The federal government’s investigation into potential securities fraud by Chinese companies whose securities are publicly traded in the U.S. appears to be heating up. The Securities and Exchange Commission recently announced administrative proceedings against the China affiliates of each of the “Big Four” accounting firms and another large U.S. accounting firm for refusing to produce audit work papers and other documents.
According to the SEC, DO China Dahua Co. Ltd, Deloitte Touche Tohmatsu Certified Public Accountants Ltd, Ernst & Young Hua Ming LLP, KPMG Huazhen (Special General Partnership), and PricewaterhouseCoopers Zhong Tian CPAs Limited have all refused to cooperate in the investigations of several China-based companies. They are specifically charged with violating the Securities Exchange Act and the Sarbanes-Oxley Act, which requires foreign public accounting firms to provide the SEC upon request with audit work papers involving any company trading on U.S. markets.
The auditing firms contend that Chinese law prevents them from complying with the probe. Audit documents cannot be removed from the country, and foreign regulators are not authorized to conduct investigations inside China. Efforts to work with the China Securities Regulatory Commission have also been unsuccessful, according to a recent Bloomberg report.
“Only with access to work papers of foreign public accounting firms can the SEC test the quality of the underlying audits and protect investors from the dangers of accounting fraud,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “Firms that conduct audits knowing they cannot comply with laws requiring access to these work papers face serious sanctions.”
To date, the SEC has deregistered the securities of almost 50 Chinese-based companies and filed fraud actions in related claims against more than 40 issuers and executives. Many Chinese-based companies gained access to North American markets through reverse mergers.
In a reverse merger transaction, an existing public “shell company,” which is a public reporting company with few or no operations, acquires a private operating company in order to facilitate access to funding in the U.S. capital markets and provide liquidity to its existing shareholders. A reverse merger allows the private company to essentially “go public” by gaining control of the acquiring company without complying with some of the more burdensome and time-consuming legal and SEC registration requirements of an initial public offering (IPO). As a result, investing in these companies can be a risky endeavor, particularly if investors cannot rely on audit reports.
If you have any questions about this case or other issues related to the risks of investing in Chinese reverse-merger companies, please contact me, Donald Scarinci, or the Scarinci Hollenbeck attorney with whom you work.