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Fraud 'Flu' Spreading at Chinese Companies

SEC Investigating Fraud at China MediaExpress

Last week it was announced that the SEC charged defunct company China MediaExpress and its chief executive officer with misleading investors, the agency's latest case alleging fraud at a U.S.-listed China-based company.

The SEC alleges that China MediaExpress falsely reported increases in its business operations, profits and overall financial condition as soon as it became a publicly traded company in October 2009 through a backdoor method known as a "reverse merger."

In a ‘reverse merger’, a Chinese (or any foreign company) is "bought" by a publicly traded U.S. shell company. The Chinese company assumes control and gets the shell's U.S. stock listing without the SEC's usual level of scrutiny of an IPO. It's a backdoor way of getting listed on U.S. stock exchanges. The Public Company Accounting Oversight Board (PCAOB) recently reported that nearly three-quarters of the 215 Chinese companies listing in the U.S. from 2007 to early 2010 did so using the reverse merger.

The fraud comes in because chairman and chief executive, Zheng Cheng, signed and attested to the accuracy of false public filings, and later tried to pay off a senior accountant who was investigating possible fraud at the company, the SEC alleged. As a result of the fraud, NASDAQ
delisted the company's stock in May of 2011. The SEC deregistered its securities in March 2012.

The China MediaExpress case is the latest in a long-running crackdown by the SEC into accounting fraud at China-based companies that are listed on U.S. stock exchanges. Accounting scandals at many of these companies have prompted auditor resignations, and led the SEC to launch investigations into the companies, their executives and their auditors.

To date, the SEC said its Cross-Border Working Group has filed more than 65 fraud cases against companies or executives, and deregistered the securities of more than 50 companies.

The SEC in December charged the Chinese affiliates of Deloitte, KPMG, PricewaterhouseCoopers, BDO and Ernst & Young with violating the law by refusing to hand over documents to aid the agency's investigations.

In this latest case, the SEC said China MediaExpress falsely claimed in its 2009 annual report that it had $57 million in cash on hand when it only had a cash balance of $141,000. It also misrepresented its cash balances in press releases as well.

After it misrepresented its financial condition, the SEC said the stock price tripled to more than $20 a share. The company's auditor resigned in March 2011.

The company's audit committee launched an internal investigation and hired a Hong Kong forensic accounting firm. The SEC said Zheng tried to bribe the accountant handling the probe with $1.5 million, but the accountant refused.

I previously have blogged about a massive fraud at Longtop Financial, a popular Chinese software company, that raised questions whether Chinese corporations are starting to show the stresses of competing in a more western-style model of business -- the publicly-owned corporation. The "cash balance" on Longtop's balance sheet, it turns out, was fake--a fiction created by the company's managers with bank complicity.

According to an extraordinary letter that Longtop's auditor, Deloitte, sent the company when it quit and that was reported by Business Insider, Longtop's banks sent out fake statements attesting to the company's fake cash balances. It wasn't until Deloitte's examiners actually physically visited the banks, and talked to other employees at the banks, that the fraud was discovered.

Chinese companies have their own auditing standards but when they list their stock on U.S. exchanges, they are expected to follow U.S. generally accepted auditing standards. Statement on Auditing Standards No. 99 requires that the auditor look for instances of fraud that were, in fact, identified and which led to the resignation of Deloitte. Here are the reasons provided by Deloitte for its resignation from the audit of Longtop Financial: (1) the recently identified falsity of the Group’s financial records in relation to cash at bank and loan balances (and also now seemingly in the sales revenue); (2) the deliberate interference by the management in our audit process; and (3) the unlawful detention of our audit files.

"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 added that "we are no longer able to place reliance on management representations in relation to prior period financial reports. Accordingly, we request that the Company take immediate steps to make the necessary 8-K filing to state that continuing reliance should no longer be placed on our audit reports on the previous financial statements and moreover that we decline to be associated with any of the Company’s financial communications during 2010 and 2011."

The China MediaExpress and Longtop Financial frauds have broader implications for the U.S. and global stock markets than just one Chinese company committing fraud. There have been other stock frauds so that we should question whether this is just the tip of the iceberg with respect to the growing number of Chinese companies that list their stock on foreign exchanges. Given the rapid movement to a Chinese-style of western capitalism, the following question must be asked: Do managers of Chinese companies have the requisite discipline and core values to ward off the temptation to manipulate financial results that tend to make the company look healthier than it really is? We know little of the culture of Chinese companies from an ethical perspective. However, it is a critical assessment to make going forward so that the financial markets can develop the long-term confidence needed in corporate China to sustain international investment.

Blog posted by Steven Mintz, aka Ethics Sage, on June 25, 2013