SEC Brings Another Gatekeeper Case

SEC Brings Another Gatekeeper Case

 Operation Broken Gate, announced Monday in a press release by the SEC, focuses on holding gatekeepers accountable. Three proceedings against accounts were included in the announcement. Focusing on gatekeepers as a means of policing the markets and halting violations is, of course, nothing new. It has long been a Commission priority.

Another gatekeeper case initiated at the time Operation Broken Gate was announced is the proceeding against New Jersey based accounting firm Patrizio & Zhao LLC and one of its partners, Xinggeng (John) Zhao. In the Matter of Patrio & Zhao, LLC, Adm. Proc. File No. 3-15534 (September 30, 2013). The Order centers on alleged violations of Rule 102(e) of the Commission’s Rules of Practice in connection with professional work done for Keyuan Petrochemicals, Inc.

Keyuan is a Nevada corporation whose shares were registered with the Commission under Section 12(g) of the Exchange Act. The headquarters of the company is located in the PRC. The company is the product of a reverse merger. Prior to being delisted, its shares were listed on NASDAQ. Now the shares of the company are quoted on OTC Link.

P&Z was retained by the company in 2009 before the reverse merger as the outside, independent auditors. Prior to its replacement at the end of 2010, Keyuan prepared reports included in filings made by the company with the Commission. In October 2010 the company filed an annual report on Form 10K. Subsequently, it restated its quarterly reports for 2009 and the first three quarters of 2010. The Form 10K and the restated quarterly reports disclosed for the first time a series of related party transactions. Those involved loan guarantees, purchases of raw materials, sales of products and short term cash transfers for financing purposes as well as transactions involving the company and its CEO and controlling shareholder and other persons.

The alleged unprofessional conduct of Respondents centered on its failures in connection with the related party transactions. From the outset Respondent Zhao had reason to believe that the engagement at Keyuan was high risk. The company was new. It did not have employees knowledgeable about U.S. accounting requirements. Chinese audit clients were typically high risk. And, those companies engaged in related party transactions.

Those concerns should have been intensified when, during the work, a series of red flags were encountered. Those demonstrated that the company had not properly identified and disclosed related party transactions. The red flags included:

Audit planning: During the audit planning the vice president of accounting told Respondents that there were no related party transactions, a fact reflected in the financial statements prepared by an outside consultant.

Identifying transactions: During the course of the work the P&Z staff obtained a list of related party transactions from the company. Later Respondents determined the list was incomplete.

Specific documents: As the work progressed documents depicting related party transactions were reviewed while others suggested that additional procedures and work on the question were required.

Management representation letter: The CEO signed a management representation letter which stated that material related party transactions, including sales, payables, and guarantees, had been properly recorded or disclosed in the financial statements despite the fact that there were no such disclosures.

Respondents failed to exercise the required level of care and professional skepticism in view of these facts. Likewise, they improperly relied on the representations of management and did not obtain sufficient evidential matter and properly audit the related party transactions. Indeed, Respondents failed to properly plan, conduct and document their work in accord with professional standards, according to the Order. In this regard they were a cause of Keyuan’s violations of Securities Act Sections 17(a)(2) and (3) and Exchange Act Section 13(a).

To resolve the proceeding Respondents each consented to the entry of a cease and desist order based on the Sections cited in the Order. Each Respondent is denied the privilege of appearing or practicing before the Commission as an accountant with a right to request reinstatement after three years. The firm also agreed to implement certain remedial procedures and pay a penalty of $30,000.

For more commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.

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