Home' A Plus Magazine : September 2016 Contents Patrick Perry is
Partner and Michael
Maguiness is Senior
Associate at Clyde & Co.
law firm in Hong Kong
statements, repor ts or valuations which
they purported to prepare or certify in vio-
lation of s11 of the Securities Act of 1933.
The auditors' liability often turned on
whether a specific departure from GAAS
or GAAP could be shown and whether
there were facts demonstrating the audi-
tor either did not hold or had no reason-
able basis for holding the audit opinion
expressed. To establish liability, the audi-
tors' conduct was required to be "highly
unreasonable," an "extreme departure
from the standards of ordinary care," and
"approximate an actual intent to aid in the
fraud." It was also necessary to show the
auditor had disregarded red flags that
would have placed a reasonable auditor
on notice of wrongdoing by the company.
Ultimately, the vast majority of class
action claims against auditors arising
out of the Chinese reverse merger saga
were either dismissed or settled. The
extremely high defence costs for all par-
ties involved in the class actions resulted
in many of the class actions being
resolved prior to discovery taking place.
The current position
The good news for accountants is that
such claims are becoming a historic prob-
lem: the number of related class action
filings has gone from the peak of 31 in
2011 to only one last year.
The drop in class action filings can be
explained by the new rules from the Secu-
rities and Exchange Commission, which
make a Chinese reverse merger harder
than before, as it requires a company to
wait at least a year after a reverse merger
before it seeks a listing on an exchange.
In addition, Chinese companies are now
turning to alternative means of raising
funds. In par ticular, they are more likely,
for example, to consider listing on the
Stock Exchange of Hong Kong instead,
according to Cornerstone Research.
While the potential for auditors to be
named as defendants in U.S . class actions
arising from Chinese reverse mergers
is now significantly less than it was five
years, the saga highlights the importance
for accounting firms in assessing which
companies they take on as audit clients.
While the auditors of the Chinese compa-
nies may not necessarily have been negli-
gent in conducting their audits, they found
themselves named as defendants in
multimillion dollar U.S. class actions and
incurring very substantial defence costs
by virtue of the fact they had audited
companies implicated in fraud.
At the peak of the saga, Moody's Inves-
tors Service issued a report on govern-
ance and accounting risks in Chinese
non-financial corporates. The repor t
identified 20 “red flags” in relation to such
companies which included:
Possible weaknesses in corporate
Riskier or more opaque business
Fast-growing business strategies;
Poorer quality of earnings or cash
Concerns over auditors and the quality
of financial statements.
The lesson to be learned for accounting
firms is that it is important to ensure that
they have sufficiently rigorous client due
diligence systems in place to identify
potential red flags. Firms that do not have
such processes in place risk taking on
clients they know ver y little about and
potentially facing significant exposures
down the track.
September 2016 43
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