In a recent opinion, the U.S. District Court for the Southern District of New York held that securities fraud claims could proceed against two members of the audit committee of Longwei Petroleum Investment Holding Ltd., a Chinese petroleum distributor with U.S. publicly traded securities. The complaint alleges that Longwei’s financial statements overstated its revenues (which were largely nonexistent) and failed to disclose a major investment in another company controlled by a Longwei insider. The court ruled that the complaint adequately alleged that the audit committee members acted with scienter – the conscious or reckless intent to deceive or defraud. The court noted that a prior case had held that, while audit committee membership alone does not establish scienter, "[a]llegations that an audit committee failed to take steps to prevent fraud may suffice". In this regard, the court noted that the complaint alleged that —
Both audit committee members signed a Form 10-K which included a statement that Longwei’s disclosure controls were not effective.
Despite these failures, neither the board nor the audit committee reported holding any meetings.
Although the company’s auditors had a history of employment with other Chinese companies with accounting irregularities, the audit committee recommended their retention annually.
The company reported a sudden increase in revenues "just in time to satisfy the terms of an escrow agreement that risked the personal stock” of the founders.
Comment: While the alleged facts in this case are rather extreme, the decision is a reminder to audit committee members of the dangers to which they may be exposed if they fail to follow up on information that could reasonably be interpreted as suggesting the possibility of fraudulent financial reporting.