Over the last several years, many Chinese companies, with the assistance of underwriters including WestPark Capital, engaged with reverse mergers with public shells, enabling the companies to trade on U.S. exchanges without going through the regulatory scrutiny entailed by an IPO.   These transactions gave the companies access to U.S. capital markets, but also subjected them to U.S. law, including the requirement to file financial statements audited by a PCAOB-registered firm with the SEC.

Eager to profit from the booming Chinese economy, many smaller North American firms held themselves out as having Chinese capabilities.  With the assistance of local Chinese accounting firms that did the actual fieldwork, the U.S. firms issued a series of unqualified, “clean,” audit opinions.

Starting in 2010, the PCAOB started to crack down on registered audit firms doing business in China.  In a March 14, 2011 report  about accounting and auditing standards at Chinese companies that have conducted IPOs in the U.S. or that have become U.S. publicly traded companies through reverse mergers, the PCAOB a number of factors that may undermine the ability of audit firms to complete their audit functions completely or effectively.

MaloneBailey, identified in the PCAOB report as the U.S.-based firm with the most Chinese reverse merger company clients, was also the subject of a negative PCAOB inspection report dated February 24, 2011.  This inspection report stated that “[i]n some cases, the deficiencies identified were of such significance that it appeared to the inspection team that the Firm, at the time it issued its audit report, had  not obtained sufficient competent evidential matter to support its opinion on the issuer's financial statements.”  In my experience, reports containing such findings are routinely referred to the PCAOB enforcement staff for prosecution.

In apparent reaction to the risks presented by its Chinese clients,  during the spring of 2011, Malone Bailey  resigned as auditor for NIVS Intellimedia Technology Group, China Intelligent Lighting and Electronics, and China Century Dragon Media and accused these companies of fraud.  As a result, the audits of the companies’ financial statements were not completed in time to enable the companies to file Forms 10-K for their 2010 fiscal years.   All of the companies were required to launch costly internal investigations, are in the process of being delisted from various exchanges and are besieged by SEC investigations and shareholder lawsuits.  The SEC recently instituted stop order proceedings against China Intelligent Lighting and China Century Dragon Media Inc. on suspicion of accounting fraud.

None of these companies have yet restated their financials or disclosed the results of their internal investigations, so it is unclear whether MaloneBailey’s allegations have merit.  Only time will tell whether the firm, having failed to detect fraud in prior periods it audited, reacted appropriately to indications of impropriety observed as the result of more stringent audit procedures, or simply threw its Chinese clients under the bus to improve its standing with the PCAOB, to the great detriment of these companies and their shareholders.