SEC Probes Chinese ‘Reverse Mergers’ and Their U.S. Auditors

The Securities and Exchange Commission, as part of a broader probe of China-based companies listed on U.S. stock exchanges and their auditors, sanctioned a California audit firm for signing off on fraudulent financial statements made by a Chinese energy company.

Moore Stephens Wurth Frazer & Torbet LLP of Orange County is one of several firms that have fallen under the SEC’s scrutiny for signing the financial statements of China-based firms accessing U.S. capital markets through so-called reverse mergers. In a reverse merger, a closely held company acquires a publicly traded company and can then sell shares without an initial public offering.

The SEC has identified “hundreds” of such small companies “where about 100 percent, not 95 percent, 100 percent of the operations are in the People’s Republic of China” and the financial statements are signed by a small U.S. auditor, Wayne Carnall, chief accountant of the SEC’s division of corporation finance, said at a Public Company Accounting Oversight Board meeting in April.

Frazer audits several such firms, including China Advanced Construction Materials Group, Inc., China Biologic Products Inc., China Fire & Security Group Inc. and China Valves Technology Inc. Other U.S.-based auditors of China reverse mergers include Fountain Valley, California-based Kabani & Company Inc., Tarzana, California-based Goldman Parks Kurland Mohidin, LLP, and Denver-based GHP Horwath, P.C.

“You look at the size of the firm. You look at the staff involved. And you question whether any of those people on staff can speak Mandarin or Cantonese,” Carnall said.

On Site

While Frazer employees were on site to perform field work for China Energy, some audit firms subcontract a local auditor to perform work they may not be able to adequately validate.

“We’ve come across situations where an auditor may be signing a set of financial statements, but performing very little of the audit work,” PCAOB Chief Auditor Martin Baumann said at the April meeting.

Frazer “did not exercise professional skepticism and due professional care” in audits of China Energy Savings Technology Inc., which was ordered to pay about $35 million in March 2009 for overstating revenue, the SEC said in a statement yesterday. Dean Yamagata, the partner in charge of the audit, was barred from practicing as an accountant for at least two years. Frazer and Yamagata didn’t admit or deny the allegations.

To settle the SEC’s claims, Frazer and Yamagata agreed to pay $129,500 and retain an independent consultant for training in fraud detection, auditor independence and other duties related to auditing functions.

No New Clients

The firm agreed not to accept any new issuer audit clients with operations located in China, Hong Kong or Taiwan until the firm has addressed the independent consultant’s recommendations.

Lawrence West, an attorney for Frazer and Yamagata at Latham & Watkins LLP, said “both the firm and Mr. Yamagata remain committed to conducting themselves in accordance with the highest professional standards, and look forward to working with the independent consultant to make sure that the firm’s policies and procedures are state-of-the-art.”

Frazer also signed financial statements for Rino International Corp., a Dalian, China-based maker of water- treatment equipment. Rino said Nov. 22 that its financial statements should no longer be relied on, and disclosed Dec. 2 that it was the subject of an SEC investigation.

Rino, which said there may be problems with as many as 40 percent of its sales contracts, has seen its shares drop 80 percent since Nov. 1.

The PCAOB, which was created by the Sarbanes-Oxley Act in 2002 to oversee auditors of public companies, is looking for ways to hold U.S. auditors accountable for work they outsource to China-based audit firms. The PCAOB is blocked from inspecting audit firms in China.

(For a letter to the editor from Donald Pangburn of GHP Horwath in response to this story, please click here.)

To contact the reporter on this story: Joshua Gallu in Washington at jgallu@bloomberg.net.

To contact the editor responsible for this story: Lawrence Roberts at lroberts13@bloomberg.net.

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