Fraud at Longtop Financial Affects Investor Confidence in Stocks of Chinese Companies
This is the first of a two-part blog dealing with ethical issues that must be raised with respect to business practices in China and its growing role as a world economic powerhouse. Today I deal with the growing problem of fraudulent business practices by Chinese companies. Tomorrow's blog addresses the politically sensitive issue of software privacy.
A massive fraud at Longtop Financial, a popular Chinese software company, brings into question 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 a few weeks ago and that was reported by Business Insider (see below), 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.
Floyd Norris at the New York Times reported on May 26 that the Longtop fraud fooled some of smartest hedge funds, mutual fund investors, and the New York Stock Exchange. It fooled the investments banks that underwrote Longtop's stock--and defended it until its demise under the guise of having conducted "due diligence" designed to set investors' fears to rest. And, for a long while, it fooled the very audit firm that is expected to protect the public interest -- Deloitte. In its audit report dated March 31, 2011, Deloitte points out that the firm had determined based on bank confirmations that it was appropriate to perform follow up visits to certain banks." According to the audit report,
"The audit steps were recently performed and identified a number of very serious defects... [that led to] a second round of bank confirmations... Within hours however, as a result of intervention by the Company’s officials including the Chief Operating Officer, the confirmation process was stopped amid serious and troubling new developments including: calls to banks by the Company asserting that Deloitte was not their auditor; seizure by the Company’s staff of second round bank confirmation documentation on bank premises; threats to stop our staff leaving the Company premises unless they allowed the Company to retain our audit files then on the premises; and then seizure by the Company of certain of our working papers. In that connection, we must insist that you promptly return our documents."
According to Blodgett, on May 20 the Chairman of the Company, Jia Xiao Gong, called Deloitte's Eastern Region Managing Partner, Paul Sin, and informed him in the course of their conversation that “there were fake revenue in the past so there were fake cash recorded on the books. ” Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Jia answered: “senior
Auditing standards in the U.S. (Statement on Auditing Standards No. 99) require that the auditor look for instances of fraud that were, in fact, identifed 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 Longtop Financial fraud has broader implications for the U.S. and global stock markets than just one Chinese company committing fraud. There have been other stock fraud 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 by Steven Mintz, aka Ethics Sage, June 1, 2011