Academic journal article Duke Journal of Comparative & International Law

Bull in the China Market: The Gap between Investor Expectations and Auditor Liability for Chinese Financial Statement Frauds

Academic journal article Duke Journal of Comparative & International Law

Bull in the China Market: The Gap between Investor Expectations and Auditor Liability for Chinese Financial Statement Frauds

Article excerpt

TABLE OF CONTENTS INTRODUCTION I. FRAUD AND CHINA II. THE LONGTOP FINANCIAL TECHNOLOGIES FRAUD     A. The Longtop Fraud.     B. Taking Deloitte to Court.     C. Why Deloitte Escaped the Possibility of Liability III. AUDITORS' LEGAL LIABILITY FOR FINANCIAL STATEMENT FRAUD.     A. Pleading Scienter     B. Accounting Networks and Vicarious Liability IV. AUDITORS' PROFESSIONAL RESPONSIBILITY FOR FINANCIAL     STATEMENT FRAUD     A. Is It Reasonable to Expect Auditors to Detect Financial        Statement        Fraud?     B. The Expectations Gap.  V. CANADIAN REGULATION: A SUCCESS STORY.     A. The Development of Canadian Tort Law on Auditor Liability     B. The Ontario Securities Act: Part XXIII. 1.     C. The Sino-Forest Fraud VI. LESSONS FOR THE UNITED STATES CONCLUSION 

INTRODUCTION

Two known fraudsters start a company in China and decide to glean hundreds of millions of dollars from U.S. investors. So the fraudsters form an entity structure that escapes both Chinese and U.S. regulation, they have local bank branches lie about deposit and loan balances, and they move most of their expenses to an off-balance-sheet entity. With debts and expenses concealed, they report industry-leading margins, so Goldman Sachs and Morgan Stanley underwrite their U.S. initial public offering (IPO). They achieve a peak market capitalization of $2.4 billion dollars. They hire a leading audit firm to attest that their fraudulent financial statements fairly represent the company, but the audits are so obviously bad that a cottage industry of short-sellers--researchers who look for obvious frauds, buy short positions in them, and then expose the frauds on the Internet--notices the implausibility of the fraudsters' financial reports. The stock price crashes, prompting the auditors to review matters a little more closely. The auditors suddenly find fraud and publicly resign, renouncing their prior audits. Unsurprisingly, investors sue the auditors in addition to the company. Yet the suit cannot survive a motion to dismiss for failure to state a claim.

This was the case of In re Longtop Financial Technologies Ltd. Securities Litigation (Longtop). (1) It is one example in a long series of audacious Chinese securities frauds. This Note examines circumstances that have left U.S. capital markets especially vulnerable to frauds by U.S.- listed Chinese firms. As described in Part I, the Chinese market places less emphasis on the quality of financial reporting than the U.S. market and accordingly has less rigorous enforcement of reporting requirements. Efforts at cross-border regulation by the Securities and Exchange Commission (SEC) have failed to provide effective protection for investors in Chinese firms listed on U.S. exchanges. Where local and SEC enforcement efforts cannot protect investors, the only remaining protection for investors is the work of the independent auditor. U.S. investors in the Chinese market rely on audits performed by U.S.-branded audit firms.

Part II analyzes the dismissal of claims against Deloitte in the Longtop scandal, even though the plaintiffs possessed nearly perfect facts for a fraud action. Part III discusses the two major legal obstacles that frustrated the plaintiffs' attempt to state a claim against Deloitte. The first was that the elevated scienter pleading requirement of the Private Securities Litigation Reform Act of 1995 (PSLRA) (2) is an especially difficult hurdle for a securities fraud action against a foreign auditor of a foreign company. Direct evidence of scienter is unlikely to be available when both the auditor and the audited company are in China. The second legal obstacle was that the auditors' global network structure successfully isolates liabilities into individual member firms. Though the plaintiffs requested voluntary dismissal of their claims against Deloitte's international umbrella entity, existing law would have likely insulated it from any liability even if the claim had proceeded. …

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