April 2014

The Securities Exchange Commission (“SEC”) has set its sights on audit committee chairs who fail to exercise appropriate oversight and stewardship over financial reporting, recently targeting two who allowed ongoing fraud in the organizations they were tasked with overseeing.  Audit committee chairs of two firms with major Chinese operations, L&L Energy (“L&L”) and Agfeed Industries (“Agfeed”), have been accused of allowing false financial reports to be filed.  These actions reflect the SEC’s current focus on not only the wrongdoers, but the gatekeepers who should serve as a check and balance on management’s activities.

In the case regarding L&L, operating in China and Taiwan, the founder was single-handedly running the organization, but created the false appearance of a professional management team in order to obtain a NASDAQ listing.  The SEC claims the audit committee chair knew that the company’s financial statements were certified for compliance under Sarbanes-Oxley (“SOX”) using the name of woman who had turned down an offer for the position of CFO and therefore did not actually work for the entity.  The SEC issued a settled cease-and-desist order against the former audit committee chair, who, despite neither admitting nor denying the charges, is permanently barred from signing any public filing with the SEC related to SOX certification.

With regard to AgFeed, an animal nutrition and hog production company that operates in both the United States and China, the alleged fraud was more widespread.  Chinese executives engaged in massive accounting misstatements in order to inflate revenues, creating fake invoices for the sale of feed and non-existent hogs.  They also fraudulently increased the reported weight of hogs actually sold (as fatter hogs generate higher market prices).  As a result, from 2008 through June 30, 2011, AgFeed’s publicly-reported revenues were inflated by approximately $239 million and recorded in a separate set of accounting records prepared specifically for disclosure to outside auditors.

These actions were allegedly designed to meet financial targets and prop up the stock price while the company was trying to raise capital for expansion and acquisition.  The SEC alleges the audit committee chair was informed of the scheme and was also advised to investigate by a former director and company advisor who told him there was “not just smoke but fire”.  Yet, he allowed the false financial reporting to continue and the outside auditors and investors to be deceived.  The SEC’s complaint seeks disgorgement of ill-gotten gains plus prejudgment interest as well as financial penalties and officer-and-director bars.

The SEC tasks all audit committees with independent review and oversight of a company’s financial reporting processes, internal controls and independent auditors.  Rule 10A-3 requires effectively all companies whose securities trade in the U.S. to comply with certain minimum standards regarding the composition and functions of their audit committees.  These minimum standards concern:

  • the independence of all audit committee members;
  • the audit committee’s authority and responsibility to select and oversee the company’s independent auditor, including resolving any disputes between the auditor and management regarding the company’s financial reports;
  • procedures established and overseen by the audit committee for handling complaints regarding the company’s accounting practices (i.e. whistleblower reporting);
  • the authority of the audit committee to engage outside advisors; and
  • the funding of audit committee activities, including the committee’s control over the compensation of the independent auditor and any outside advisors to the committee.

Without the confidence in the system provided by these internal controls and checks and balances, the financial system is undermined. The SEC has stated that

“Accurate and reliable financial reporting lies at the heart of our disclosure-based system for securities regulation, and is critical to the integrity of the U.S. securities markets. Investors need accurate and reliable financial information to make informed investment decisions. Investor confidence in the reliability of corporate financial information is fundamental to the liquidity and vibrancy of our markets.”

Andrew J. Ceresney, director of the SEC’s Division of Enforcement particularly described the AgFeed situation as follows:

“AgFeed’s accounting misdeeds started in China, and U.S. executives failed to properly investigate and disclose them to investors.  This is a cautionary tale of what happens when an audit committee chair fails to perform his gatekeeper function in the face of massive red flags.”

If true, the allegations regarding these audit committee chairs involve more than failing to see red flags and are more accurately described as actual knowledge of fraud that was not reported to outside auditors or investors. There has been much scrutiny of SEC handling of these types of cases and questions regarding whether the penalties (i.e. director bars, but with no requirement to admit guilt) continue to let these types of fraud participants off too easily.

Fulcrum Inquiry performs forensic accounting services.