Deloitte Hides From S.E.C. Behind Chinese Wall Over Longtop
When diplomacy doesn’t work, call in the Cavalry.
The U.S. Securities and Exchange Commission (SEC) yesterday formally requested a U.S. Federal Court to compel Deloitte Touche Tohmatsu (Deloitte) Shanghai to turn over documents and workpapers related to their audit of Longtop Financial Technologies Limited (“Longtop”), a Cayman Islands company, based in China, that listed its shares on the New York Stock Exchange in 2007. Deloitte Shanghai audited Longtop’s financial statements for several years, both before and after Longtop’s 2007 initial public offering in the United States.
Deloitte Shanghai resigned as auditor for Longtop on May 22, 2011, after discovering numerous financial improprieties while conducting its audit for the year ended March 31, 2011.
An excerpt of the resignation letter from Deloitte Shanghai to the Longtop Audit Committee on May 22, 2011:
As part of the process for auditing the Company’s financial statements for the year ended 31 March 2011, we determined that, in regard to bank confirmations, it was appropriate to perform follow up visits to certain banks. These audit steps were recently performed and identified a number of very serious defects…In the light of this, a formal second round of bank confirmation was initiated on 17 May. Within hours however, as a result of intervention by the Company’s officials including the Chief Operating Officer, the confirmation process was stopped amid serious and troubling new developments including: calls to banks by the Company asserting that Deloitte was not their auditor; seizure by the Company’s staff of second round bank confirmation documentation on bank premises; threats to stop our staff leaving the Company premises unless they allowed the Company to retain our audit files then on the premises; and then seizure by the Company of certain of our working papers.
In that connection, we must insist that you promptly return our documents.
Then on 20 May the Chairman of the Company, Mr. Jia Xiao Gong called our Eastern Region Managing Partner, Mr. Paul Sin, and informed him in the course of their conversation that “there were fake revenue in the past so there were fake cash recorded on the books”. Mr. Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Mr. Jia answered: “senior management”.
We bring these significant issues to your attention in the context of our responsibilities under Statement on Auditing Standards No. 99 “Consideration of Fraud in a Financial Statement Audit” issued by the American Institute of Certified Public Accountants.
…These recent developments undermine our ability to rely on the representations of the management which is an essential element of the audit process; hence our resignation.
Deloitte Shanghai registered with the U.S. accounting firm regulator, the PCAOB, in June of 2004. Registration is required for all audit firms, in and out of the United States, who wish to provide audit services to U.S. listed companies. According to their most recent annual report to the PCAOB, Deloitte Shanghai issued audit reports for 48 U.S. listed companies, including Longtop.
U.S. listed Chinese companies have significant risks for investors, including some huge gaps in the regulatory coverage. Some of these companies went public via a loophole called a reverse merger that bypasses the SEC scrutiny typically imposed on a traditional IPO. (Longtop was a traditional IPO so it would have been scrutinized more carefully.) In addition, the PCAOB is unable to conduct on site inspections of audit firms in some countries, including China, that provide financial statement opinions to companies listed on U.S. exchanges. Finally, the offering documents and annual reports for Chinese-based companies contain pages and pages of risk factors, including acknowledgment of limited access to the “final solution” for aggrieved investors.
From Longtop’s 2009 Annual Report: (2010 has not yet been issued because of Deloitte’s resignation and the allegations of fraud.)
We are incorporated in the Cayman Islands and substantially all of our assets are located outside of the United States. We conduct substantially all of our operations in China through our wholly-owned subsidiaries in China. The majority of our officers and directors reside outside of the United States and a substantial portion of the assets of those persons are located outside of the United States. As a result, it may be difficult for our shareholders to bring actions against us or these individuals in the Cayman Islands or in China in the event that shareholders believe their rights have been infringed under the securities laws or otherwise. Even if shareholders are successful in bringing an action of this kind, the laws of the Cayman Islands and of China may make it difficult or impossible for such shareholders to enforce judgments against our assets or the assets of our directors and officers. In addition there is uncertainty as to whether the courts of the Cayman Islands or [China] would recognize or enforce judgments of U.S. courts against us or such persons predicated upon the civil liability provisions of the securities laws of the United States or ay state, and it is uncertain whether such Cayman Islands or [China] courts would be competent to hear original actions brought in the Cayman Islands or [China] against us of such persons predicated upon the securities laws of the United States or any state.
Why would any investor buy shares in a Chinese company under these conditions?
Well, as P.T. Barnum once said, “There’s a sucker born every minute.” Or, translated to a 21st century short-term trading aesthetic, “There’s always a greedy, arrogant, and often deliberately ignorant investor who is willing to be sold.”
Deloitte Shanghai refuses to turn over the Longtop workpapers and documents relevant to the S.E.C. in their investigation of the company and, theoretically, the audit firm.
“Chinese law prohibits Deloitte China from providing the requested documents directly to a foreign regulator,” said spokesperson Lauren Mistretta. “Deloitte China is caught in the middle of conflicting demands by two government regulators, and DTTL hopes that this matter will be resolved in a timely and sensible matter.”
What’s troubling is that the S.E.C. and the PCAOB should have seen this coming.
Deloitte spokesperson Lauren Mistretta:
Deloitte China’s Form 1, which is its initial registration, and subsequent Forms 2, you will see that Deloitte China advised the PCAOB at the time it filed its registration application that it could not provide a blanket consent to comply with all PCAOB requests for documents because of legal conflicts with China law, that it provided a legal opinion in support thereof, and that its registration statement was accepted by the PCAOB thereafter. Deloitte China subsequently continued to advise the PCAOB of this in each of its annual filings. Moreover, this is not a matter unique to Deloitte China. It is a widely recognized profession-wide issue, and all of the Big 4 firms, as well as other firms, have filed similar statements.
The PCAOB, and its parent agency the S.E.C., accepted these conditions and allow them to continue without appreciating the consequences under reasonably foreseeable circumstances.
The PCAOB has been unable so far to negotiate access to Chinese audit firms – and all E.U. firms. The PCAOB did recently refuse to register a new audit firm in Hong Kong given the ongoing uncertainty over inspections there. In the meantime, all of the four largest global audit firms and many, many others continue to produce thousands of audit opinions for U.S. listed companies with no regulatory oversight.
The SEC may be able to compel companies to comply with the subpoena requests but the auditor cooperation issue is a bit more like sticky rice. One of the objections to producing the “workpapers” cited by Deloitte Shanghai, according to the S.E.C filing, implies that the documents are paper files sitting in an office.
According to D&T Shanghai, Chinese law prohibits the production of audit working papers to people or entities outside of China without express approvals from Chinese authorities. See Deitch Decl. ~~ 22-23. Similarly, according to D&T Shanghai, China’s “States Secrets” laws preclude the production of information and documents “relating to the national economy” without prior approvals.
The Deloitte Shanghai letter to the Longtop Audit Committee quoted above implies that Longtop withheld physical files and audit evidence. However, the S.E.C rightfully points out, their objection to producing these files for the regulator may be moo shu given the reality of how the global audit firms do business, especially when the work involves a U.S. listed company.
It is the Staffs understanding that the bulk of the responsive files were generated in and are currently located in China. However, D&T Shanghai has also represented that the vast bulk of the responsive materials are maintained in electronic form, which minimizes any hardship of actual physical production, and limits the amount of material that has to be gathered from a foreign jurisdiction. Moreover, the actual production would take place here in the United States.
The S.E.C. knows, based on its recent experience with investigating and sanctioning PwC in the Satyam scandal in India, that foreign member audit firms are generally subject to significant quality assurance oversight by the U.S. audit firm and provided non-voluntary expert support for their audits of U.S. listed firms. Deloitte, as a global firm, has quality and risk management policies and procedures that almost certainly require a second partner and subject matter expert review by U.S. GAAP and S.E.C. reporting experts before issuance of quarterly and annual reports by U.S. listed clients of their member firms.
The member audit firms and their clients don’t always appreciate the time and money spent on this extra step, but it’s a cost of doing business – and raising money in the United States.
These quality assurance reviews are performed by U.S. professionals on a remote basis, using files they can see from their computers at home. If the bits and bytes of the Longtop workpapers have already traveled over the Chinese Wall, that particular objection to the S.E.C.’s request may be moot.
The S.E.C. must consider how much longer they will allow companies to list in the U.S. if they honestly and clearly tell you they are out of the reach of U.S. courts when something goes wrong.
The PCAOB must consider how much longer they will allow foreign-based audit firms to produce audit opinions if the PCAOB can not inspect them and if home countries refuse to cooperate with U.S. regulators.
U.S. courts must consider how seriously to take claims by global audit firms that they were “duped” by foreign fraudsters when they willingly set up shop, trumpet expertise, plan huge growth and hiring, take shareholder’s fees for auditing shams, and then hide behind Chinese Walls to evade responsibility.
U.S. investors must accept the consequences for trusting their money to those that laugh loudly at attempts to hold them accountable.