SEC Closes In On Deloitte China

Noose tightens around Deloitte

It happened in 2011, but the sudden collapse of financial services firm Longtop Financial more than 2 years ago is still in the news as the US securities regulator tries to determine what caused the crisis that sparked a prolonged winter for US-listed Chinese stocks. While Longtop itself became the first victim of that crisis long ago, the next big victim could soon be the company’s auditor, the China affiliate of global accounting giant Deloitte Touche Tohmatsu. A final showdown on that front could be coming soon, following word that the US Securities and Exchange Commission (SEC) has finally gained access to auditing records that are most likely related to the Longtop case.

The SEC has been seeking auditing records for Longtop for nearly 2 years now, following the collapse after a short seller uncovered accounting irregularities at the company. That collapse was followed by several others under similar circumstances, leading to an investor confidence crisis and a prolonged downturn for Chinese stocks that has lasted for more than 2 years now.

The chill has brought new public listings for Chinese firms in New York to a virtual halt. It has also led to a massive exodus of Chinese from New York’s 2 main stock exchanges, as some companies were forced to leave by the SEC and others privatized as their stocks sank to all-time lows.

While the clean-up of questionable Chinese firms is largely finished by now, one lingering issue is what role, if any, the companies’ auditors played in the crisis. Many suspect that those auditors helped companies to embellish their books and hide problems, even though the outside accountants claim they were also the victims of deception by their clients.

The issue has remained unresolved all this time because the auditors refused to hand over records to the SEC, citing territorial issues. In most cases, the auditors said their relevant work was conducted in China, and therefore they would risk breaking Chinese laws by handing over any documents to the US regulator. But in a major breakthrough, the SEC and its Chinese counterpart, the China Securities Regulator Commission (CSRC), signed a breakthrough agreement in May to facilitate the cross-border sharing of audit documents. (previous post)

Now Chinese media are reporting that the CSRC has completed its gathering of relevant audit documents requested in one case, and is preparing to hand those documents over to the SEC. (Chinese article) The reports don’t specify the name of the company or its auditor, but I strongly suspect that it’s Longtop and that the audits were conducted by the China affiliate of Deloitte.

The fight over access to these documents back to 2011, when the SEC first subpoenaed Deloitte as part of its investigation of Longtop’s collapse. Deloitte refused the SEC’s request, prompting the latter to charge the former with failing to assist in a financial fraud probe. (previous post)

The SEC has been quite determined in this case, taking the relatively rare step of negotiating with a foreign government to gain access to locally-based audit documents. If the documents received by the SEC are indeed related to the Longtop case, we could potentially see a final finding in the matter by September or October. I suspect that finding will show Deloitte was negligent at the very least, and could even end up with accusations of fraud.

So, what does this mean for everyone involved? Obviously a finding against the Deloitte China unit would be bad news for that company, and could easily be followed by similar investigations against other auditors. At the same time, such a finding would be an important step to restoring investor confidence toward these long-suffering US-listed Chinese firms. Any of those firms that were thinking of using creative accounting tricks might now think twice before taking such action, since they will know they can no longer depend on territorial issues to protect their audit records from being obtained and reviewed by the SEC.

Bottom line: The SEC could soon receive auditing records related to the collapse of Longtop Financial, resulting in fraud or negligence charges against Deloitte’s China arm.

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