China and its amazing economic growth have created a whole lot of wealth for investors over the past several years.  Indeed, many fortunes have been made by investors willing to buy Chinese companies whose stocks are listed on U.S. exchanges.  But investing in emerging markets in general—and specifically in China—is not without its growing pains.

Case in point is the recent dust up in the shares of Chinese poultry industry firm Yuhe International (YUII).  The shares got pummeled last week on news that its independent audit and accounting firm, Grant Thornton, resigned as the company’s public accountant.  Why did Grant Thornton feel the need to resign after only three months of service?  In essence, they did so because of Yuhe’s “perceived” inability to comply with U.S. governance rules laid out by the Sarbanes-Oxley Act of 2002.

I say “perceived” because the situation with Yuhe and Sarbanes-Oxley compliance was largely a misunderstanding on the part of Yuhe executives.  This misunderstanding was read by some investors as a potential accounting fraud scandal, so when the news of the Grant Thornton resignation hit the wires, the stock sold off sharply.

Corporate governance and compliance issues, while not common with China-based companies, do occur from time to time.  The reason why is because many Chinese companies are just now getting used to navigating the maze of U.S. regulatory rules.  To get to the bottom of the Yuhe issue I did a lot of research, including speaking directly with Yuhe CEO Mr. Zhentao Gao.

According to Gao, before Yuhe’s U.S. listing the company paid its vendors through an entity known as Weifang Hexing Breeding, a company 80% owned by Gao. These vendor payment transactions were originally set up to facilitate and expedite the payment process from Yuhe to its farm vendors. This type of vendor payment arrangement, though prohibited by the Sarbanes-Oxley Act, is actually quite common in China.

After Yuhe shares went public in the U.S., the Weifang Hexing Breeding entity was not included in the public company’s accounting ledger. The problem, of course, is that rather than discontinue use of the separate entity immediately after going public, Yuhe continue to use the separate entity to pay its vendors. Although this is not appropriate when seen through the eyes of the Sarbanes-Oxley Act, it was by no means an intentional ploy by Yuhe to deceive the investing public.

Gao was quite forthcoming in our conversation, and he admitted to me that the company has made mistakes in its internal controls.  He also told me that the company is in the process of strengthening its internal regulatory process, and it has stopped making payments to vendors through the separate entity. They’ve also spent $1.4 million to comply with the rules set by the Sarbanes-Oxley Act, a process they expect to be complete by the end of the year.  I believe the Yuhe situation represents the learning curve that nearly all newly listed Chinese companies face as they make their way on to U.S. equity exchanges.

To be certain, this episode was an uncomfortable tutorial for Yuhe and its shareholders.  But the wider lesson here for all China investors is that there is always a chance that you’ll be blindsided by the growing pains associated with Chinese firms trying to conform to U.S. regulatory and accounting rules.  Of course, this concern should not sway anyone from buying Chinese stocks listed on U.S. exchanges.  The incredible upside potential that comes with investing in the China miracle is just too great to be stymied by the growing pains.

Related Articles:

• Strong Sales of ‘Small Luxuries’ Fuel These 3 China Stocks
• Top 5 Emerging Market Airlines
• Taiwanese Stocks Will Continue to Perform in 2010