Despite marked alleged differences between revenues and profits reported in China Century Dragon Media’s U.S. IPO prospectus and the equivalent figures reported in its Chinese operations’ filings in China, a federal court has granted the dismissal motion in the securities class action lawsuit filed against the U.S.-listed Chinese company.
On November 30, 2011, Central District of California Judge John Kronstadt granted China Century Dragon Media’s motion to dismiss (without prejudice, it should be noted), finding that the plaintiffs had not sufficiently alleged that the figures the company reported in its offering documents were false. Although this is not the first time a dismissal motion has been granted in a securities suit involving a U.S.-listed Chinese company, Judge Kronstadt’s ruling may represent the first time a motion to dismiss was granted in a securities suit against one of the Chinese companies based on a assessment of the sufficiency of the factual allegations. A copy of Judge Kronstadt’s ruling can be found here.
China Century Dragon Media sells advertising on Chinese television. Its Chinese operations are conducted through Beijing CD Media Advertising Co. China Century Dragon Media controls all of Beijing CD Media Advertising through contractual relationships between subsidiaries of China Century Dragon Media and Beijing CD Media Advertising.
China Century Dragon Media conducted an IPO in the NYSE Amex exchange on February 7, 2011. On March 28, 2011, the company announced that its auditor, MaloneBailey had submitted a resignation letter in which the auditor cited “discrepancies,” “irregularities” and the possibility that the company’s accounting records may have been “falsified.” Amex halted trading in the company’s shares. Shareholder litigation ensued. Separately, on June 21, 2011, the SEC initiated proceedings to dtetermine whether or not it should issue a stop order suspending the effectiveness of the company's registration statement (refer here).
In their amended complaint, the plaintiffs allege, among other things that the revenue and profit figures the company reported in its Prospectus differed substantially from figures that Beijing CD Media Advertising reported to the Chinese State Administration for Industry and Commerce (SAIC). The plaintiffs allege that the Prospectus reports, for fiscal year 2008, that the company had revenues $45 million and profits of more than $8 million, and for fiscal year 2009, the company had revenues of about $75 million and profits of nearly $15 million. By contrast, the plaintiffs allege, Beijing CD Media Advertising’s filings with the SAIC reported FY 2008 revenues of $15 million and profits of only about $360,000, and FY 2009 revenues of only $9.5 million and profits of only $260,000.
The plaintiffs allege that because all of China Century Media Dragon’s operations run though Beijing CD Media Advertising, the financial information reported to the SEC and to the SAIC should be substantially the same. The plaintiffs allege that the lesser figures reported to the SAIC are the true figures and that the figures reported in China Century Media Dragon’s prospectus were false and misleading. The defendants moved to dismiss.
The November 30 Order
In his November 30 order granting the defendants’ motion to dismiss, Judge Kronstadt first determined that though the plaintiffs asserted claims only under the ’33 Act, their claims “sound in fraud” and therefore must meet the heightened standards for pleading fraud under Fed.R.Civ.P 9(b).
Judge Kronstadt found that the plaintiffs’ allegations “fail to meet the heightened standard of pleading with respect to the claim that the profit and revenue reports in the SEC filings were false.” Though the CSAIC numbers and the SEC numbers were different, that is “merely consistent with” the possibility that the SEC figures were false, but “does not suffice to make that claim plausible.” In order to establish that the SEC figures and not the CSAIC figures are false, the plaintiffs must “plead with greater specificity.”
In order to establish the requisite specificity, the plaintiffs could, Judge Kronstadt suggested, allege that “Chinese and American accounting standards are sufficiently similar such that the SAIC and SEC numbers should be substantially the same,” or that “Defendants relied on the same underlying financial data in preparing the SEC and SAIC reports.”
Accordingly, Judge Kronstadt granted the defendants’ motion to dismiss, with leave to amend
Judge Kronstadt’s ruling does not represent the first occasion on which the motion to dismiss has been granted in one of the many securities suits that have been filed against U.S.-listed Chinese companies since the beginning of 2010. For example, as noted here, in October 2011, the motion to dismiss was granted in the securities lawsuit involving China North East Petroleum. However the dismissal of that case, on loss causation grounds, was based on the fact that the plaintiffs had failed to sell their shares at a profit when the company’s share price spiked after its initial plunge on disappointing news. The dismissal in the China North East Petroleum case was due to the unusual circumstances surrounding the movement of the company’s share price. The ruling in the China North East Petroleum case did not address the sufficiency of the plaintiffs’ substantive allegations.
So Judge Kronstadt’s ruling apparently represents the first occasion as part of the current wave of securities suits against U.S.-listed Chinese companies when a dismissal motion was granted based on the insufficiency of the substantive factual allegations. This ruling is all the more striking given the circumstances surrounding the resignation of the company’s auditor, which came just weeks after the company’s U.S. IPO.
It should be emphasized, however, that the dismissal was without prejudice; the plaintiffs were given leave to replead their allegations. In preparing the amended pleadings, the plaintiffs will be aided by Judge Kronstadt’s observations about what kinds of factual allegations would be sufficient to establish that the financial figures reported in the company’s prospectus were false. Although it remains to be seen, the plaintiffs may well be able to overcome the initial pleading threshold after they amend their complaint.
And while the motions to dismiss were granted in this case and the China North East Petroleum cases, the dismissal motions have been denied in other securities suits involving U.S.-listed Chinese companies, including in the case involving Orient Paper (refer here); and in the case involving China Educational Alliance (refer here). To be sure, even in those cases in which the plaintiffs’ claims survive the initial pleading threshold, their claims stiff face substantial challenges, not the least of which are problems involved with effecting service of process and in conducting discovery in China, as well as deriving from the geographic distances and language issues involved. (Refer here)
Notwithstanding these challenges involved, plaintiffs’ lawyers continue to pursue claims involving U.S.-listed Chinese companies. For example, during November 2011, two more securities suits were filed involving Chinese companies: On November 16, 2011, a lawsuit was filed involving Keyuan Pharmaceuticals (about which refer here), and on November 29, 2011, an action was filed involving China Organic Agriculture (refer here).
With these latest lawsuits, there have now been a total of 37 cases filed so far this year against U.S.-listed Chinese companies, and since January 1, 2010, there have been a total of 48, representing a significant part of all class action securities lawsuit filings during that period.
What Better Place to Sink Your Money than a Publicly Traded Hole in the Ground?: There are many reasons why the various Chinese companies are running into difficulties in the U.S. Many of the companies may not have been prepared for the burdens and responsibilities involved with a U.S.-listing. For other companies, there may be a question whether or not the company should have been publicly listed in the first place.
Many of these questions may well be asked about the U.S.-listing of cave near the remote village of Yishui, in China. As discussed in a December 2, 2011 New Yorker online article entitled “China’s Cave, Inc.” (here), the cave bills itself as one of the “Top Ten Tourist Attractions in Shandong” and China’s “Underground Grand Canyon.” The cave company, BHTC XV, obtained a U.S.-listing through a reverse merger with a public traded shell; its shares trade over-the-counter.
There are no financial or accounting issues involving this company, and the cave may be a stellar tourist attraction. But one may well ask whether a U.S. listing really is a good idea for a company like this. The mere fact that a company like this went through the reverse merger whirlygig underscores how out of hand the whole process became. No wonder there were some problems when the music stopped.