The role of auditors and other gatekeepers working in emerging overseas markets and the ability of regulators to monitor them has again come under the spotlight after a searing Ontario Securities Commission statement alleging a billion-dollar fraud by Sino-Forest Corp.

The OSC’s May 22 statement of alleges that Sino-Forest, a Chinese forestry company with its principal office in Hong Kong and its registered office in Mississauga, and members of its overseas management engaged in numerous deceitful and dishonest courses of conduct connected with the purported purchase and sale of timber in China. It also alleges that Sino-Forest provided misleading disclosure to investors and that certain former executives attempted to mislead OSC staff’s investigation into the company’s dealings once accusations of fraud arose.

"This is a complex international investigation and we have dedicated significant resources to this file, moving swiftly to take action against these individuals," said Tom Atkinson, the OSC’s director of enforcement. "This is an important first step and our investigation is continuing into this matter, including an examination of the role of the gatekeepers."

According to Dimitri Lascaris, one of the lead counsel in a class action launched in Ontario Superior Court by investors in June, 2011 (Smith v Sino-Forest Corporation, 2012 ONSC 24): "This case cries out for regulatory enforcement. I think that the speed with which the OSC has acted is unusual and is perhaps indicative of a more rigorous approach by the securities regulators."

But for some, such cases can never unfold swiftly enough under the present regulatory framework.

Joseph Groia, a securities lawyer with Toronto-based firm Groia & Company and the OSC’s director of enforcement from 1987 to 1990, said every enforcement director at the OSC talks about getting tough on fraud but he sees the current action merely as "window dressing."

"The reality is that this is much too late to benefit those shareholders who lost a lot of money," he said.

When Howard Wetston took over as chair of the OSC in late 2010, he announced that "the OSC is examining new tools to deliver strong investor protection through an enhanced enforcement regime …We are investigating cases faster and commencing more prosecutions."

The OSC’s manager of public affairs, Carolyn Shaw-Rimmington, said that "progress is certainly being made with respect to the OSC’s enforcement activities. For example, last year, we made greater use of the criminal courts, securing 14.5 years in jail in 2011, compared to 195 days in 2010."

But Groia counters that the very ability of North American regulators such as the OSC to investigate has come under question.

"We are really dealing with a very significant crisis of confidence in the ability of the OSC and all the other securities regulators in Canada and the U.S.," Groia said. "Increasingly, regulators are being confronted with the awful reality that the whole way of regulating companies —particularly offshore companies — doesn’t work anymore. The government and regulators are going to have to take a very close hard look at how we allow foreign companies — particularly those offshore — to access North American capital.

"I don’t think we are anywhere near to making the regulatory changes we need to deal with companies like this one."

In the case of Sino-Forest, the underwriters and auditors will be left holding the bag, Groia said, when class action lawyers look for recompense. "The OSC is proposing to take away the ability of the foreign directors and officers to serve in that capacity for Canadian public companies — that’s not very punitive," he said. "They may order them to pay some money, but they have no meaningful way to collect it from those offshore. So, you have to look at who can pay compensation, which would be the underwriters and auditors, who are known as ‘deep pockets’ in the industry."

In its heyday, Sino-Forest said it controlled more than 800,000 hectares of timber assets in China, reporting revenues of more than $1.9-billion in 2010. The company’s share price rose from $5.75 on June 30, 2006 to $25.30 on March 31, 2011, giving it a market capitalization of more than $6 billion. In early June 2011, the share price plummeted after a report from private analyst Muddy Waters accused the company of fraud. On March 30, 2012, Sino-Forest launched bankruptcy proceedings in Ontario and, four days later, the company’s auditors resigned. On May 9, the TSX delisted Sino-Forest’s shares.

The OSC alleges that Sino-Forest and its former senior executives "engaged in a complex fraudulent scheme to inflate the assets and revenue of Sino-Forest and made materially misleading statements in Sino-Forest’s public disclosure record related to its primary business."

The OSC statement alleges that from June 30, 2006 until January 11, 2012, Sino-Forest "engaged in numerous deceitful and dishonest courses of conduct … that ultimately caused the assets and revenue derived from the purchase and sale of Standing Timber (that constituted the majority of Sino-Forest’s business) to be fraudulently overstated."

The OSC statement pointed out that during this time, the company’s auditors (Ernst & Young LLP in Canada, and BDO Ltd. in Hong Kong) "were not made aware of Sino-Forest’s systematic practice of creating deceitful purchase contracts and sales contracts."

Sino-Forest’s legal counsel did not respond to requests for comment, while Ernst & Young spokeswoman Amanda Olliver confirmed that "we are co-operating with the Ontario Securities Commission’s ongoing investigation."

The OSC also alleges that former chairman and CEO Allen Chan "secretly controlled companies that received over $22 million" as a result of Sino-Forest’s purchase of a controlling interest in Hong Kong-based forester Greenheart Group Ltd. "By concealing Chan’s substantial interest in this transaction, Chan and Sino-Forest made materially misleading statements in Sino-Forest’s public disclosure record," the OSC statement said.

The OSC also said David Horsley, the former senior vice-president and chief financial officer did not comply with Ontario securities law and acted contrary to the public interest. "As CFO of Sino-Forest, Horsley authorized, permitted or acquiesced in Sino-Forest’s and overseas management’s making of materially misleading statements," the OSC alleges, adding that Chan and four senior executives "materially misled staff during the investigation of this matter."

The allegations follow separate reports released earlier this year by the OSC and the Canadian Public Accountability Board that said auditors in emerging economies were not meeting Canadian standards. The CPAB report focused specifically on 24 audits of Canadian public companies operating in China and found 12 of them not up to snuff.

According to the CPAB report some of the audit firms did not control the confirmation process, or relied on confirmations with questionable reliability. As well, they didn’t properly identify related-party transactions, and provided insufficient audit evidence to support the ownership or existence of significant assets, the recognition of revenue and the appropriateness of the income tax rate used.

Brian Hunt, the CPAB CEO, would not comment on whether the board’s reports covered the Sino-Forest audits but did say that, "in general, an audit is not designed to identify fraud, although the auditors do need to deal with fraud should they come across it."

He added, however, that "any time an auditor is beyond national borders, you have to be much more aware of the jurisdiction’s business practices, norms and legal structures than you do within your borders. Business practices elsewhere are different and you must understand those differences and adjust your audit procedures and processes accordingly."

The OSC, in its report on offshore audits, said that staff saw conclusions that were not supported by analysis, and a lack of skepticism when examining information in the course of their audits. "This disconnect raised issues on what work, if any, was done to substantiate the auditor’s conclusion or ensure that risks were sufficiently mitigated," the report said.

Many of the shortcomings cited in the CPAB and OSC reviews were identified in particular in the June 2011 class action lawsuit and related evidentiary documents. According to Lascaris, a partner with Ontario-based law firm Siskinds LLP, "there were plenty of red flags in our view that ought to have, at minimum, caused the underwriters and auditors to exercise heightened vigilance."

Groia believes regulators need to work a lot harder at preventing cases like Sino-Forest. "If I have learned anything in the last 20 years in the marketplace is that talk about getting tough on crime won’t stop fraud from taking place. We need to be better at preventing and detecting these cases at earlier stages."

The first step, Groia said, would be "to mandate that auditors do annual high-risk audit engagements for every issuer who has operations offshore. And management has to be required to pay for it because these audits will be significantly more expensive."

Secondly, companies that access the Canadian capital markets "should be required to have their working funds in either North American banks or off shore branches of those banks so that their monies are not out of the reach of regulators and others that may have claims to make against them," Groia said.

"We need to go to the gatekeepers and say we’re not going to come after you for liability," he added, "but we are going to put more emphasis on the jobs you do up front. By doing so, we could avoid cases like Sino-Forest."

According to OSC spokesperson Carolyn Shaw-Rimmington, the commission has little to add to the public statements already released, saying only that "staff have analyzed thousands of pages of evidence in different languages and managed an investigation on two continents. Our investigation is continuing into this matter." A hearing has been scheduled for July 12, 2012.

Meanwhile, a stay in the class action proceedings against Sino-Forest under the Companies Creditor Arrangement Act is in effect until September.

"We intend to pursue our claim as soon as that stay is lifted," said Lascaris. "In the interim, we continue to gather evidence to support our claims."