How Deloitte US May Be Held Liable For ChinaCast Fraud

I wrote this week at Forbes about the ChinaCast fraud.

ChinaCast was a Delaware company traded on NASDAQ that has a significant number of US investors. The company’s operations, providing post-secondary education and e-learning services, are inChina. According to a recently filed lawsuit, Deloitte Touche Tohmatsu CPA Ltd (DTTC) in Beijing, Peoples Republic of China signed the ChinaCast audit opinion but not until, according to the complaint, Deloitte’s US firm agreed the company’s disclosures were in accordance with Generally Accepted Accounting Principles (GAAP) and SEC reporting requirements.

What’s different about this Chinese fraud lawsuit is that it names a US Big Four firm as a defendant. Not only has that not been done before but the US firms have traditionally been able to insulate themselves fairly successfully from frauds that happen abroad. It’s that global network “thang”.

As I wrote in October of 2011:

Soyoung Ho, who writes for Thomson Reuters Insights (subscription only), has posted some thoughtful articles on the subject but the quotes she gets sometimes don’t add up.
Deloitte’s Chinese Affiliate May Be Exposed to U.S. Court Decisions
Roberta Karmel, a professor at Brooklyn Law School and a former SEC commissioner, had some harsh words for the SEC and the New York Stock Exchange to even let U.S. investors be at risk in the first place by allowing Chinese companies—many of them that are found to have accounting problems—to be listed in the U.S..
“Should the SEC allow any companies that are audited by auditors who refuse to produce information in U.S. courts to be listed on an exchange to be sold to U.S. persons?” Karmel said.
“Should the New York Stock Exchange allow a company to be listed under circumstances where its auditors are not going to be forthcoming with information if problem arises? It’s kind of giving a stamp of approval to the companies which they don’t seem to deserve.”
“They have been structured as a worldwide organization. They have separate [firms] in various jurisdictions,” Karmel said. “How can Deloitte say ‘oh yes, we have Deloitte Shanghai and they are Deloitte, but we have no control over it’? They are, however, putting their names on these audits. That seems to be a preposterous posture.”
As a former SEC Commissioner, Professor Karmel should know that Deloitte U.S. and the international coordinating firm, Deloitte Touche Tohmatsu Limited doesn’t control Deloitte China any more than I can control my 130 lb. Rottweiler if she’s determined to chase that squirrel.
Read the fine print. The global audit firm network is a legal structure created to support a brand, not a professional services firm serving the public and the global financial system.

Or maybe read the decision of the Florida court in the Banco Espirito Santo case against BDO International. Or look at why the SEC and PCAOB did not sanction the PwC U.S. firm or PwC International Limited for the $1 billion in sins of Price Waterhouse India and its audit of Satyam, a U.S. listed, India-based company. Or look at why the plaintiffs settled rather than going to trial over claims against the U.S. firm and International firms in the Satyam case and the Parmalat case.

With regard to ChinaCast, I wrote in Forbes this week:

The fraud allegedly perpetrated by ChinaCast, and for which its directors, DTTC and Deloitte US are being sued, is a laundry list of classic fraud moves. The complaint says ChinaCast was an easy audit to get right.

“In 2007, the Company’s business and operations were limited, and its primary assets were cash and term deposits, i.e., deposits placed with financial institutions with remaining maturities of greater than three months but less than one year when purchased. In 2008, the Company started to pursue a strategic move into the “bricks and mortar” university business, resulting in the Company (supposedly) purchasing one university a year for each of 2008, 2009 and 2010… the Company undertook only one or two significant transactions (such as share issuances and university acquisitions) per year between 2007 and 2010, each of which should have attracted close scrutiny from any auditor.

Yet nearly all of those limited number of transactions were sham transactions in which (with respect to the university purchases) cash consideration was never provided by the Company or (in the case of share offerings) cash transferred to the Company was immediately looted.”

What did ChinaCast do? Some of the same old stuff the PCAOB said this week smaller auditors keep missing in their audits.

Audit areas with frequent inspection findings in the 2007-2010 period related to:

  • auditing revenue recognition;
  • auditing share-based payments and equity financing instruments;
  • auditing convertible debt instruments;
  • auditing fair value measurements;
  • auditing business combinations and impairment of intangible and long-lived assets;
  • auditing accounting estimates;
  • auditing related party transactions;
  • use of analytical procedures as substantive tests; and

Except, in this case, ChinaCast’s auditor was a big firm, Deloitte. (Quotes are from the recent lawsuit against the Deloitte firms and the company’s executives and directors.)

Auditing business combinations: “The Company’s audited financial statements included in the 2007 10-K represented that ChinaCast Technology (HK) Limited (“CCT HK”), a Hong Kong subsidiary of the Company, was 98.50% owned by the Company.  the Company never owned a majority ofthe voting interests of CCT HK, and consolidation of CCT HK was not permissible. Indeed, records readily obtainable by Deloitte from the Hong Kong Companies Registry confirm that Ron Chan, the Company’s former CEO, has personally owned 50% ofCCT HK at all times since 2003.”

Bank confirmation and related party transactions: “The largest assets on ChinaCast’s balance sheet were “termdeposits.” As disclosed in the 10-K, “Term deposits consist of deposits placed with financial institutions with remaining maturities of greater than three months but less than one year when purchased.” 2007 Form 10-K at F-13. For the fiscal year ended December 31, 2007, term deposits comprised over eighty percent ofChinaCast’s total bank balances…Specifically, the 2007 10-K represented that the Company ‘has not entered any financial guarantees or other commitments to guarantee the payment obligations ofany third parties.” 2007 Form 10-K at 25. Plaintiffs specifically read, reviewed, and relied on these representations in purchasing securities of ChinaCast….These representations regarding term deposits and the absence of financial guarantees were blatantly false…As of December 31, 2007, at least 76% of the Company’s term deposits were pledged to guarantee the debts of third parties {i.e., at least RMB 455,310,000 were pledged out of the RMB 596,768,000 total). None of these pledges were disclosed.”

Use of analytical procedures as substantive tests: “On or about April 11, 2008, the Company announced that its wholly owned subsidiary Yu Pei Information Technology (Shanghai) Limited (“YPIT”) acquired an 80% interest in Hai Lai Education Technology Limited, which, in turn, owned the Foreign Trade and Business College (“FTBC”) of Chongqing Normal University…Deloitte’s audited financial statements reported that “[f]he consideration for the acquisition was RMB480,000, of which RMB475,850 was paid during 2008.” These representations were false. TheCompany’s bank statements and accounts do not contain any evidence of any payment made in 2008 related to the acquisition of FTBC. In other words, Deloitte certified the largest payment on the Company’s cashflow statements for 2008, while knowingly or recklessly ignoring the fact that there was no evidence of any such payment.”

Those are just a few of the transactions Deloitte’s China firm missed and Deloitte’s US firm signed off on the accounting and disclosure for. According to ChinaCast’s proxies, Deloitte Touche Tohmatsu was paid $1 million for this audit each year in 2010 and 2009. Paul Gillis, Professor of Practice and Co-director of International MBA program Guanghua School of Management at Peking University says, “That’s high.”

(I wonder how much Deloitte US was paid for their portion of the engagement?)

So how do the plaintiffs attorneys plan to rope in Deloitte US? I explained at Forbes:

When they named Deloitte US as a defendant, the lawyers for the plaintiffs, Lowenstein Sandler LLP, broke new ground in recent China fraud-related litigation.  To make it work they pull out a rarely used provision of the Securities & Exchange Act of 1934, Section 18.

One of the Lowenstein partners on the case, Lawrence Rolnick, wrote about Section 18 for back in October 2008. That discussion centered on “…whether to bring suit [for crisis-related losses] on their own as individual plaintiffs, seek appointment as lead plaintiffs in a class action or passively await the outcome of class suits in which they are members of the putative class.”

What makes Section 18 attractive for the case against Deloitte US for ChinaCast? An investor can sue any person who “made” the false or misleading statement, or “caused” it to be made.

Rolnick explained in 2008: Section 18 provides an express statutory cause of action to any person who purchases or sells a security in “actual reliance” on a false or misleading statement of material fact included in any application, report or document filed pursuant to the Exchange Act, unless the person knew that such statement was false.”

As a result, Section 18 is better than Section 10(b) for this case for at least two reasons. First, a Section 18 plaintiff doesn’t have to plead or prove that the defendant acted with any form of scienter, such as an intent to defraud or areckless “no audit at all”. The defendant in this case, Deloitte US, has the burden of proof, via an affirmative defense at trial, that it acted in good faith and did not know that the statements were false or misleading. Section 18, therefore, makes it much easier to overcome a motion to dismiss and get to meaningful discovery that leads to a successful trial outcome, or at least a better settlement.

Although I don’t write much about directors’ liability in these fraud cases, Kevin LaCroix has an excellent summary of how judicial attitudes are changing about what is expected of directors when a company is global. It’s a must read.

In rejecting the defendants’ arguments, Chancellor Strine articulated a vision of responsibility for independent directors of companies with overseas operations or assets that I think might come as a shock to many outside directors. He said that:

If you’re going to have a company domiciled for purposes of its relations with investors in Delaware and the assets and operations of the company are situated in China that, in order for you to meet your obligation of good faith, you better have your physical body in China an awful lot. You better have in place a system of controls  to make sure that you know that you actually own the assets. You better have the language skills to navigate the environment in which the company is operating. You better have retained accountants and lawyers who are fit to the task of maintaining a system of controls over a public company…

This is a very troubling case in terms that, the use of a Delaware entity in something along these lines. Independent directors who step into these situations involving essentially the fiduciary oversight of assets in other parts of the world have a duty not to be dummy directors. I’m not mixing up care in the sense of negligence with loyalty here, in the sense of our duty of loyalty. I’m talking about the loyalty issue of understanding that if assets are in Russia, if they’re in Nigeria, if they’re in the Middle East, if they’re in China, that you’re not going to be able to sit in your home in the U.S. and do a conference call four times a year and discharge your duty of loyalty. That won’t cut it.…

If it’s a situation where, frankly, all the flow of information is in the language that I don’t understand, in a culture where there’s, frankly, not legal strictures or structures or ethical mores yet that may be advanced to the level where I’m comfortable? It would be very difficult if I didn’t know the language, the tools. You better be careful there. You have a duty to think.

Read more about the ChinaCast lawsuit at

7 replies
  1. Francine
    Francine says:


    It does not make me happy to see the firms sued but it is very intellectually satisfying to analyze a substantive suit and see that the lawyers have come up with something novel. I’d love to see the defense of these suits on their merits but since the cases rarely go to trial, you don’t get to see how the firms defend themselves.

  2. Carl Olson
    Carl Olson says:

    It’s about time that the Big 4, including Deloitte, takes financial responsibility for negligent/fraudulent opinions. Full speed ahead. The auditors are supposed to be protecting the stockholders–their opinions are addressed to both the directors and stockholders.

  3. Michael Moshiri
    Michael Moshiri says:

    Interesting article Francine. Thanks for breaking this down…

    I wonder when the firms will wake up to the real impact of these types of errors on their own brands and the public’s trust in their work. Not a week goes by where we don’t see the big 4 firms’ names dragged in the mud for some oversight that could have and should have been avoided.

    I remember way back when I started with EY, the partner in my practice sat us all down and explained to us how the appearance of impropriety can be just as damaging as the actual improper action.

    It seems to me that the firms have matured into a new line of thinking: that the “appearance” is more important than the actual proper action.

  4. Paul Gillis
    Paul Gillis says:

    Does helping out the Chinese member firm by reviewing the filing to make sure there are no obvious errors mean that the U.S. firm is taking on responsibility for the audit?

    Does sending a U.S. partner to China to help with U.S. listed companies mean the U.S. firm is responsible for all U.S. audits in China?

    If the court decides the answer to those questions is yes, then I expect the U.S. firms stop doing it. That would not be a good outcome for investors.

  5. Francine
    Francine says:

    @Paul Gillis

    I don’t think the US firms can stop doing this unless they have sufficient local partners adequately trained to provide the review. It’s a necessary step both from a standards perspective and an in-firm quality and risk management perspective. If the courts determine that this step is a final approval step, a “control” step, and it is being done by the US firm, I expect that will have a profound influence on the firms and the quality of the audits coming out of China and Hong Kong. As if it could get any worse…

    I’m not sure why the Chinese audit firm in this and other instances is signing the audit rather than the US firm when it’s a Delaware registered company. That, to me, seems the first change the SEC should consider forcing to avoid this regulatory hornet’s nest. Then the US firm can start truly focusing on adequately supervising and reviewing the work on the ground in China or Hong Kong – if any is done.

  6. Ankur
    Ankur says:

    Hi Francine,

    Thank you for such wonderful insights and stories pertaining to the audit fraternity and corporate governance. I appreciate your work and am an ardent follower.

Comments are closed.