By Sarah N. Lynch
WASHINGTON, March 11 (Reuters) - Federal securities regulators filed unusual civil charges on Tuesday against the former independent audit committee chairman and top U.S. officials of an animal feed company, saying they failed to properly investigate an elaborate accounting fraud orchestrated in China.
The Securities and Exchange Commission’s case against K. Ivan Gothner, who previously served as the audit committee chairman for AgFeed Industries Inc, marks a rare move by the agency. It comes as the SEC is seeking to hold “gatekeepers” such as auditors, lawyers and board members more accountable.
The SEC’s lawsuit, filed in a federal court in Tennessee, also accuses four ex-AgFeed executives based in China of manipulating the books at the now-bankrupt company to boost revenue.
Later, when U.S. managers and directors took over the reins at AgFeed, the SEC said they “engaged in a scheme to avoid or delay disclosure of the fraud.”
“Today’s enforcement action is a cautionary tale about what happens when an audit committee chair fails to perform his gatekeeper function in the face of massive red flags,” SEC Enforcement Director Andrew Ceresney told reporters on a conference call about the case.
Bradley Bondi, head of the SEC enforcement practice at lawyers Cadwalader, Wickersham & Taft, called the case “a warning shot across the bow” for public company audit committees.
“This is a reminder that audit committees must follow up on red flags and seek outside counsel for assistance,” said Bondi, who is not involved in the case.
According to the SEC, AgFeed’s Chinese management kept two sets of books - a real one and a fake one to present to investors.
From 2008 through June 2011, they inflated the company’s revenue by $239 million by using phony invoices for feed and hog sales and by inflating hog weights because fatter hogs fetched higher prices. To cover up the fraud, they later reported the fake hogs had died.
AgFeed, which filed for bankruptcy in July 2013, was based in China and publicly traded on the Nasdaq OMX stock exchange.
It merged with a U.S. company in 2010 and divided its operations between the two countries.
By about February 2011, most of the company’s board and executive were replaced with American officials.
Gothner served as the chief executive officer of the company from December 2011 through the summer of 2013, though the SEC’s complaint only charges him for events that occurred in his role as an independent director, the company’s audit committee chairman and vice chairman at AgFeed.
Both he and Edward Pazdro, who at one point served as the company’s chief financial officer and director of internal and external reporting, are fighting the SEC’s charges.
Their lawyers say the SEC’s case wrongly punishes them for doing the right thing and trying to investigate the accounting fraud properly as soon as they caught wind of it.
Gregory Bruch, an attorney at Bruch Hanna LLP who represents Gothner, said his client was instrumental in calling for an internal investigation as soon as the accounting irregularities came to light.
In addition, the company hired outside experts to do a fixed asset review and subsequently hired law firm Latham & Watkins LLP and formed a special committee to investigate further.
By December 2011, he said, the company notified investors not to rely upon the financial statements anymore. “This is not a case where he is complicit in the fraud,” Bruch said.
“He is acting in the interest of investors and this is the result - that he is now the poster child for a pure case against an audit committee chair which the SEC staff has been looking to bring.”
Lyle Roberts, a partner at Cooley LLP who represents Pazdro, made similar comments, noting that his client was “instrumental in investigating the misconduct.”
“The SEC’s attempt to wrap Mr. Pazdro into its case against the company and its Chinese employees is misguided and unwarranted,” he said.
The SEC has in the past filed cases against audit committees or its members, though such enforcement actions are not common.
One of the more recent cases came in 2011, when the SEC accused outside directors and audit committee members of a body armor supply company with ignoring red flags of accounting fraud.
In Tuesday’s case, the SEC also charged AgFeed and four of its former Chinese executives with fraud.
Those four executives are: former Executive Chairman Songyan Li, former Chief Executive Officer Junhong Xiong, former Chief Financial Officer Selina Jin and Shaobo Ouyang, a former controller for the Chinese hog operation.
An attorney representing the company declined to comment.
There is no known defense counsel for the four Chinese executives, and they could not be reached for comment.
Two other former AgFeed U.S. executives reached separate agreements with the SEC in the case.
Former interim CEO John Stadler settled without admitting or denying the charges, agreed to pay $100,000 and will be barred from serving as an officer or director.
Clayton Marshall, who also at one point served as the company’s CFO, reached a cooperation agreement with the SEC.
He will be suspended from practicing as an accountant for a public company for five years, and neither admitted nor denied the SEC’s findings. The SEC said it has not yet been determined whether or not Marshall will face a penalty.
Marshall’s attorney declined to comment. Stadler’s could not be immediately reached for comment.