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Financial Reporting and the Law

A recent SEC enforcement action is a warning to audit committee members to take appropriate action in response to recommendations relating to evidence of potential accounting fraud. The March 11 SEC press release announcing the filing of charges notes that the audit committee chair “ignored the recommendation [of a company advisor] and internalized the situation while false financial reporting continued.”

The SEC’s complaint alleges a massive accounting fraud involving fake revenues to meet financial targets. Implicated in the fraud are AgFeed Industries, Inc., an animal nutrition and hog production company with operations in the United States and China; a former director of the company, who was the chair of the audit committee and thereafter a vice-chairman of the board; and various former executive officers. The former director, while audit committee chair, received evidence of financial fraud and consulted with a former AgFeed director and then-current company advisor. The advisor recommended that AgFeed hire professional investigators, guided by outside legal counsel, to conduct an investigation. However, the audit committee chair did not take this advice.

From approximately mid-2008 through June 30, 2011, AgFeed’s publicly reported revenues were falsely inflated by approximately $239 million due to actions by former members of AgFeed’s Chinese management, including inflating revenues by booking sales of nonexistent hogs and manipulating hog weights and later covering it up by, among other things, reporting that the fake hogs had died.

According to the SEC’s complaint, the audit committee chair learned of the fraud in early May 2011, prior to seeking advice from the company advisor. Specifically, he learned that “since at least 2009, ‘there were a lot of frauds’ in Jiangxi and that the region ‘kept at least two account [books], one for inside and one for outside.’” Later in May 2011 and through the beginning of June 2011, the audit committee chair learned that an AgFeed executive admitted to the fraud, obtained a partial copy of the two sets of books on a USB drive, obtained a memo from AgFeed’s in-house counsel from China that concluded that the company was involved in a widespread accounting fraud, and learned that the second set of books had been destroyed at the former CEO’s direction. Notwithstanding this evidence—as well as additional red flags that arose in June and July 2011—the audit committee chair failed to provide the USB drive or the memo to the company’s outside auditor, failed to hire a professional firm to conduct a review, and otherwise did not investigate the fraud reports. Ultimately, the company announced in September 2011 that it had formed a special board committee to investigate accounting practices in its China operations and announced in December 2011 that various accounting improprieties required it to restate its financial statements.

This case demonstrates the SEC’s renewed focus on accounting fraud and gatekeepers. In this regard, Andrew J. Ceresney, director of the SEC’s Division of Enforcement, stated that the case “is a cautionary tale of what happens when an audit committee chair fails to perform his gatekeeper function in the face of massive red flags.”