PE group sues Deloitte over China accounting

A group of US venture capital and private equity firms has filed a lawsuit against Deloitte’s US and Chinese affiliates over what they claim to be a fraudulent accounting of ChinaCast Education Corp, according to US court documents.

The firms, which include Fir Tree, Columbia Pacific, Lake Union Capital and Ashford Capital Management among others, all invested in ChinaCast in between 2008 and 2012, after the company went public through a reverse merger in 2007, according to the filing.

ChinaCast has been under fire since ousting its chief executive Ron Chan on allegations of fraud. Chan denies any wrongdoing, but the plaintiff’s complaint states that ChinaCast assets were transferred to an entity owned by Chan and Deloitte’s accountants failed to detect this.

“Deloitte put its name and brand behind the certification of financial statements that were almost entirely false,” the complaint said. As such, the firms are now seeking to recover tens of millions of dollars of investment losses from the global accounting firm.

Deloitte issued a response to the lawsuit, saying: “We do not believe that the plaintiffs have a valid basis for bringing this action against Deloitte Touche Tohmatsu CPA Limited (DTTC) and, accordingly, we will defend ourselves vigorously.”

This is the most recent in a string of accounting troubles at Chinese companies that have impacted public and private markets alike. In December, the US Securities and Exchange Commission charged the Chinese affiliates of five of Asia’s largest accounting firms with violating securities laws by refusing to hand over their audits of nine different Chinese companies under investigation for fraud.

The lawsuit highlights the fact that many Chinese businesses that listed in the US probably shouldn’t have gone public, according to Paul Boltz, partner at Ropes & Gray. Yet most auditing firms are not hired to be forensic accountants, and so simply follow written procedures when auditing the companies, he added.

Another cause of the problem, according to a Shanghai-based lawyer, is that auditing in China is priced at a tenth of what the rest of the world charges. Thus, other Asia-based branches of an accounting firm that could come in to help the China branch resist doing so, preferring to devote their time and resources to their own projects to maximize profit. 

If accounting scandals continue, it may mean that even the audits of Chinese companies by the big four global accounting firms will lose credibility, which would make exits by IPO or even trade sale much more difficult, according to William Hay, general counsel at Baring Private Equity Asia.

“[It could] become much harder to do due diligence in China because we rely on those audits every year,” Hay said.

Even after investment, private equity firms often have to rely on auditing firms in China to keep up with their portfolio companies in post-transaction due diligence and for exiting, Hay explained.

Hay said that eventually, private equity firms like Baring may do most of the auditing work on Chinese companies themselves.

Boltz added that he has already seen several private equity firms redouble their efforts to vet Chinese companies.

“Firms are taking more care to appoint a CFO to the company, someone they can trust to watch the store,” said Boltz.

This article originally appeared on privateequityinternational.com