In our last post, we provided some background to the Sino-Forest saga, a Canadian quoted company currently rocked with allegations of fraud related to its Chinese forestry assets.
In our post, we commented on an article from the National Post in Canada. We thought it would also be useful to draw attention to some of the other comments in the Post article.
According to the Post, "no matter how you break it down, the past nine days have been a debacle for Canada's capital markets, as an obscure short-seller took down the shares of a 19 year old Canadian Forestry giant in record time.
If Mr. Block turns out to be wrong, then it is shocking that investors took his word above the bankers, analysts and auditors who backed this company for years. It undermines Bay Street institutions and could go down as one of their biggest embarrassments.
If he is correct about Sino-Forest, then it's Armageddon reminiscent of Bre-X. It will take years to figure out how the company was able to raise so much money and fool so many outsiders. Almost nobody will come out of it looking good."
One comment in the article particularly struck us:
"Mr. Block, for his part, has no trouble explaining potential cracks in the financial system. He describes the capital markets as a 'hot potato' where the various groups (auditors, bankers, lawyers etc.) pass the blame to each other when the system suddenly fails." According to Mr. Block, "the gatekeepers whom investors think are providing protection against fraudulent listings don't function as they should."
Is Mr. Block correct, and does his view also translate to hedge funds? Do hedge fund administrators, auditors and lawyers provide sufficient protection against hedge fund fraud and NAV error?
In this case, Sino-Forest's auditors are Ernst & Young Toronto. The firm's 2010 financial statements are available here, and received a clean audit report dated March 14, 2011. As an aside, we're pleased to see that Ernst & Young direct their audit report to the Sino Forest "shareholders" as a body. As we have discussed before, EY has adopted "Cayman GAAP" - whatever that might be - to decide that they have no reporting responsibility to the shareholders in any offshore hedge fund and hence direct their hedge fund audit opinions only to the directors. Shamefully, Deloitte appear to have picked up the same tactic for the 2010 year end, although this is a topic for another post.
If Sino Forest is a complete fraud - which seems possible - or is at least subject to some form of material misstatement - which certainly seems possible - then it will also be a catastrophic audit failure. This leads us to make three comments.
Firstly, it is evidently extremely difficult to obtain clear evidence as to ownership of assets in certain countries. In China, auditors face an obvious language barrier, and a different legal system where ownership and property rights are not documented and enforced following anything like the practices of Western legal systems. It is fair, therefore, to have some sympathy for the auditors and at least recognize the inherent difficulty of unambiguous verification of title for companies operating in these countries. However, at the same time, the starting point of any audit must be to prove that a company actually owns what it says it owns. If the audit can't do that with certainty, then the entire audit is, we hate to say, worthless.
Secondly, we are reminded of a recent email we received from a friend of the firm: "we have seen a growing trend of corporate frauds at overseas companies such as the recent one in Longtop....we have found that one consistent item across some of these is that they were audited by overseas Big 4 auditors who missed big items such as cash."
In the case of Longtop (a Chinese software company), according to Business Insider, "the cash balance on Longtop's balance sheet, it turns out, was fake - a fiction created by the company's managers and helpers....According to an extraordinary letter that Longtop's auditor, Deloitte, sent the company when it quit last week, Longtop's banks sent out fake statements attesting to the company's fake cash balance. It wasn't until Deloitt'e's examiners physically visited the banks, and talked to other employees at the banks, that the fraud was discovered."
Some other examples of similar frauds are Satyam India, the software company with an estimated $2.5 billion of fake cash and other assets (PwC India has recently settled for a $6 million fine) and, of course, Parmalat.
These issues are all combined and lead to our third observation. Once more, investors should recognize the purpose of the audit - as we have discussed before, the financial statements are the responsibility of management, and it is the auditor's responsibility to gather sufficient evidence to determine whether those financial statements are free of material misstatement. In practice, this means that the audit seeks out a baseline of evidence to support management's assertions. The purpose of the audit is not to actively search out information which could disprove management assertions.
This, ultimately, is the question: where on the continuum should an effective audit fall between "innocent until proven guilty" and "guilty until proven innocent"? Should the efforts of the auditors go towards proving what management has told them - or should the auditor work harder to find information which may contradict management's assertions?
Taking the example of a hedge fund, let's think about a fund which owns a hard to value distressed bond. Is it enough for the auditor to circularize the broker the manager used in its year end pricing matrix and confirm the same price of 65; or should the auditor independently contact other brokers, not used by the manager, who may, perhaps, have a lower mark?
As an aside, there is also an interesting extension from this observation. At what point does a major audit firm, auditing multiple funds holding the same security, say that it cannot be materially correct for each client to hold the same security at different prices? While there may be sufficient evidence to prove one manager's mark, does that evidence in turn disprove another manager?
It is obviously unrealistic to expect any seachange in the core framework for the audit process. However, it is a fair point to at least question whether the current audit process is sufficent when a company holds assets which are hard to value or where title is hard to prove. For this type of company - which includes many hedge funds trading hard to price assets - should the auditors dig deeper and look for more independent evidence, outside the sources suggested by management? This approach would make an audit longer and more expensive - probably much more expensive in the case of companies such as Sino Forest. But, against a history of multi billion dollar frauds, it might be better to pay the auditors extra basis points now, rather than lose 10,000 bp later on.
Hedge Fund Operational Due Diligence
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