Even though the story has been brewing for months, the mainstream media and the SEC suddenly seem to have decided that the alleged accounting frauds involving certain U.S.-traded Chinese companies are the central story of the moment. You can hardly pick up the business papers or turn on the television these days without encountering some coverage of this issue. One problem with this sudden torrent of coverage is that there are now so many items and events that it is easy to fall behind. To make sure that everyone is on top of the latest, here is a round up of the most recent news and developments about this continuing story.
Time to Hit Pause on the Litigation Onslaught?: Plaintiffs’ lawyers seem to be engaged in an old-fashioned race to the courthouse in connection with each new Chinese company swept up in this story. But when it comes to trying to litigate against companies based in China, there arguably are some practical reasons to move with greater deliberation, at least given problems that are likely to arise. Here, I have in mind not only the distances involved and language barriers, but even more basic issues – like service of process, for instance.
According to a June 15, 2011 ThompsonReuters News & Insight article entitled “Plaintiffs Hit First Roadblock in China Fraud Case,” (here) the plaintiffs in the Duoyuan Printing Inc. securities class action lawsuit (about which refer here) have not been able to effect service of process on five of the company’s current and former directors and officers named as defendants in the suit. The plaintiffs lack the personal addresses for the individuals, who reside in China. As the story notes, “serving individuals in China is an arduous and costly process and requires a central Chinese authority to forward any requests to local Chinese courts.”
From the article’s account of a recent hearing in the case, it appears that there may be procedural alternatives available that could help address this issue in that case. But even if plaintiffs in this and other cases can overcome the service of process hurdle, there are other issues. As the article notes, “plaintiffs face numerous obstacles, such as difficulty in pursuing evidence-gathering in China and limitations on their ability to collect judgments or legal awards.”
This latter point, about the ability to collect any awards, seems particularly salient. As this wave of accounting scandals has unfolded, I have frequently wondered whether the plaintiffs’ lawyers who are now rushing into court will see any reward for their labors. Earlier securities class action lawsuits filed against Chinese companies have hardly resulted in any sort of massive bonanza. For example, earlier this week, NYSE-traded and China-based agricultural company Agria Corporation announced (here) that it had settled the securities class action lawsuit that had been filed against the company, in exchange for a payment by the company’s D&O insurers of $3.75 million. While $3.75 million is a respectable sum, it does raise the question whether, if that amount is representative of the settlement range for these kinds of suits, these cases will wind up being worth it for the plaintiffs’ lawyers, given the practical, logistical and legal barriers these cases entail.
Of course, the plaintiffs’ lawyers intend to engage in a for-profit enterprise, so they clearly must think these cases will prove worth pursuing. We shall see. From what I have seen of the D&O limits that many of these companies carry, it could all turn out otherwise.
The Role of the Auditors: In a June 13, 2011 post on the New York Times Dealbook blog, Wayne State University Law Professor Peter Henning wrote an interesting column entitled “The Importance of Being Audited,” (here), in which he examines the critical role the auditors have played in raising questions about many of these companies. A problem that can arise when the auditors raise questions or even resign is that the companies involved may delay reporting these auditor actions. As Henning details in his column, these delays have in some cases been substantial.
But while the auditors have served a key role identifying many of the companies that have accounting concerns, some auditors have also found themselves targeted for alleged complicity in the misstatements. As detailed in a June 9, 2011 Reuters article entitled “Auditors Face Suits Over U.S.-Listed Chinese Blowups” (here), recent securities lawsuits involving Chinese companies have in some instances also included the companies’ auditors as defendants. Among the recent cases cited in the article are those involving Puda Coal and China Integrated Energy. Other case mentioned in which the auditors have been sued include those involving China MediaExpress and Orient Paper.
In addition, the recent lawsuit filed in Ontario involving Sino-Forest also named the company’s auditor as a defendant. In a June 9, 2011 New York Times article entitled “Troubled Audit Opinions” (here), Floyd Norris examined the role of Sino-Forest’s auditor, the Toronto office of Ernst & Young, in the accounting questions surrounding the company. On the one hand, the audit firm issued a clean audit opinion. On the other hand, serious questions have been raised in the media about Sino-Forest (see below). Which, for Norris, raises question not just about the audit, but raises questions about what investors realistically can expect from an audit, the purpose of which is not necessarily to detect fraud.
As the questions swirl about the veracity of the Chinese companies financial statements, fundamental questions about the reliability of the financial statements are inevitable. Which in turn will lead to questions about the auditors’ role in the process, and to questions whether the auditors were complicit in the financial misstatements.
Securities Analysts or Short-sellers?: Many of the accounting concerns involving Chinese companies have come to light through on-line postings by supposed securities analysts. But as I noted in an earlier post (here), some Chinese companies have gone on the offensive, charging that the supposed analysis is really just an attack job by financially motivated short-sellers seeking to undercut the companies’ share prices.
The most recent company to raise this assertion is Sino-Forest, which has attacked Muddy Waters Research, the financial analyst responsible for the first report questioning the company’s financial statements. The June 9 Floyd Norris column I referenced in the preceding section specifically discussed the role of Muddy Waters Research in the controversy surrounding Sino Forest. Similarly, a June 9, 2011 Wall Street Journal article entitled “’Backdoor’ China Plays Under Fire” (here) described the questions surrounding China Media Express, the questions about which also first arose following the publication by Muddy Waters of a report raising concerns about the company’s financial statements.
On June 9, 2011 the New York Times DealBook blog ran an article entitled “Muddy Waters Research Is a Thorn to Some Chinese Companies”(here), describing Muddy Waters Research’s founder, Carson C. Block, who is “delivering a controversial message to investors enamored with Chinese companies: buyer beware.” The article cites critics of these kinds of firms, whom the critics allege, are “rumor-mongering” because they hope to profit by shorting the stocks of the companies they are attacking.
And the SEC Gets Into the Act: As I noted in an earlier post (here) , the SEC seems to have found itself once again in a reactive mode, this time on the question of whether or not it is adequately protecting investors with respect to the potential dangers of reverse merger companies. With the onslaught of media coverage , the SEC is stepping forward, trying to assert itself into the dialog and to establish that it is on patrol and looking for problems.
For starters, on June 9, 2011, the SEC released an Investor Bulletin (refer here) cautioning investors about companies that entered the U.S. markets through a “reverse merger” with a U.S. listed shell company. Among other things, the SEC cautioned in its press release regarding the Bulletin, that “investors should be especially careful when considering investing in the stock of reverse merger companies.” The Bulletin also details enforcement actions the agency has taken just since March 2011 against six companies that obtained their U.S. listing through a reverse merger. These companies had either failed to maintain current financial statements or questions had arisen about the accuracy or completeness of the company’s financial statements.
In addition, on June 13, 2011, the SEC announced (here) that it had instituted proceedings to determine whether stop orders should be issued suspending the effectiveness of registration statements filed by two companies – China Intelligent Lighting and Electronics Inc. (CIL) and China Century Dragon Media Inc. (CDM). The purpose of a stop order is to prevent a company or its selling shareholders from selling their privately-held shares to the public under a registration statement that is materially misleading or deficient. The agency said that it initiated these proceedings after the companies’ independent auditor resigned and withdrew its audit opinions on the financial statements included in the companies’ registration statements.
A Final Comment: I started this news roundup by saying that one problem with the torrent of information is that it is getting hard to keep up. Another problem is that the coverage is getting overheated. There are over 500 U.S.-listed Chinese companies and the questions that have been raised so far have involved only a small number of these companies. The concerns are now being generalized to all of the Chinese companies.
This very large group of companies is unfairly being swept with the same broad brush. That is not only unfortunate from an investment perspective, but also from a D&O insurance perspective. This has turned into the classic contagion event, where every company in the entire category is being treated as if it were plague-infested.
The media may now have switched to an “all China, all the time” mode on this topic, but that does not mean that this story relates to all U.S.-listed Chinese companies. A discerning underwriter that understands the difference could profit from these circumstances.