside saw two floors that appeared to be empty and a third with open boxes strewn about.

Reverse mergers are a legitimate way to raise capital. But USA TODAY's examination of Huiheng highlights the difficulties investors face as they try to verify the reality behind the financial statements and other claims made by some small international firms.

An SEC warning

The examination comes as a Securities and Exchange Commission working group seeks to tighten regulation of foreign-based firms whose stocks trade only in the U.S. That effort includes a review of auditors, underwriters and other gatekeepers who helped Chinese firms execute reverse mergers. The SEC issued an investor alert about reverse mergers in June, and last month approved rules by the three major U.S. listing markets that raised reverse-merger standards.

Since March, about three dozen Chinese firms have suspended or halted trading in the U.S. after auditors found significant accounting issues, said Kara Brockmeyer, a co-head of the SEC working group. The panel is working with the Public Company Accounting Oversight Board and China securities regulators to get inspection access to overseas auditors and their records.

"We are very much on high alert," SEC Chairman Mary Schapiro said. "We have found companies that have inflated their sales and earnings, that have misstated their cash to deceive investors, and that have had their auditors resign because they didn't feel that the financial statements could be relied upon."

Chinese reverse-merger firms have produced lackluster results. A Bloomberg index of the 12-month stock performance of nearly 80 of those companies looks like a ski slope with a peak above 200 in Nov. 2010 and the low well below 100 now.

At least 11 of the firms have had to halt trading or have been delisted from major U.S. stock exchanges this year amid investigations by regulators. Chinese reverse mergers accounted for nearly 26% of all federal securities fraud class-action filings for the first half of 2011, according to the Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research.

SEC records show small, private Chinese firms have dominated U.S. reverse mergers in recent years, an era when they often were unable to meet requirements for trading on China's securities exchanges.

The combination of small size and higher risk has prompted many accounting and law firms to steer clear, said Paul Gillis, a former PricewaterhouseCoopers partner who's now an accounting professor at the Guanghua School of Management at Peking University in Beijing.

While saying his law firm conducts due diligence checks on reverse-merger firms, "most of these do not have adequate corporate governance in place and simply do not pass the smell test," said attorney Rocky Lee, a Hong Kong-based partner at Cadwalader Wickersham & Taft.

Even sophisticated investors have been burned. Billionaire hedge fund manager John Paulson suffered hundreds of millions of dollars in paper losses in June on Sino-Forest, a Chinese reverse-merger timber company. The firm's shares sank on Toronto's stock exchange after a short seller alleged Sino-Forest had overstated its assets. The Ontario Securities Commission issued a cease-trading order, and Sino-Forest's CEO resigned. This month, the firm delayed releasing third-quarter results for the second time, said it would not make a $9.775 million interest payment due Dec. 15, and announced that it would explore "all strategic options," including a possible sale of the company.

This nation; no, that one

Although based in Shenzhen, Huiheng Medical officially is a Nevada-based holding company that operates through a thicket of subsidiaries in China, Tibet and the British Virgin Islands.

Steven Dickinson, co-author of the China Law Blog for the Harris & Moure law firm in Seattle, said some Chinese firms routinely use complex structures to avoid taxes in China. But he warned "you should be able to understand the corporate structure after the first reading of a prospectus."

Huiheng's SEC filings, which state the firm "designs, develops and markets radiation therapy systems used for the treatment of cancer," include cautionary notes for investors. The filings said the firm has met delays selling its technology in China, and had no international sales in 2009 or 2010. Huiheng also said it has struggled to apply financial controls and has missed SEC deadlines.

The company last year bought a small U.S. medical firm and its catheter patents in a deal in which CEO Hui Xiaobing paid the $260,000 cost, SEC filings show. That deal hasn't produced sales. Huiheng said it could use the catheter to irradiate incision areas after breast cancer lumpectomies. But the U.S. Food and Drug Administration in 2007 said the catheter's documentation must warn that its safety and effectiveness for such procedures "has not been established."

Huiheng's filings show the firm executed the reverse merger with help from Richard Propper, a venture capitalist and financial strategist. He's the CEO of Chardan Capital, a San Diego merchant bank with a website that says it works with "medium sized enterprises in the People's Republic of China." The website also says the bank invested $10 million in Huiheng.

Propper gained voting and investment control of more than 52,000 shares of the firm's preferred stock, SEC records show. That's an ownership class that usually has a higher claim on a firm's assets and earnings than common stock.

Propper teamed on Huiheng with his son, Kerry Propper, CEO and co-founder of Chardan Capital Markets, a New York investment bank. That bank and Roth Capital Partners, a California investment bank, were co-underwriters for a planned 2008 Huiheng stock offering that was later withdrawn, SEC records show.

Chardan Capital Markets was censured and fined $40,000 for three violations of short-selling rules from 2005 to 2009, Financial Industry Regulatory Authority records show. The bank, co-founded by Propper in 2003, consented to sanctions without admitting or denying findings.

Roth is a defendant in securities fraud lawsuits that seek class-action status and involve other Chinese reverse-merger companies, court records show. One, Duoyuan Printing, disclosed in March that the SEC is conducting a fraud probe. Roth, which is fighting the lawsuits, declined to comment about Huiheng.

The Proppers have worked on reverse mergers of several other Chinese firms, often earning fees or stock. But financial results of some of those firms have proven far less than stellar.

One was A-Power Energy Generation Systems, which provides on-site power plants to Chinese industrial firms. Nasdaq halted trading of A-Power shares in August, a month when the firm disclosed an SEC investigation of potential securities law violations and announced the resignations of three board members and its corporate accountant. A-Power disclosed in November that Nasdaq may restore its listing if the firm files its annual report and complies with other obligations by year's end.

Kerry Propper's investment bank was a co-underwriter for the 2007 public offering of Fuqi International, a Chinese company that said it designed jewelry for China's luxury goods market. Fuqi announced in March that Nasdaq had decided to delist its stock after the firm delayed public filings.

The New York bank was also one of three underwriters for the 2006 stock offering of Fuwei Films, a reverse-merger firm that manufactures and distributes plastic films. Last year, the bank joined Fuwei and the firm's other underwriters in the $2.15 million settlement of a securities fraud class-action lawsuit filed by investors. All defendants continued to "deny any wrongdoing whatsoever," according to the settlement.

Schapiro said the SEC working group is exploring ways to ensure that underwriters and market makers conduct proper due diligence tests of reverse-merger firms they bring to the U.S.

Last year, a U.S. firm that the Proppers had scheduled for another Chinese reverse merger instead acquired the back office operations of David J. Stern, a Florida attorney who made millions processing home foreclosures amid the recession.

The aim was to take Stern's system nationwide in a new firm called DJSP Enterprises. But the plan foundered as the Florida attorney general's office began investigating whether Stern's records were falsified to speed foreclosures. Stern disclosed in March he was closing the business.

DJSP, its shares voluntarily delisted from Nasdaq, is now targeted by proposed securities class-action lawsuits. Neither the Proppers nor their banks have been named as defendants.

In 2003, the federal government sued the Proppers for allegedly failing to make promised payments to the Acorn Technology Fund, a limited partnership that received funding from the Small Business Administration. They agreed to a paid settlement last year, court records show.

In a statement on his bank's website, Richard Propper said he agreed to the settlement "because it confirmed that there had been no wrongdoing on our part. Had the government not made the terms so attractive, we would have continued to pursue vindication in the courts and there is no doubt that we would have succeeded."

The Proppers didn't respond to requests for comment on Huiheng and other reverse mergers.

Huiheng ran into legal problems soon after its reverse merger. Harborview Master Fund, Diverse Trading Ltd. and Monarch Capital Fund, institutional investors that controlled the U.S. firm in the deal, approved it and invested $1.25 million in exchange for stock.

But they grew disillusioned as the promised Huiheng customer orders and joint venture deal allegedly failed to materialize. They sued Huiheng, Chardan Capital, Chardan Capital Markets and officials of all three in a 2009 New York State Supreme Court case.

That lawsuit charged that Huiheng's chief finance officer said the firm bribed Chinese hospital officials to win purchasing deals. It also alleged Huiheng prepaid firms controlled by its CEO, who holds most of Huiheng's stock, for material that wasn't delivered, then wrote off the debts.

The company was losing money, had to restate its financials and couldn't get its accounting firm to sign an audit, the lawsuit alleged. Hui and individuals linked with the Chardan banks "expended substantial sums of money … on personal items, including estates in California," the lawsuit also charged.

Huiheng and several co-defendants in the case settled out of court in 2010 with no admission of liability by buying back some of the stock. An unnamed investor found by CEO Hui Xiaobing took on the obligation, an SEC filing shows.

Possible flags

Despite the settlement, USA TODAY found other issues that might concern potential investors. The amended annual report Huiheng filed with the SEC last year shows that CEO Hui's brother-in-law, Huang Jian, is the firm's vice president and a director. Hui Yang, the CEO's nephew, was corporate secretary until 2009.

Daryl Koehn, a professor of ethics and business law at the University of St. Thomas in Minnesota, said many Chinese firms run by family relatives have been successful. However, she said, "The best practice of corporate governance in the U.S. is you don't have family members on the board."

Nathan Parmelee, who leads an analyst team researching international stocks for the Global Gains newsletter issued by The Motley Fool, a multimedia financial services firm, raised concern that two Huiheng distributors accounted for 90% of the company's China sales in 2010.

Parmelee, who reviewed Huiheng SEC filings for USA TODAY, also noted that the firm's marketing director, Tang Shucheng, previously served as vice general manager of one of those distributors. "That whole relationship is immediately a red flag," said Parmelee, because the filings don't list the distributor's current owner, and show the distributor has delayed payments to Huiheng.

Parmelee said Huiheng has had a "deterioration … in its ability to collect on receivables and generate cash between … the company's reverse merger and now, when it's just eating through cash."

Huiheng denied USA TODAY interview requests. Afterward, the reporter who observed the firm's Shenzhen headquarters building from outside saw the apparently empty floors, a parking lot able to hold roughly 15 cars, and little activity.

On the U.S. front

Huiheng's financial filings say the company is pursuing international operations. But the closest sign of any U.S. activity was a 2009 Baton Rouge news release saying the firm would build a manufacturing plant there by 2010. That plan hasn't become reality.

Scott Dyer, a spokesman for Baton Rouge Mayor-President Melvin "Kip Holden, said Huiheng met with delays getting technology approvals from the U.S. Food and Drug Administration and Underwriters Laboratories. Both agencies said they could not confirm any Huiheng applications unless and until formal decisions were issued.

Meanwhile, Huiheng's business in China appears to struggle. In 2009, Yangcheng Wan Bao, a newspaper in Guangzhou, quoted the firm's CEO as saying his industry was "on the verge of stopping production" because China had restricted equipment purchases by state-run hospitals.

Additionally, some radiosurgery experts challenge Huiheng's technology claims. One is Dan Leksell, an advisor for Swedish radiosurgery giant Elekta who's delivered radiosurgery lectures worldwide for 40 years. His father, the late neurosurgeon Lars Leksell, created the Gamma Knife, a non-invasive machine used to treat brain cancer.

Leksell, who examined Huiheng's gamma system treatment statements and equipment photos at USA TODAY's request, said the company's statements were "simply not credible."

When treating brain cancer, radiosurgeons stabilize a patient's head, preventing any movement. Some radiosurgery firms have developed computerized controls they say detect and compensate for slight movements of patients treated for tumors elsewhere in the body. But Leksell cautioned "even if they screw the patient down, inside the patient's body, things will move."

Studies about successful outcomes of patients treated with Huiheng radiosurgery equipment drew skepticism from Leksell and Rebecca Emerick, executive director of the International RadioSurgery Association, which gives information to doctors, insurers and others. Emerick said they lacked long-term patient follow-ups.

"Overall, these papers are old (and) do not appear to be published or peer reviewed," said Emerick, who described them as being of "very poor quality."