Caterpillar Inc uncovered "deliberate, multi-year, coordinated accounting misconduct" at a subsidiary of a Chinese company it acquired last summer, leading it to write off most of the value of the deal and wiping out more than half its expected earnings for the fourth quarter of 2012.
Shares of Caterpillar fell 1.5 percent in afterhours trading following news of the fraud, which was discovered after problems were found with the Chinese company's inventory.
Caterpillar, the world's largest maker of tractors and excavators, said on Friday it would take a non-cash goodwill impairment charge of $580 million, or 87 cents per share, in the quarter.
Analysts had expected the company to report $1.70 per share when it reports its results on January 28, according to Thomson Reuters I/B/E/S.
Caterpillar closed the purchase of ERA Mining Machinery Ltd and its subsidiary Siwei, China's fourth-largest maker of hydraulic roof supports, last June, paying HK$5.06 billion, or $653.4 million. ERA had been publicly traded in Hong Kong, doing business through Siwei, which is known for making equipment to support roofs in mines.
A member of the Caterpillar board during the course of the Siwei deal told Reuters the board was distracted at the time by a larger transaction and paid relatively little attention to the Siwei acquisition.
"It came as a complete surprise to us," the former board member said of the fraud, speaking on condition of anonymity because of the sensitivity of the situation. "It was presented to us as a pretty straightforward transaction. It's a shame. It should have been investigated further."
The source said the driving force behind the deal was Ed Rapp, the former Caterpillar chief financial officer who now serves as a group president with responsibility for China, among other operations. The source said it was Rapp who presented the deal to the board and pushed for its completion.
A Caterpillar spokesman declined to comment on Rapp's role in the deal. Rapp could not be immediately located for comment.
At the time of the Caterpillar purchase, ERA Mining was listed in the Growth Enterprise Market (GEM) of the Hong Kong stock exchange, which is "designed to accommodate companies to which a higher investment risk may be attached," according to the offering circular filed by Caterpillar last year in Hong Kong.
The company was previously known as ERA Holdings Global Ltd. and provided "corporate secretarial services" before being acquired by Siwei in September 2010 through a reverse takeover.
Caterpillar's write-off could revive concerns over accounting scandals and corporate governance issues of Chinese companies voiced by investors including Muddy Waters founder Carson Block.
Reverse takeovers have been of particular concern, since most of the recent accounting scandals in the United States have come from small Chinese companies who went public via a reverse takeover, including China MediaExpress Holdings Inc. A Hong Kong arbitration panel on Wednesday ruled China MediaExpress was a "fraudulent enterprise."
In a statement, Caterpillar said an ongoing investigation launched after the deal closed "determined several Siwei senior managers engaged in deliberate misconduct beginning several years prior to Caterpillar's acquisition of Siwei."
According to a question-and-answer dialog Caterpillar included in its statement, the company found discrepancies in November between the inventory in Siwei's books and its actual physical inventory, triggering the probe.
The company also said it had replaced several senior managers at Siwei, adding that their conduct was "offensive and completely unacceptable."
Representatives for Siwei didn't respond to calls and requests for comment on the Caterpillar announcement. The company employs about 4,000 people in Zhengzhou and produces hydraulic roof supports used to prevent rocks from falling into a coal mine's working area.
Siwei competes with market leader Zhengzhou Coal Mining Machinery, according to Zhengzhou Coal's IPO prospectus filed in November.
Citigroup and law firm Freshfields Bruckhaus Deringer LLP served as financial and legal advisers to Caterpillar on the transaction. Blackstone and DLA Piper acted as ERA's financial and legal advisers.
Freshfields said in an emailed statement that it wasn't able to comment on client matters. Representatives for Blackstone, Citigroup and DLA Piper didn't respond to requests for comment on Saturday.
The Siwei deal came as part of Caterpillar's larger ambitions in China. In early 2012, it added Jon Huntsman, the former U.S. ambassador to China, to its board of directors.
The company, which already has 23 manufacturing facilities in China and four more under construction, said the Siwei episode would not change its strategy in the country.
Caterpillar's experience with Siwei may also renew focus on the standoff between the U.S. Securities and Exchange Commission and audit firms over access to accounting documents of U.S.-listed Chinese companies suspected of fraud.
While Siwei was not U.S.-listed, the broader accounting question has been a thorny one for U.S. companies looking to grow their business in China.
(Reporting by Ernest Scheyder; Additional reporting by Soyoung Kim in New York, Elzio Barreto in Hong Kong and Kevin Yao in Beijing; Writing by Ben Berkowitz; Editing by Gary Hill, Tim Dobbyn and Susan Fenton)