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What to Do if Your Auditor or Audit Committee Requests an Investigation

April 11, 2012

Louis Taubman

China – Article 5


Louis Taubman Er (Arila) Zhou

As discussed in previous articles, the past year has been largely negative for U.S. listed Chinese companies. As a result of numerous accounting scandals and allegations by short sellers, many U.S. listed Chinese companies have undertaken an independent investigation at the requests of either their independent auditor and/or the audit committee of the company’s board of directors.

An independent investigation is an investigation regarding one or more concerns raised by either the auditor or audit committee, usually regarding some element(s) of the company’s financial statements and/or financial controls and procedures. An independent investigation is usually conducted by an outside law firm, in conjunction with a forensic accounting firm and, very often, an independent Chinese law firm to advise the investigation team with regard to issues of Chinese law. Such investigations can last several months and can cost between several hundred thousand and several million U.S. dollars. As a result of the serious, time consuming, and costly nature of such investigations, a company’s board of directors should seriously consider its options prior to commencing such an investigation.

A company’s board of directors must ask itself whether an independent investigation is strictly necessary. Once commenced, an independent investigation is very difficult to stop prior to its completion without raising a negative inference with regard to the issues under investigation. Similarly, a company’s failure to fully cooperate with the investigation team can lead to negative conclusions in the final investigation report or a resignation of the investigation team, which may be viewed as a validation of the concerns that prompted the investigation. Therefore, once a company’s board of directors has determined that an investigation is necessary, usually because its auditors will not complete their audit of the company’s financial statements in the absence of the investigation, the board of directors should consider two crucial issues: (1) what is the scope of the investigation and (2) who will own the attorney-client privilege with the investigative team. These issues are of vital importance as they will influence the timing and cost of the investigation and who will be permitted access to the investigation report once it is completed.

A company’s audit committee should strictly define the scope of the investigation with the investigation team prior to commencing the investigation. Failure to do so may allow the investigation team to expand the scope of the investigation without recourse. This will not only lead to increased time and expense to the company, but will also increase stress on the management and employees of the company who may have to interact with the investigation team through interviews and extensive document productions. The audit committee should inform management of the concerning issues and emphasize that full cooperation with the investigation team is critical to the investigation’s successful completion. If the scope of the investigation is not strictly defined, this will likely lead to frustration and misunderstanding from both the company and the investigation team. It is also advisable to appoint a management coordinator who can interact with the investigation team to ensure smooth cooperation from company personnel.

The audit committee should also address the issue of attorney-client privilege with the investigation team. It is important for all parties to know in advance who controls the privilege and, as a result, who may waive this privilege in the event that the company receives a subpoena or similar request from the SEC or the market that the company’s stock trades on (e.g. Nasdaq). The board of directors should understand that if the audit committee controls the privilege, then only the audit committee will be able to permit or restrict access to the investigation report and the members of the investigation team. This will be of critical importance in the event the company becomes subject to an SEC investigation, a delisting proceeding or a class action. Addressing the issue up front will prevent confusion later.

An independent investigation is an extremely serious undertaking. It will cost the company a great deal of money, will likely disrupt the day to day operations of the company and may result in negative findings regarding the company and/or members of its management. Therefore, a company should consider first whether such an investigation is necessary. Once it is determined that such an investigation is unavoidable, the company’s audit committee should take the time to discuss the issues of scope and privilege with the investigation team before commencing the investigation. Because of the potential negative impact of non-cooperation or early termination of an independent investigation, the audit committee should not proceed with an investigation team until it is satisfied with these threshold issues.