The Audacity of Chinese Frauds

May 26, 2011

By FLOYD NORRIS

To pull off a fraud that humiliates the cream of the global financial elite, you need to have some friends. And where better to have them than at the local bank?

The fraud at Longtop Financial Technologies, a Chinese financial software company, was exposed this week in an amazing letter from its auditors, Deloitte Touche Tohmatsu. It appears to be a tale of corrupt bankers and their threats to auditors who had learned of the lies.

Deloitte, which had given clean audit opinions to Longtop for six consecutive years, apparently was well on its way to providing a seventh, for the fiscal year that ended March 31. But for some reason — Deloitte did not say why —the auditor went back to Longtop’s banks last week to again seek confirmation of cash balances.

It appears Deloitte sought confirmations from bank headquarters, rather than the local branches that had previously verified that Longtop’s cash really was on deposit. And that set off panic at the software firm.

“Within hours” of beginning the new round of confirmations on May 17, the confirmation process was stopped, Deloitte stated in its letter of resignation, the result of “intervention by the company’s officials including the chief operating officer, the confirmation process was stopped.”

The company told banks that Deloitte was not really the auditor. It seized documents, Deloitte wrote, and made “threats to stop our staff leaving the company premises unless they allowed the company to retain our audit files.”

Despite the company’s efforts, Deloitte learned Longtop did not have the cash it claimed and that there were “significant bank borrowings” not reflected in the company’s books.

A few days later, Deloitte said, Longtop’s chairman, Jia Xiao Gong, told a Deloitte partner that there was “fake cash recorded on the books” because there had been “fake revenue in the past.”

The stock has not traded since that confrontation. The final trade on the New York Stock Exchange was for $18.93, a price that valued the company at $1.1 billion. At its peak in November, it had a market capitalization of $2.4 billion.

It now seems likely that the stock is worthless. It is a real company, but its revenue and profits probably were a small fraction of the amounts reported. The existence of the “significant” debt means that whatever assets are left are likely to be owned by the banks, not the investors.

Deloitte may have decided to check the numbers again because it knew a growing group of bears on the stock had been challenging the Longtop story as too good to be true, questioning both its financial statements and the claims it made for its software. A month earlier, Deloitte resigned as the auditor of another Chinese company, China MediaExpress, in part because of questions about bank confirmations.

It is never good for an auditor to have certified a fraud, but Deloitte seems to have acted properly. It got bank confirmations, and it got them directly from the banks rather than relying on the company to provide them, as PricewaterhouseCoopers had done when it failed to notice a huge fraud at Satyam, an Indian technology company.

But the confirmations were lies.

“This means the Chinese banks were in on the fraud, at least at branch level,” says John Hempton, the chief investment officer of Bronte Capital, an Australian hedge fund. He was one of the bears who questioned Longtop’s claims and now stands to profit from the stock’s collapse.

“This is no longer a story about Longtop, and it is not a story about Deloitte,” he added. “Given the centrality of Chinese banks to the global economy, it’s a story much bigger than Deloitte or Longtop.”

The Securities and Exchange Commission has started an investigation, and no doubt more details will emerge, including the names of the banks involved. Just what, if anything, Chinese officials choose to do could provide an indication about whether defrauding foreign investors is deemed to be a serious crime in China.

Fraud in Chinese stocks is not new. But it had seemed that the worst problems were in small companies without Wall Street pedigrees. Many of the fraudulent companies went public in the United States by the reverse-merger shell route, a course long favored by shady stock promoters. That route allowed companies to start trading without going though a formal underwriting process or having its prospectus reviewed by the S.E.C. And many used tiny audit firms based in the United States that seemingly did little if any work.

What is stunning about Longtop and some other recent disasters is the list of smart people who were fooled.

Longtop did not go public through a reverse merger. Its initial public offering, in 2007, was underwritten by Goldman Sachs and Deutsche Bank. Morgan Stanley was a lead manager in a 2009 offering of more shares. Major owners of the stock included hedge funds run by people known as “tiger cubs” because they got their start at Julian Robertson’s Tiger Fund.

On May 4, only a couple of weeks before the fateful struggle at Longtop offices, an analyst for Morgan Stanley, Carol Wang, wrote:

“Longtop’s stock price has been very volatile in recent days amid fraud allegations that management has denied. Our analysis of margins and cash flow gives us confidence in its accounting methods. We believe market misconceptions provide a good entry point for long-term investors.”

By then, Longtop officials had begun to scramble. According to its last audited balance sheet, cash accounted for more than half of Longtop’s $606 million in assets. Bears were asking why the company needed all that cash and were questioning whether it existed.

In mid-March, just after the fraud at China MediaExpress was exposed, Longtop announced plans to put some of the cash to use by spending up to $50 million to repurchase its own shares. On April 28, the company tried to assure analysts that the fraud claims were bogus. Derek Palaschuk, a Canadian accountant who served as the company’s chief financial officer, wrapped himself in Deloitte’s prestige, saying that those who questioned Longtop were “criticizing the integrity of one of the top accounting firms in the world.”

“For me,” he said, “the most important relations I have other than with my family, my C.E.O., and then the next on the list is Deloitte as our auditor, because their trust and support is extremely important.”

Mr. Palaschuk had an explanation for why the company had not repurchased any shares. It had some very good news that it had not yet released, and “we were advised by our securities counsel that we should not be in the market purchasing our own shares in the event that this would be considered insider trading.”

Longtop is not the only Chinese fraud that caught prominent Americans. Starr International, an investment company run by Hank Greenberg, the former chairman of American International Group, invested $43.5 million in China MediaExpress and had a representative on the company’s board. Starr has filed suit in Delaware against the company and Deloitte.

Goldman Sachs was not the underwriter of ShengdaTech, a Chinese chemical company traded on Nasdaq, but its investment arm, Goldman Sachs Investment Management, had accumulated a 7.6 percent stake in the company before its auditor, KPMG, refused to sign off on the company’s 2010 annual report and then resigned in late April. KPMG cited “serious discrepancies” regarding bank balances and “discrepancies between KPMG’s direct calls to customers and confirmations returned by mail.” Just as at Longtop, it appeared that auditors had been given false confirmation letters.

In each of those three cases — Longtop, China MediaExpress and ShengdaTech — the auditors discovered discrepancies, but only after signing off on financial statements. That was not the case in this year’s other — and perhaps most embarrassing — resignation by a Big Four auditing firm.

In December, KPMG was retained by China Integrated Energy, which claimed to be a leader in the production of biodiesel. Just hiring a Big Four auditor enabled it to raise $24 million from institutional investors in the United States. Three months later, KPMG certified the financials.

Six weeks after that, KPMG repudiated the report and resigned. By then, China Integrated Energy executives had refused to cooperate with a board investigation into claims that the company was a complete fraud.

The Chinese audit firms, while they are affiliated with major international audit networks, have never been inspected by the Public Company Accounting Oversight Board in the United States. The Sarbanes-Oxley Act requires those inspections for accounting firms that audit companies whose securities trade in the United States, but China has refused to allow inspections.

In a speech at a Baruch College conference earlier this month, James R. Doty, chairman of the accounting oversight board, called on the major firms to “improve preventative global quality controls,” but said that actual inspections were needed.

Two weeks ago, Chinese and American officials meeting in Washington said they would try to reach agreement “on the oversight of accounting firms providing audit services for public companies in the two countries, so as to enhance mutual trust.”

Frauds and audit failures can, and do, happen in many countries, including in the United States. But the audacity of these frauds, as well as the efforts to intimidate auditors, stand out. If investors such as Goldman Sachs and Hank Greenberg cannot fend for themselves, something more needs to be done if Chinese companies are to continue to trade in American markets. - NYT