What lurks in Deloitte’s Longtop Financial audit work papers?

by Kurt Schulzke

Deloitte’s China unit (DTTC) is hiding something. Why is an open question. The firm’s continuing refusal to comply with a May 2011 SEC subpoena for audit work papers will inevitably fuel speculation. A bizarre May 2, 2011 resignation letter from DTTC to Longtop Financial Technologies Ltd touched off the SEC’s investigation. The letter reads, in part, as follows:

We hereby give you formal notice of our resignation as auditor of the Company. . . .

As part of the [31 March 2011 audit], we determined that, in regard to bank confirmations, it was appropriate to perform follow up visits to certain banks. These audit steps . . . identified a number of very serious defects including: statements by bank staff that their bank had no record of certain transactions; confirmation replies previously received were said to be false; significant differences in deposit balances reported by the bank staff compared with the amounts identified in previously received confirmations (and in the books and records of the Group); and significant bank borrowings reported by bank staff not identified in previously received confirmations (and not recorded in the books and records of the Group).

In the light of this, a formal second round of bank confirmation was initiated on 17 May. Within hours however, as a result of intervention by the Company’s officials including the Chief Operating Officer, the confirmation process was stopped amid serious and troubling new developments including: calls to banks by the Company asserting that Deloitte was not their auditor; seizure by the Company’s staff of second round bank confirmation documentation on bank premises; threats to stop our staff leaving the Company premises unless they allowed the Company to retain our audit files then on the premises; and then seizure by the Company of certain of our working papers.

In that connection, we must insist that you promptly return our documents. . . .

Yikes. As if that were not bad enough:

Then on 20 May the Chairman of the Company, Mr. Jia Xiao Gong called our Eastern Region Managing Partner, Mr. Paul Sin, and informed him . . . that “there were fake revenue in the past so there were fake cash recorded on the books”. Mr. Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Mr. Jia answered: “senior management”. . . .

The subpoena demands DTTC’s Longtop audit documents, some of which are apparently now no longer in DTTC’s possession. It is unclear what DTTC or the Chinese government expect to gain from withholding them. Audits of  SEC registrants are performed for the benefit of investors, not the registrants’ management, the audit firms, nor the governments of the countries where the registrants’ do their business. Every U.S. public company auditor knows this. While DTTC has argued that Chinese law prohibits them from complying with the subpoena, the SEC’s most recently filing in the case, SEC v. Deloitte Touche Tohmatsu CPA Ltd., D.D.C. Case 1:11-mc-00512-GK-DAR, argues otherwise.

On March 28, 2013, the SEC filed yet another memorandum (reproduced in full, below), arguing that DTTC has offered no good rationale for its position, objecting to DTTC’s “contumacious conduct,” and asking the court to order DTTC to comply forthwith:

As the SEC explained during the March 13, 2013 hearing, the Court can and should order DTTC to comply with the Subpoena regardless of what DTTC contends are the prohibitions imposed by Chinese law, because, among other reasons: (1) the United States’ interest in enforcing the securities laws clearly outweighs China’s interest in secrecy; (2) at present, the SEC has no alternative means for obtaining all of the documents sought by the Subpoena; (3) DTTC, having availed itself of U.S. markets with full knowledge of U.S. rules requiring that it respond to information requests, cannot show that it has acted in good faith in relying on asserted Chinese law prohibitions; and (4) DTTC indisputably has not shown that any of the requested documents in fact contain state secrets protected from disclosure under Chinese law .  .  . That said, DTTC’s claims about Chinese law are exaggerated and speculative. The CSRC has not issued a written “directive” to DTTC specifically requiring CSRC approval before DTTC produces documents to the SEC, and it is not at all clear that sanctions, if any, that might be imposed on DTTC for producing documents would be “severe.”

The SEC’s memo argues persuasively that U.S. law requires DTTC to produce the documents and that DTTC knew this when they first began auditing Chinese companies, including Longtop. What is most puzzling is why DTTC would want its audit brand associated throughout the world with the steadfast refusal to comply with the SEC’s subpoena. Whatever the work papers contain must be explosive for the firm or the Chinese government, or perhaps both, to justify such a legally and politically risky rearguard action.

Perhaps DTTC initially assumed that the SEC would lose interest in the chase or get busy with other things. If so, they appear to have miscalculated. The SEC may rightly see this as an existential conflict. To justify their role in U.S. securities markets, it may fairly be said that the SEC must either get the work papers or disbar DTTC from future SEC practice. It would be interesting to know whether the SEC has received information on DTTC, apart from the resignation letter, from Longtop whistleblowers.



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