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Henry Blodget

LFT: Just another Chinese fake.

Longtop Financial (LFT), a popular Chinese software company, has just been exposed as a colossal fraud.

The “cash balance” on Longtop’s balance sheet, it turns out, was fake–a fiction created by the company’s managers and helpers.

The Longtop fraud follows other China stock frauds that have made many of Wall Street’s best and brightest look like fools. It has also increased the skepticism of American investors toward Chinese companies.

As well it should.
Unlike some of the more famous American-company frauds in recent years–Enron, Worldcom–it turns out that Longtop had institutional help in perpetrating its fraud. The reason Longtop was able to fend off skeptics for so long, despite multiple analysts arguing that it was a fraud, was that Chinese banks were complicit in the scam.

According to an extraordinary letter that Longtop’s auditor, Deloitte, sent the company when it quit last week (see below), Longtop’s banks sent out fake statements attesting to the company’s fake cash balances. It wasn’t until Deloitte’s examiners actually physically visited the banks, and talked to other employees at the banks, that the fraud was discovered.

The Longtop fraud fooled some of smartest hedge funds and mutual fund investors in the country. It fooled the New York Stock Exchange. It fooled the investments banks that underwrote Longtop’s stock–and defended it until its dying breath, claiming all sorts of “due diligence” designed to set investors fears to rest. And, for a long while, it fooled Deloitte.

It serves as a good reminder that, all you really may be investing in when you invest in any stock, are just black marks on a page.

Here’s an excerpt from the Deloitte letter:

As part of the process for auditing the Company’s financial statements for the year ended 31 March 2011, we determined that, in regard to bank confirmations, it was appropriate to perform follow up visits to certain banks.
These audit steps were recently performed and identified a number of very serious defects including: statements by bank staff that their bank had no record of certain transactions; confirmation replies previously received were said to be false; significant differences in deposit balances reported by the bank staff compared with the amounts identified in previously received confirmations (and in the books and records of the Group); and significant bank borrowings reported by bank staff not identified in previously received confirmations (and not recorded in the books and records of the Group).

In the light of this, a formal second round of bank confirmation was initiated on 17 May. Within hours however, as a result of intervention by the Company’s officials including the Chief Operating Officer, the confirmation process was stopped amid serious and troubling new developments including: calls to banks by the Company asserting that Deloitte was not their auditor; seizure by the Company’s staff of second round bank confirmation documentation onbank premises; threats to stop our staff leaving the Company premises unless they allowed the Company to retain our audit files then on the premises; and then seizure by the Company of certain of our working papers.

In that connection, we must insist that you promptly return our documents.

Then on 20 May the Chairman of the Company, Mr. Jia Xiao Gong called our Eastern Region Managing Partner, Mr. Paul Sin, and informed him in the course of their conversation that “there were fake revenue in the past so there were fake cash recorded on the books”. Mr. Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Mr. Jia answered: “senior

We bring these significant issues to your attention in the context of our responsibilities under Statement on Auditing Standards No. 99 “Consideration of Fraud in a Financial Statement Audit” issued by the American Institute of Certified Public Accountants.

Reasons for our resignation

The reasons for our resignation include: 1) the recently identified falsity of the Group’s financial records in relation to cash at bank and loan balances (and also now seemingly in the sales revenue); 2) the deliberate interference by the management in our audit process; and 3) the unlawful detention of our audit files. These recent developments undermine our ability to rely on the representations of the management which is an essential element of the audit process; hence our resignation.

Prior periods’ financial reports and our reports thereon

We have reached the conclusion that we are no longer able to place reliance on management representations in relation to prior period financial reports. Accordingly, we request that the Company take immediate steps to make the necessary 8-K filing to state that continuing reliance should no longer be placed on our audit reports on the previous financial statements and moreover that we decline to be associated with any of the Company’s financial communications during 2010 and 2011.

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