The credit rater Standard & Poor’s may have been late to throw Sino-Forest Corp. into the wood chipper when it withdrew its opinion on the company’s debt this week. At least it wasn’t last.
The end seems near for Sino-Forest. The Chinese-Canadian timber company’s bonds are priced for a default. Securities regulators in Canada have accused the company of fraud and suspended trading in its stock. One question lingers: Which of the company’s paid opinion merchants will be the last to step aside? Will it be a credit rater? Or will it be the company’s auditor, Ernst & Young LLP in Toronto, which has yet to rescind any of its reports on Sino-Forest’s finances?
So far Ernst looks like the favorite, with only one rating company left in the hunt. Think of it as a contest between giant tortoises to see which one is slower. This time-honored ritual -- of market gatekeepers waiting to blow the whistle until long after a scam has been exposed -- has become so familiar, we might as well revel in the spectacle.
Fitch Ratings withdrew its junk rating on Sino-Forest on July 14, six weeks after the short-selling research firm Muddy Waters LLC released a lengthy report accusing the company of fraudulently overstating its timber holdings in China. S&P pulled its rating this week after downgrading the company to CCC-, three levels above default, citing “heightened information risks.” That’s a euphemism for “we have no idea what’s going on here.”
This leaves just Moody’s Investors Service and Ernst, both of which, like S&P and Fitch, are paid by the same companies on which they render opinions. Moody’s this week downgraded the company three steps to Caa1, its fifth-lowest mark. That’s well into junk territory. So at least Moody’s is on record saying that Sino-Forest is a very high credit risk.
Ernst is still clinging to its position that Sino-Forest’s books are clean, under the accounting profession’s usual pass-fail standard. Beyond that, the firm refuses to speak publicly about its audit work for the company, whose board includes two former Ernst partners.
There’s every reason to believe Muddy Waters’ call was spectacularly correct. Once again a Big Four accounting firm seems to have been caught with its pants down, having told the investing public for years that a multibillion-dollar enterprise’s numbers could be trusted, only to see its imprimatur discarded by the markets and its conclusions upended by government investigators. Even the lowly credit raters, notorious for being slow to pull the trigger on dying companies, have been quicker on the draw this go-around.
‘Perpetuate a Fraud’
Canada’s main securities regulator, the Ontario Securities Commission, suspended trading last week in Sino-Forest’s shares. The commission said Sino-Forest, as well as certain officers and directors, seem to have misrepresented the company’s revenue, exaggerated its timber holdings and engaged in acts “they know or reasonably ought to know perpetuate a fraud.”
As if that shouldn’t have been enough to shake Ernst’s confidence, Sino-Forest said this week that its chairman and chief executive officer, Allen Chan, had resigned, pending completion of an internal review of Muddy Waters’ allegations. The company placed three other employees on leave “after certain information was uncovered during the course of” the review, without saying what that information was. In its Aug. 28 news release, Sino-Forest said “the allegations made in the OSC’s temporary order, while unproven, are of a serious nature.”
Ernst’s only public response has been to say nothing of substance. “We are aware of the OSC’s temporary order and the company’s press release, and are evaluating these developments,” an Ernst spokeswoman, Amanda Olliver, said in an e-mail. “Our professional obligations prevent us from speaking more specifically about client matters.”
Surely the company’s officers and directors must be grateful to Ernst for keeping their secrets from the public’s prying eyes. Meanwhile the only thing investors have to go by from Ernst is the form letter it signed March 14 attesting to the company’s year-end financial statements. Whatever evidence Ernst had to support its view that Sino-Forest’s books were kosher, it’s hard to imagine the firm’s partners could be so sure now.
Ernst does have options, aside from bracing for the inevitable years of litigation and investigations. It could resign, explain why it is doing so and face criticism for acting too late. It could withdraw its previous audit opinions. It could insist to Sino-Forest’s directors that it be permitted to answer questions from the public about the work it has performed, as a condition of remaining onboard. Or it could hang on in silence, as it’s doing now, and watch its reputation endure more damage.
That it’s choosing the last of these approaches -- and eating even the credit raters’ dust in the process -- reinforces the perception that Ernst fell down on the job and may have something to hide. No client could be worth this, no matter how much it’s paying in fees. A plug-pulling is long overdue.
(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)
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