Chinese State Secrecy Laws Being Pulled Apart Under Audit Stresses

November 28, 2011 Posted by China Briefing Reading Time: 3 minutes

Nov. 28 – In the past two years, a wave of accounting scandals, particularly allegations of securities fraud, have hit China-based companies listed on U.S. stock exchanges. Since 2010, more than 30 securities class actions have been filed against China-based, U.S.-listed companies. One of these cases is Munoz v. China Expert Technology, Inc., filed in 2007 by shareholders of Shenzhen-based China Expert against the company’s outside auditors, i.e. PKF Hong Kong, PKF New York and BDO McCabe Lo, for failing to detect an alleged US$132 billion fraud. The China Expert suit is at a slightly more advanced stage compared to the other proposed class-actions.

Rather than naming China Expert as the defendant, the shareholders pursued the accounting firms. Considering China Expert’s shaky finances and financial structures, and likely lack of adequate insurance coverage, it could be difficult for plaintiffs to collect judgments against it. On the other hand, accounting firms have deep pockets and would be a more lucrative option for the plaintiffs. The rulings of this case could therefore open the door for shareholders to pursue auditors of these China-based companies.

China Expert launched a U.S. initial public offering in 2004 using the reverse merger practice whereby it purchased an existing American shell company and issued stocks through it. According to the shareholders’ complaint, the financial statements issued by China Expert reported that the company had 16 contracts to build government computer systems in China. The plaintiffs alleged that the two PKF units and BDO McCabe failed to “perform rudimentary auditing procedures” to determine that the contracts actually existed. In addition, a private investigator hired by the plaintiffs discovered that, rather than having over US$132 million in revenues as represented by China Expert, it had less than US$1 million during the relevant period. The company’s stock, which exceeded US$8 in November 14, 2006, fell to 10 cents per share by mid-October 2007.

On November 7, 2011, the U.S. District Judge Alvin Hellerstein in New York rendered two rulings in the China Expert case which are likely to have significant implications for other similar cases. Firstly, he denied PKF New York’s motion to dismiss the case, secondly, he denied PKF Hong Kong and BDO’s HK unit’s request to limit discovery in China.

In the motion to dismiss, PKF New York based their argument on the high court’s ruling in Janus Capital Group Inc. v. First Derivative Traders in June 2011, which limited the exposure of advisers who assisted but were not the “maker” of an untrue statement of a material fact in securities cases. The judge concluded that discovery is required to determine whether PKF New York had sufficient explicit or implicit control to “make,” rather than simply assist with the preparation of the statements in the audit opinions. This holding allows the shareholders’ claims to proceed to the next phase.

PKF HK and BDO’s HK unit argued that discovery should be limited in China, citing the country’s state secrecy laws as its basis. In reaching his conclusion to allow discovery to proceed, the judge stated that deference to state secret laws will be decided on a case-by-case basis, and balanced the national interest of the U.S. in relation to the obligations of issuers and accountants against that of China in relation to state secrets. The judge noted that while “the national interest of the United States is observably strong; China’s is speculative.” This is partly because the scope and definition of state secrets under Chinese law are broad and vague, and it is unclear what interests the protection of these secrets serve.

In addition, the judge found its support in case law that an American court cannot be deprived of the power to order a party subject to its jurisdiction to produce evidence simply because production of evidence may violate a foreign “blocking” statute.

Related Reading

China Briefing – Financial Management
This issue of China Briefing details FCPA regulations, fraudulent accounting practices within Chinese companies and due diligence issues for IPO listings. It also covers PRC GAAP regulations, compliance with them and the differences between EU and U.S. standards.