Why audit a U.S. listed Chinese company? | China Accounting Blog | Paul Gillis

Why audit a U.S. listed Chinese company?

I have written quite a bit about the epidemic of frauds in Chinese stocks.   Few frauds allegations against Chinese companies have been proven to date, although many companies have been delisted after their auditors have resigned. A good starting point for keeping score on fraud allegations is the number of class action lawsuits filed against U.S. listed Chinese companies. The class action bar seems to have a hair trigger for filing these suits, but they do represent allegations of wrongdoing. Many are unlikely to be proven or the suits may be dropped if the odds of settlement become too low. 

According to a report by Advisen, five class action lawsuits were filed against Chinese companies in 2009. The number increased to 23 in 2010 and to 44 in the first half of 2011.  

It will take years for these lawsuits to be sorted out, if they ever are sorted out. There are many obstacles to shareholders recovering from these companies. The assets and the officers are usually in China, and even if the shareholders are successful in obtaining a judgment, they may be unable to enforce it.   

Many of the suits have not named the auditors as co-defendants. The auditors, however, are potentially an attractive target.  The Big Four have each paid out more than $1 billion in settlements over the past decade. They have a much harder time ducking a court date. But in many cases the auditors are the heroes, having discovered the fraud. That fact is often overlooked when plaintiffs ask the question of why it was not discovered earlier. 

China Express Technology Inc. was a pioneer defendant in class action lawsuits against U.S. listed Chinese companies. It was sued in 2007 with allegations of fraud, but never appeared in court, resulting in a default judgment that was likely impossible to enforce.  The plaintiffs then turned their attention to the auditors, BDO and PKF. The defense lawyers asked that the case be dismissed, a request that was denied by the judge who wrote in a handwritten opinion: “enough has been alleged to make out a plausible claim for relief.” It is not at all certain that the firms will face liability, but it does appear that they will have to mount an expensive defense.

There are big fees available for auditing companies listed on the NYSE and NASDAQ. My research for 2009 showed that the average fee for auditing a NYSE listed Chinese company was $2,566,000. For a NASDAQ listed Chinese company it was $637,000. The fees are much smaller for those companies that came to market as reverse mergers and those companies have the highest risk of facing fraud allegations.  

Even if firms are successful in avoiding judgments against them, they will be spending a fortune in defense costs and increased professional liability insurance. Many of the firms auditing companies involved in the scandals are small U.S. based firms. While many may already be in too deep to get out, you have to wonder why they got into China in the first place.

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