The Ontario Securities Commission's allegations against Sino-Forest Corp. and its top leadership team point to an alleged fraud perpetrated over a period of years in a brazen fashion – but one that still went unnoticed by outside experts working with the company.
The breadth of the alleged fraud raises more questions about the company's Canadian "gatekeepers" – a term that typically refers to outside experts such as auditors, lawyers and underwriters who work for companies to help them get public listings on stock exchanges. OSC enforcement director Tom Atkinson suggested Tuesday the commission has expanded its investigation to look at the work of those gatekeepers.
The ability of the company to operate for years apparently without arousing the suspicions of its Canadian auditors or bankers also points to the complexity and opaqueness of doing business in China, where different practices can make it challenging for foreigners to measure a company's performance.
Sino-Forest executives allegedly boldly manufactured sham deals and created complex transactions to transfer falsified revenues among shell companies run by "caretakers" with undisclosed connections to management. The OSC, for example, alleged that Sino-Forest's biggest supplier for years was in fact secretly controlled by the company and its management team. Senior executives allegedly registered and capitalized Yuda Wood, which was in turn paid $650-million for its timber between 2007 and 2010. None of the insider connections were disclosed.
In its allegations Tuesday, the OSC noted that auditors Ernst & Young "were not made aware" of Sino-Forest's "systemic practice of creating deceitful purchase contracts and sales contracts." The commission makes no further comment on the audit firm's work. A spokeswoman for Ernst & Young could not be reached for comment Tuesday.
The OSC issued a report in March calling on boards, underwriters, auditors and stock exchanges to improve the practices for listing foreign companies on Canadian stock exchanges, saying there has been a broad lack of "skepticism" about business practices in emerging companies like China.
Ernst & Young is already facing a class-action lawsuit from shareholders of Sino-Forest, who claim the auditor missed evidence of impropriety at the company.
Former U.S. auditor Brian Fox, who founded audit verification software firm Capital Confirmation Inc., said Sino-Forest is the largest in a recent series of Chinese-based corporate scams that all involved an inability by auditors to accurately confirm the details or parties to key corporate deals.
"The auditors were missing the forest for the trees," Mr. Fox says.
In cases like Sino-Forest and others, he said auditors are following a check list of processes to confirm the details of transactions, but are too blindly accepting of the answers they get from management or third parties, who are often bribed or coerced into confirming inaccurate information.
While auditors complain they were not told of improper conduct, Mr. Fox says the excuse is becoming hollow.
"If you're just going to trust what the client tells you, then why do an audit at all?" he asks.