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Blame Game

Can an auditor’s Chinese affiliate get its US arm in trouble? Deloitte is about to find out

On Feb. 15, with little fanfare, a group of US-based investors filed a lawsuit against the directors of one of the many Chinese companies forced to delist from US boards in the last few years. They also are suing the US and Chinese affiliates of the company’s accountant, Deloitte Touche Tohmatsu.

Suing a company for fraud isn’t anything new. The target of the suit, ChinaCast Education, was one of a slew of Chinese companies that listed on foreign stock exchanges in the mid-2000s and were audited by the Chinese divisions of the Big Four accounting firms, but delisted after missing filing deadlines (paywall), coming under short-seller fire, or losing investors billions. The company has admitted to copious book-cooking—it told investors in a December 2012 regulatory filing that financial reports from 2009-2011 “should no longer be relied upon.”

What is unusual, though, is the plaintiffs’ move to hold not just Deloitte’s China office liable, but also its American one. The Securities Exchange Commission initiated administrative proceedings against the Chinese offices of Deloitte and other accounting firms for their failure to turn in audit work papers for Chinese companies facing fraud investigations. And other investor lawsuits also target the Chinese accounting units. But the ChinaCast lawsuit maintains that Deloitte’s US office shares blame, because it deemed ChinaCast compliant with US accounting standards even though it was not, according to the complaint seen by Quartz.

This hinges mainly on the allegation that the Deloitte-certified 10-K, the annual report a company must file to regulators, broke the rules because ChinaCast’s publicly listed entity did not own a majority stake in the company’s Hong Kong subsidiary. Rather, it was the CEO, Ron Chan, who had owned the Hong Kong subsidiary’s controlling stake since 2003, says the complaint. (ChinaCast’s latest investor letter says it’s still investigating when Chan gained ownership.) This allowed him later to transfer $35 million in stock offering proceeds to an undisclosed third party. Deloitte did not respond to Quartz’s request for comment, but both the US and Chinese affiliates told the Wall Street Journal on Feb. 22 that the suit had no basis.

Still, the lawsuit may be a little quixotic. As Paul Gillis, co-director of the IMBA program at Peking University’s Guanghua School of Management, explains that “the big accounting firms are usually very careful to try to ring-fence their liability for failed audits.”

“Accounting firms are always good targets for lawsuits, since they have deep pockets,” Gillis told Quartz. “But the courts and legislation have made it tough to win a case against auditors.” One reason it’s tough comes down to a complicated legal doctrine (law professor Peter J. Henning breaks it down in his article on lawsuits by Madoff investors).

Regardless of how fruitful the lawsuit proves, though, Deloitte appears already to recognize that its China office is a liability, if not (so far) a strictly legal one. Deloitte announced in January that it was tightening operations in China (paywall). But this suit means that might not be the end of it, says Peking University’s Gillis.

“The U.S. firms are probably going to reconsider their involvement in Chinese audits,” he says. “That would be unfortunate, since the China firms really do need their help.”

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