Investors Suing Auditors in U.S. Courts Over Chinese Firms

Investors who have suffered a drubbing from accounting scandals at U.S.-listed Chinese companies are starting to sue the auditors who blessed their financial statements, but it will be tough for them to win in American courts.

Shareholders already have sued a string of China-based, U.S.-listed companies for fraud, saying they lost money when stocks tanked after financial scandals emerged. They contend companies invented sham businesses, inflated revenue or gave vastly different information to U.S. and Chinese regulators.

The episodes have embarrassed auditing firms, raising questions about whether they have done enough to confirm basic numbers such as cash balances on a company’s books. In one recent episode, Deloitte Touche Tohmatsu CPA Ltd quit working for Longtop Financial Technologies Ltd, saying it found “falsity” in the software company’s records.

So far, though, most of the lawsuits have named just the companies as defendants but given their structures and shaky finances getting any compensation for losses may prove difficult. Plaintiffs would face difficulty in collecting on any judgments against entities which have most of their operations in China and their often have legal homes in the Cayman Islands.

As a result, the auditors may be added as defendants as the cases proceed.

Accounting firms are a deep-pocketed target in many class-action securities fraud cases. In one of the biggest, PwC in 2007 agreed to pay $225 million to settle a class-action case brought by investors in Tyco International Ltd following an accounting scandal.

“If the companies are true frauds, they may not be able to pay, and certainly, people would be looking to maximize their recovery,” said Andrei Rado, of plaintiffs’ law firm Milberg.

Milberg is suing Chinese companies including Puda Coal Inc. and China Integrated Energy. Those lawsuits do not include auditors as defendants.

U.S. class-action lawyers have sued more than two dozen China-based companies since the beginning of 2010. The lawsuits typically allege securities fraud and misrepresentation.

To prevail against auditors, plaintiffs must prove they acted with intent or recklessness. They would have to prove that the auditors knowingly made false statements when issuing reports that signed off on a company’s financial statements.

“That’s going to be the real challenge: for the plaintiffs to show that the auditors could and should have done a better job,” said Adam Pritchard, a professor at the University of Michigan law school. “They have to show the auditors knew of the fraud in China.”

Plaintiffs would have to look at the auditors’ work papers and communications with the company. But those documents are likely in China, where U.S. court rules on evidence-gathering often are not honored.

Another obstacle for shareholders is the vast networks that comprise the so-called Big Four group of firms, which includes Deloitte , Ernst & Young , KPMG , and PwC .

A spokeswoman for Deloitte declined to comment. Representatives of Ernst & Young, KPMG and PwC didn’t immediately return calls seeking comment.

The auditors’ Chinese or Hong Kong affiliates may be out of reach of U.S. lawsuits, and Chinese entities often have refused to comply with U.S. court proceedings.

U.S. entities or parent groups could claim they have only loose legal or structural relationship with their Asian counterparts, giving them cover from lawsuits.

A ruling in a case involving the collapse of Italian dairy company Parmalat SpA could be a beacon of hope for shareholders.

In 2009, U.S. District Judge Lewis Kaplan in New York said that shareholders could pursue a lawsuit against former auditors Grant Thornton International and Deloitte Touche Tohmatsu. Kaplan said the auditors’ parent companies exercised “substantial control” of member firms.

A few lawsuits have already hit accounting firms over dealings with Chinese firms. Shareholders suing Orient Paper saying it failed to disclose related-party transactions and overstated revenue, have also named auditor Davis Accounting Group as a defendant. The accounting firm, now defunct, couldn’t be reached for comment.

Starr Investments, a firm run by former AIG head Maurice “Hank” Greenberg, has sued China MediaExpress Holdings and its auditor Deloitte Touche Tohmatsu.

Reed Kathrein, who represents shareholders suing China MediaExpress in a separate lawsuit, said he was considering adding Deloitte to that case. He said Deloitte’s audit was not sufficient and amounted to “no audit” at all under U.S. Generally Accepted Accounting Principles.

“It’s no doubt we intend to look at them as a source of recovery,” said Kathrein, of law firm Hagens Berman.

In defending themselves, auditors are likely to counter that they, too, were deceived. That is the argument that auditors BDO McCabe Lo (which has since changed its name to BDO Ltd) and PKF New York used in a case over China Expert Technology, a Shenzhen-based company that shareholders claim forged $131 million in revenue.

The company did not respond to the shareholder lawsuit and in 2008 was declared to be in default. But the case against its former auditors is still pending.

Both ex-auditors have asked a federal judge in Manhattan to dismiss the lawsuit, saying the plaintiffs’ own allegations suggest that the company “actively misled its auditors by concealing its alleged fraud.”

The best hope for investors may be the U.S. Securities and Exchange Commission, which has launched an inquiry into U.S. audit firms with China-based clients.

No Big Four auditor has been accused of wrongdoing by the SEC over China company audits. The agency in December did censure audit firm Moore Stephens Wurth Frazer & Torbet and required it to disgorge fees from its work for China Energy Savings Technology Inc.

Moore Stephens didn’t admit or deny the SEC’s findings, the company has said.

On Thursday, the SEC scrambled to warn of the risks surrounding Chinese companies that have listed in the United States through reverse mergers, though critics said the intervention was too little, too late.

If the SEC, which has subpoena power and can force companies and auditors to cooperate in investigations, sues more auditors or companies, investors could benefit.

“It really paves the way for private suits if there’s a government suit to piggyback on,” said Pritchard of the University of Michigan.

(Reporting by Carlyn Kolker, editing by Martin Howell)