Documents shed light on pitfalls of China audits

* Disputes with Chinese highlight governance differences

* Letters aimed at legal defense, multiplying lawsuits

* Accusations include hiding in the company washroom

By Nanette Byrnes

WASHINGTON, Sept 26 (Reuters) - When Michael Marks and John
Wang stepped off the board of directors of Jiangbo
Pharmaceuticals JGBO.O in June, they said goodbye to the
Chinese company with a 23-page resignation letter complaining
of months of unanswered questions, unpaid bills and management
deception.

The letter, one of a recent spate of similarly explicit
resignations by directors and auditors, reflects concern that
outside directors and auditors at troubled companies may
increasingly face legal problems themselves.

These "noisy" resignations have, for the most part, come at
Chinese companies with U.S.-traded stocks, companies whose
advisers are in particular legal peril, experts say. The
problems are emerging as an early sign of different U.S. and
Chinese standards of good corporate governance.

While Chinese companies themselves may prove hard for U.S.
courts and regulators to reach, directors and auditors with
ties to the West are "likely to be the only people the SEC and
the courts are really likely to have jurisdiction over and
whose liability can be enforced," said Henry Klehm, a partner
with law firm Jones Day. For auditors and board members, these
departure notes have become "the first step in establishing a
defense," Klehm said.

Traditionally board and auditor resignation letters have
been short and dry, offering few important details. The Jiangbo
letter is completely different, outlining with great
specificity a frustrating and failed two-month attempt by the
board's audit committee to investigate questions raised by
regulators at the Securities and Exchange Commission.

FRUSTRATED INVESTIGATION

Jiangbo, based in the city of Laiyang in Shandong province,
had once been a favorite of U.S. investors. The company, which
produces both Western pharmaceuticals and Chinese herbal
medicine, incorporated in the United States in 2008, and its
stock traded at $14 a share as recently as early 2010.

But this year after the SEC raised questions about the
company and the directors resigned, its value fell sharply.

According to the directors, Jiangbo staff avoided answering
their questions, once going so far as to hide in the employee
washroom; failed to produce requested employee lists, bank
statements and shipping records, and though Jiangbo chairman
Wubo Cao pledged cooperation, he often blocked progress.

It proved a road map for unhappy Jiangbo investors, whose
lawyers quickly sued the company, quoting liberally from the
directors' letter, as well as for regulators. In July, about a
month and a half after the directors' letter arrived, Nasdaq
cited the obstructed board investigation as one of the reasons
it was delisting the company's shares.

Jiangbo CEO Linxian Jin said by email that he could not
respond to issues raised in the letter due to ongoing
litigation, but that "we are trying our best to cooperate with
the SEC and shareholders to resolve the issues." Marks and Wang
did not respond to requests for comment.

PARTICULAR TARGETS

According to Cornerstone Research, 25 securities
class-action lawsuits were filed by shareholders of Chinese
companies in the first half of 2011, more than double the
number filed against Chinese firms in all of 2010.

In a recent survey by BDO USA, 61 percent of directors said
they believed their liability risk as a director had increased
during the past few years, and shareholder suits were not the
only worry. The SEC has in recent years taken action against
directors for failure to follow up on red flags and against
auditors for improper professional conduct.

The SEC is reading these resignations. On Sept. 8, the
regulator took auditor Deloitte Touche Tohmatsu to court,
demanding it produce the records of its audit of Longtop
Financial Technologies LGFTY.PK, a maker of software for
Chinese financial services companies. One impetus for the
action, according to court records, was Deloitte's May
resignation letter in which it referred to "numerous indicia of
financial fraud" and "deliberate interference" by company
managers.

Detailed auditor resignations have also been submitted at
China-Biotics (CHBT.PK), China MediaExpress (CCME.PK) and
ShengdaTech. None of the three companies replied to requests
for comment.

Whether this newfound openness in resignation letters will
persist is unclear. In the past there has been some discussion
of regulators requiring more transparency and candor in letters
in general, said University of Georgia Terry College of
Business accounting professor Dennis Beresford, but so far
regulators have not made such disclosures mandatory.
(Editing by Howard Goller and Matthew Lewis)