FT Alphaville " The joys of auditing a China short target Let us know if you can make sense of this boardroom drama at Nasdaq-listed e-learning company ChinaCast Education: As previously disclosed in a Form 8-K dated March 26, 2012, the Company terminated Ron Chan as chief executive officer and effected his resignation as a director. In connection with his termination, the Company actively sought to reach Mr. Chan to conduct an orderly transition of his management functions to interim chief executive officer Derek Feng. This transition was meant to include, among other things, the return of the company seals, business licenses and financial seals of the Company's Chinese subsidiaries relating to its e-learning and training services business and one of its universities, which items the Company believes are in Mr. Chan's possession or persons under his direction. Under PRC law, the company seals, financial seals and business licenses are necessary for these Chinese subsidiaries to enter into contracts, conduct banking business, and take official corporate action, including registering the change in management with the relevant authorities in China. Mr. Feng and interim chief financial officer Doug Woodrum made a number of unsuccessful attempts to contact Mr. Chan in connection with his termination to conduct this orderly transition. On March 30, 2012, Mr. Chan appeared at the Company's Shanghai office and tried to assert control over the business by refusing to comply with the terms of his termination and resign from his legal representative and other positions with the Company's Chinese subsidiaries. At the same time, Mr. Feng and Mr. Woodrum, along with the Company's PRC legal advisors, continued to assert their control over the premises per their authority granted by the Company's board of directors. Thereafter, Mr. Chan remained on the premises and continued to take steps to obstruct the transition of management. As a result of Mr. Chan's actions, the new management of the Company is being frustrated from resuming normal operations in Shanghai. The Company believes that its legal position is sound. However, if the Company's efforts to regain control of its assets in China are unsuccessful, there may be a significant material adverse effect on its business, financial condition, results of operations and business prospects. And... The Company's current loss of control over its assets in Shanghai, China and its efforts to regain control also are occupying significant management time and resources. So, trade in ChinaCast shares was halted on Monday. The board also sent a letter to shareholders in somewhat more colourful language, laying out Mr Chan's alleged transgressions. Mr Chan meanwhile sent his own letter to shareholders with similarly strong accusations levelled at other board members. As Paul Gillis, a professor at Peking University, writes, there's no evidence of fraud at ChinaCast Education. But he adds: "Few have come back from these kinds of problems." With a market cap of just over $200m at the time of the halt, ChinaCast is not going to rock the world on the scale of Sino-Forest, even if it might provide us all with some similarly gripping reading. But it's not the sort of thing that looks good for prestigious western auditors. Like Deloitte, for example, who are ChinaCast's auditors. Deloitte actually pointed out some problems with ChinaCast's reports a year ago: The following material weaknesses have been identified and included in management's assessment: 1) Lack of sufficient skilled resources in the finance team to meet the demands of rapidly expanded businesses which resulted in a delayed closing process. 2) Lack of contemporaneous documentation of certain decisions made by the Board of Directors. Unsurprisingly, the company also attracted the interest of short sellers last year. Meanwhile, a blog post on Forbes by Richard Pearson points out that Deloitte are not having a great season with Chinese company filings. Last month, they resigned from auditing two Hong Kong-listed Chinese companies: Boshiwa International, a maker of children's wear, and Daqing Dairy Holdings, which produces milk formula. These two companies weren't the targets of short sellers. In 2011, the firm dropped China Media Express and Longtop Financial after fraud allegations from short sellers. Pearson also looks at Qihoo, another Chinese company audited by Deloitte which has been the focus of short sellers recently. Here's a very interesting Q&A with a short seller, Andrew Left of Citron Research, on his views about Qihoo. Oh and it's probably not just Deloitte having an "interesting" results season - as Gillis writes in another post, on his blog, new rules are being drafted that will affect the way foreign auditing firms work in China: The changes will bring China in line with international practice. I am not aware of any other jurisdiction that allows unlicensed persons to own a CPA firm. This will bring pain to many Big Four partners, who must obtain a Chinese CPA license or lose their right to ownership. Of course, spotting problems in a company's paperwork can be notoriously difficult in China, where many of the third-party checks that auditors would typically carry out have been circumvented by companies setting up sock-puppets to echo its fraudulent account of itself, as John Hempton wrote in relation to the China Media Express and Longtop Financial cases: The critical revelation is that the bank was in on the scam. If the bank is in on the scam it is possible for the auditor to conduct all the standard tests and do all their duty and sign-off completely dodgy accounts in good faith. Related links: Auditors on alert over Chinese results - FT Problems with ChinaCast highlight issues with VIEs and Deloitte's China challenge - Reuters Canadian short seller targets ChinaCast Education - Financial Post This entry was posted by Kate Mackenzie on Wednesday, April 4th, 2012 at 13:45 and is filed under Capital markets. Tagged with Auditors, china, rto, Sino-Forest Corporation.