Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

Chinese companies' listing debuts are a vital force in the current global IPO marketplace. According to a December 8, 2007 Wall Street Journal chart (here), 195 Chinese companies listed their shares through November, raising $87.3 billion - representing a 26.7% share of the 2007 global IPO volume. By contrast, the IPOs of 174 U.S. domiciled companies raised $38.5 billion, which represents an 11.8% share. In addition, according to a December 3, 2007 Wall Street Journal article entitled "Chinese Firms Will Test Market Appetite for IPOs" (here), "December could see the launch of three issues that, in total, might eventually raise more than $12 billion." By years' end, the amount raised in 2007 by Chinese company IPOs could well exceed $100 billion.

Stock exchanges around the world are jockeying for a piece of this action. A December 3, 2007 Financial Times article entitled "Markets Jostle to be China's IPO Buddy" (here) notes that "Singapore and Hong Kong are falling all over themselves to be the destination of choice for capital hungry mainland companies, while smaller Chinese companies are still attracted to the perceived lighter-touch regulation of London's Alternative Investment Market." By the same token, the three anticipated December offerings mentioned above are all scheduled to take place in Hong Kong or Shanghai - not in New York.

In order to try to increase its share of this business, on December 3, Nasdaq opened a Beijing office. The Financial Times article, commenting on the office opening, snipes that the U.S. exchanges "face steep challenges, including the time zone and worries about the country's litigious environment." (More about what the litigious environment has meant for Chinese companies below.) But the biggest challenge for the U.S. exchanges is that "Asia is so awash with liquidity that issuers rarely need to look beyond Hong Kong."

For all that, in 2007, Nasdaq still managed to increase the number of its Chinese listings. According to a December 3, 2007 Wall Street Journal article about the Nasdaq Beijing office opening (here), as of the end of November Nasdaq had 52 listed mainland Chinese companies, with a combined market capitalization of $57 billion, up from 33 Chinese firms with a total capitalization of $25 billion at the end of 2006. The 19 listings by Chinese companies this year are "more than double last year's total of nine."

Give the ample liquidity available in Asian financial markets, it is worth asking why Chinese companies would nevertheless be willing to confront U.S regulatory requirements, litigiousness, and time zone differences to list their shares in New York. According to a May 10, 2007 Financial Times article entitled "New York Proves an Attractive Destination" (here), the large privatized Chinese enterprises are attracted to Hong Kong, but maturing small venture-capital backed companies are attracted to New York because "they can still get better valuations and wider analyst coverage in [the high tech and life sciences] sectors than in the resurgent Chinese domestic markets or in the other parts of the world.' One source is quoted in the article as saying that a New York listing helps the companies to establish their brand internationally, for which "nothing matches a U.S. listing."

But before we break out the champagne to celebrate Nasdaq's success in attracting more Chinese companies' offerings in 2007, it is worth taking a look at what the increased number of Chinese listings has actually wrought. Even a quick look suggests that just because a Chinese company is eager to list its shares does not necessarily mean that the company is ready for the scrutiny that comes with a U.S. listing. Indeed, a more detailed analysis confirms that some of the Chinese companies that have listed their shares on U.S. exchanges may not have been ready for the burdens and responsibilities, to their investors' disappointment.

The most telling fact is that of the roughly 165 companies that have been sued in securities class action lawsuits in 2007, seven are Chinese companies. Even more significantly, of those seven companies, five completed their IPOs less than 12 months prior to the initial lawsuit filing - including one, Giant Interactive, that debuted on November 1, 2007 and was first sued on November 26. A sixth company, Focus Media Holdings, which was first sued on November 27, 2007, had just completed a secondary offering on November 7, 2007.

A review of the allegations of the lawsuits against the seven companies reinforces the view that at least some of these Chinese companies that the U.S exchanges succeeded in attracting to New York may not have been ready for prime time.

Here is a brief summary of the allegations against the seven companies:

Xinhua Finance Media (first sued on May 22, 2007, refer here): The plaintiffs allege that the Prospectus issued in connection with the company's March 8, 2007 IPO failed to disclose that the company's CFO at the time of the offering was simultaneously an investment banker in charge of a securities firm that is the subject of an SEC investigation, and that he was also an investor in two companies that had been sued by the SEC for fraud.

Qiao Xing Universal Telephone (first sued on August 9, 2007, refer here): The lawsuit arises out of the company's restatement of its financials for the years 2003, 2004 and 2005. The company stated at the time that misstatements resulted from deficiencies in the company's internal controls over financial reporting.

China Sunergy Company Limited (first sued on September 10, 2007, refer here): The lawsuit alleges that the company's Prospectus in connection with its May 17, 2007 IPO failed to disclose that the company was having difficulty obtaining a sufficient supply of polysilicon, which forseeably would have a near-term impact on earnings.

LDK Solar Company (first sued on October 9, 2007, refer here): The company was sued after the company's financial controller resigned, reporting to the SEC and the company's external auditor that the company lacked internal controls and that the company's reported polysilicon inventory was 25% overstated.

Fuwei Film (Holdings) Company (first sued on November 19, 2007, refer here): The lawsuit alleges that the Prospectus in connection with the company's December 19, 2006 offering failed to disclose that the company's main operating assets were obtained through transactions that may not have been valid under Chinese law. On October 15, 2007, three of the company's major shareholders, including one director, were arrested on suspicion of legal violations.

Giant Interactive Group (first sued on November 26, 2007, refer here): The lawsuit alleges that the Prospectus released in connection with the company's November 1, 2007 IPO failed to disclose that the company had experienced a third-quarter 2007 decline in users (i.e., prior to the offering), which it disclosed for the first time on November 19 (less than 3 weeks after the offering).

Focus Media Holding (first sued on November 27, 2007, refer here): The lawsuit alleges that the company's Prospectus in connection with its November 7, 2007 secondary offering failed to disclose that acquisitions in its Internet advertising division were depressing the division's gross margins. In the company's November 19 earning release, it disclosed that its gross margins had declined due to several recent acquisitions.

To be sure, there is nothing uniquely Chinese about these kinds of allegations (except perhaps with respect to the Fuwei Film allegations). But it is the frequency of these allegations relative to the number of listings that is disturbing. Five of these seven companies are listed on Nasdaq (LDK Solar and Giant Interactive are NYSE listed), meaning that these five represent roughly ten percent of the 52 Nasdaq listed Chinese companies. Moreover, four of the seven are among the 19 Chinese companies that debuted on Nasdaq in 2007 - representing roughly 21% of all Chinese companies that listed on Nasdaq this year.

If the U.S. exchanges' "success" means only that they have attracted companies that stumble out of the blocks, investors may soon lose their sinophilia. This process may already be taking place. A December 7, 2007 Wall Street Journal article entitled "China IPOs Lose Some Allure" (here) noted that two Chinese companies, WSP Holding and VisionChina Media, had to cut their prices to sell shares in their December 6 offerings.

All of this could be interpreted to suggest that in the U.S exchanges' haste to woo Chinese listings, they may be attracting companies that are not prepared for everything that goes with a U.S. listing. U.S toy retailers learned the hard way that consumers expect to be protected from toys with lead-based paint. The U.S exchanges shouldn't have to learn this same lesson all over again in the financial marketplace. The measure of the U.S exchanges' "success" in the global IPO marketplace should not be based on quantity, but on quality, in order for the U.S markets to maintain their reputation for transparency and integrity and to continue to offer superior valuations for companies that can, in fact, withstand the scrutiny. For the sake of the competitiveness of the U.S financial markets, the U.S exchanges themselves must take steps to ensure that foreign issuers continue to perceive that "nothing matches a U.S. listing."

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In a July 18, 2007 publication entiled "IPO Executive Insights 2007" (here) the Nixon Peabody law firm published the results of its survey of 100 chief executive officers and chief financial officers whose companies conducted initial public offerings in the past three years. The report contains a number of interesting observations, but perhaps the most remarkable are in the summary of advice the executives have for companies now considering going public. For example, one survey respondent cautioned:

Going public is like standing in front of the X-Ray machine for every. Once one goes public one cannot go back. In other words, you are completely exposed; everything about the business is in the public domain and is in front of the competition. It is a very different environment than being a private company....Living under regulations like Sarbanes-Oxley can be crushing to a company that is not prepared to understand and manage such regulations.

A July 23, 2007 Wall Street Journal article further summarizing the survey results can be found here (subscription required).

The noted regulatory constraints might be a reason that some companies might consider listing their shares on the London Stock Exchange's Alternative Investment Market (AIM) (here). Perhaps the most valuable part of the survey report is its brief discussion of the advantages and disadvantages for a U.S.-based company in listing shares on the AIM.

The report notes that "utilizing AIM does provide a company certain advantages due to its flexible regulatory approach, lower costs and streamlined admissions process." However, the report also points out a number of risks for U.S.-based companies considering an AIM offering." The risks include:

Number of Shareholders May Trigger Reporting Obligations: Once shares are issued, "a company may have difficulty controlling the number of shareholders of record who eventually own its stock." The problem is that U.S. companies that have more than $10 million in assets "will become subject to the provisions of the Exchange Act" (including its periodic reporting requirements) if they have 500 or more shareholders of record.

Time Requirements: A company selling its shares on AIM must develop a relationship with institutions selling the company's shares. Because of travel requirements and time zone differences, these requirements can be substantial.

Reduced Liquidity: AIM has a reputation for being illiquid, and as a result investors may have difficulty disposing of their shares.

Poor Post-IPO Performance: "Post-IPO Performance for AIM shares compare unfavorabley with companies listed on NASDAQ."

AIM's Limited Diversity: Mining and energy companies account for close to half of AIM's total market value. A company that is not in one of these industries "may not garner the interest of institutional investors who buy AIM stock or the attention the company would otherwise get in another marketplace."

In light of these limitations, it is hardly surprising that, as the report notes, "AIM's growth has slowed in 2007." According to the report, the number of AIM offerings during the first four months of 2007 was more than 50% below the number of offerings during the comparable period in 2006.

Book Note: We here at The D & O Diary are impatiently waiting for our household resident teenagers to hurry up and finish reading the recently released Harry Potter book so that we can get a crack at it. While waiting our turn, we have been fortunate to have found a terrific book that we are happy to recommend to our readers.

Some readers will be sure to recall the rich combination of modern physics, philosophy and drama in Michael Frayn's Tony award-winning play "Copenhagen." (Others may recall Frayn's superbly funny farce, Noises Off.) In his 2006 book The Human Touch: Our Part in the Creation of the Universe (here) Frayn returns to the overlapping area between theoretical physics and philosophy to examine, in brilliant and entertaining fashion, questions about the universe and man's role in it. This book is as rich and rewarding as it is well-written. It would be difficult to capture the depth and breadth of this book in a single snippet, but I offer the following brief excerpt of an example of the book's reach and elegance:

Our own particular speck of the universe, the planet we live on, is as irregular as everything else. A sphere, which seems a neat enough idea - but a sphere that isn't exactly spherical, wobbling a little on its axis and spinning not quite regularly. With a surface as rumpled as an unmade bed, splashed with seas and lakes as haphazard as the spills on a bar, under a shifting blanket of air and water vapour as confused as a drawerful of tangled string.

The oddest feature of this wobbly spheroid, though, is one particular class of things scattered about amidst the rest: a range of entirely anomalous objects that construct themselves out of the material around them, and then replicate themselves - perhaps the only objects of this sort in the entire universe. Among these weird anomalies is a sub-group with a few thousand million members that are even odder, because they also have some inkling of just how odd they are.

Perhaps not everyone will find this kind of thing an adequate substitute for the urgent strivings of the adolescent wizards at Hogwarts, but I find it sufficient (at least for now).

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Regular readers know that I have previously questioned (most recently here) the case for regulatory reform. Among the grounds the reformers routinely cite as the basis for regulatory reform is the U.S.'s loss of global IPO marketshare. A February 20, 2007 Wall Street Journal article entitled "Do Tough Rules Deter Foreign IPO Listing in the U.S.?" (here, subscription required) reports the findings of a recent study by Thomson Financial which found "little evidence of foreign companies shying away from U.S. exchanges since the adoption of Sarbanes-Oxley." Thomson Financial apparently studies new stock issues in the past 20 years and concluded that "in terms of dollars raised, foreign IPO activity in the U.S. looks very healthy indeed."

The study found that foreign IPOs (excluding investment funds and closed end funds) accounted for 16% of 2006 IPOs in U.S. exchanges, the highest proportion in the 20-year period studied. In addition, the $10.6 billion raised in foreign company offerings represents 26% of 2006 IPO volume, the highest level since 1994. According to the study's author, "the statistics show that things look rather healthy" and that even after Sarbanes-Oxley, "there doesn't seem to be any really significant deterioration of the IPO market."

The competitive challenge for the U.S. markets is not that they can't attract foreign companies' listings, it is that financial activity in general is increasingly global, and that global growth has more to do with what is happening overseas than with the state of regulation in the U.S. markets. As the February 20, 2007 Bloomberg.com article entitled "IPOs Shun U.S. Exchanges While Wall Street Collects Record Fees" (here) points out, activity on overseas markets may be booming, but "it is not that America's economy and markets are shrinking - it is that the other ones are growing." The article also notes that "for companies based in Europe, the Middle East and Asia, the choice of where to raise capital often comes down to geography and time zones."

The increasing competitiveness of the global financial marketplace is due to a host of causes, most having nothing to do with the level of regulatory scrutiny in the U.S. As I have noted in prior posts, we should be wary of allowing the effects of larger global financial forces to serve as a pretext for reducing the level of regulation in our markets. The evidence above does not support the hypothesis that foreign companies are unwilling to list their shares here, and the increased financial activity overseas has no relation to the level of regulatory rigor in this country.

There is, however, one area, where the U.S. securities markets clearly are at a competitive disadvantage - cost. As the Bloomberg article notes, "for all the talk about keeping U.S. markets competitive and safeguarding jobs, the reality is that investment banks have helped price the U.S. out of the global IPO market." U.S firms charge more to underwrite shares than do firms elsewhere; according to Bloomberg, U.S. investment banks charged fees averaging 4.4 percent of the value of stock sales in 2006, by comparison than 2.3 percent in Europe.

Whether or not the higher underwriting costs for listing in the U.S. really are deterring foreign business, cutting costs would be a particularly easy way to remove at least one impediment to doing business here, and it is a step that doesn't require any governmental authority's cooperation to accomplish. At a time when U.S. financial firms are booking record profits, this seem like a reasonable first step toward removing impediments to the competitiveness of the U.S markets.

In my commentary on reform proposals, I have also frequently noted (refer here) that other countries' reforms are narrowing differences between the U.S. and other countries. An article in the February 17, 2007 issue of the Economist magazine entitled "If You Can't Beat Them, Join Them" (here, subscription required) comments that while European business interests may not welcome American style class action lawsuits, "welcome or not, class action lawsuits are on the way." Britain, Netherlands, Germany and Spain all already permit some form of collective action, and Italy and France are considering their own versions. (France recently tabled its version until after the May elections.) To be sure, these European versions lack many of the attributes of American class action litigation, including contingent fees, jury verdicts on damages, and the possibility of punitive damages awards. The Economist declares that these new forms of collective action deserve a "caution welcome" because they permit efficient resolution of widespread claims, and because they provide injured European investors a way to seek remedies without having to resort to U.S. courts.

Reasonable minds can disagree over whether the differences or similarities between the U.S and the European models of collective civil actions are most important now. But as global investors become more accustomed to seeking judicial remedies for management misconduct, the similarities will matter more than the differences.

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An October 25, 2006 article in the Raleigh, N.C. News and Observer entitled "Voyager Hit by New Lawsuit" (here) provides an interesting example of the kinds of claims and liability exposures that officials at pre-IPO companies can face, particularly where the anticipated IPO fails to launch.

Voyager Pharmaceuticals is a Raleigh, N.C.-based pharmaceutical company focused on trying to develop an experimental Alzheimer's treatment called Memryte. Voyager had plans to raise $100 million through an initial public offering. A copy of Voyager's S-1 can be found here. According to the news article, investors had committed $65 milion when the IPO was cancelled on December 13, 2005. A copy of the withdrawl request can be found here. Voyager recently advised shareholders that because it was unable to raise needed additional cash, it was halting the late Phase II studies of Memryte.

According to the news article, Voyager filed a first lawsuit in March 2006 against Dr. Richard Bowen, Voyager's co-founder and former Chief Science Officer. Voyager alleged that Bowen had "derailed the IPO by acting erratically and spreading false information."

On October 11, 2006, John Stone, a Voyager shareholder, filed a separate shareholders derivative lawsuit against Voyager's CEO and CFO. This second lawsuit alleges that the defendants misled investors by inflating the company's value. Specifically, Stone alleges that in January 2004, Bowen transferred over 1 million Voyager shares to the CEO and the CFO. Stone further alleges that even though the transfer took place in 2004, it was backdated to November 2001. Stone alleges that by backdating the transfer to a time when the shares had lower values, the beneficiaries avoided income taxes and Voyager's net worth was overstated.

In response to Stone's allegations, the Board has formed a special committee to investigate. The Board has not yet responded.

Voyager appears to have its own special set of issues and to that extent its officials' current legal woes have little to suggest for other companies. But the Voyager lawsuits do represent the kinds of unfortunate disputes that can arise when deals go bad. And at another level, the sequence of event at Voyager and the lawsuits themselves provide examples of the kinds of risk exposures that officials at pre-IPO companies face. Obviously, one risk for a pre-IPO company is that the planned IPO will not go forward, which, as the Voyager example shows, could lead to claims against senior management of the company.

When a company is on a trajectory toward an IPO, there is a natural tendency to focus on the liability exposures the company will face after it goes public. But the process leading up to the IPO involves changes and circumstance that can create its own set of risks and exposures. As a company readies itself to go public, it often restructures its operations, its accounting, its debt, or other corporate features. The company also makes pre-offering disclosures, for example, in road show statements. The process also creates expectations that can create their own set of problems. All of these changes, disclosures and circumstances potentially can lead to claims, even if the offering does goes forward.

Often pre-IPO company management is reluctant to take the time to address D & O insurance issues at the appropriate time before the company is deep into the IPO process. But claims can and do arise involving companies' pre-IPO activities. The significance of the pre-IPO period in a company's life cycle underscores the importance of having a skilled and experienced insurance professional involved well before the time of the IPO.


What a "Foreign Corrupt Practice" Looks Like: Regular D & O Diary readers will recall that I view the Foreign Corrupt Practices Act as a growing source of potential liability to companies and their senior management (most recent post on the topic here). This liability exposure is escalating as U.S. businesses are increasingly drawn into the global economy and confronting the different business standards and cultural norms in other countries.

An October 26, 2006 article in the Financial Times entitled "Taking a Cut Acceptable, Says African Minister" (here, subscription required) provides a vivid picture of how these kinds of problems can arise. The article describes efforts by a South African company to enforce a judgment the company obtained against the government of Equatorial Guinea. (Equatorial Guinea, located in West Africa and about the size of Maryland, is sub-Saharan Africa's third largest oil producing country.) The company had attempted to seize two luxury homes located in Cape Town that are owned by Teodorin Ngeuma Obiang, the son and heir-apparent of Equatorial Guinea's President, who is also Equatorial Guinea's forest minister. In justifying the seizure of Obiang's Cape Town homes, the company alleged that Obiang had bought the houses with Equatorial Guinea's government's money, because Obiang's $4,000/month salary as forestry minister is insufficient to permit Obiang to afford the $7 million homes.

Obiang's surprisingly candid response to the question of where he got the money to buy the luxury homes gives a stark picture of the culture of corruption that afflicts his country. Obiang declared in an affidavit that ministers and public servants in Equatorial Guinea were allowed to own companies bidding for government contracts with foreign groups, which , if successful, would permit the ministers and officials to "receive a percentage of the total contract the company gets." This, Obiang stated in his affidavit, "means that a cabinet minister ends up with a sizeable part of the contract price in his bank account."

So here's how it works in Equatorial Guinea; you want to do business, you set up a local company -- probably not a bad idea to set up the company with the President's son. Your local company gets the contract and of course a "sizeable part" of the deal winds up in the President's son's bank account.

It may not be surprising that this goes on; what is surprising is how straightforward Obiang was in describing the corrupt practices, and that he was willing to do so in a sworn document filed with a South African court. His affidavit certainly confirms the existence of rampant corruption in Equatorial Guinea. The matter-of-fact way Obiang conveyed the information suggests the challenge any company would face in trying to do business there. Corruption is simply expected. Equatorial Guinea is an oil-rich couintry. Foreign companies will be drawn there because of the country's natural resources and depleting oil reserves elsewhere. The expectation to do business Obiang's way not only complicates the business transaction, but created liability exposures under the FCPA and under anti-bribery laws in OECD (Organization for Economic Cooperation and Development) countries. As I have frequently noted on this blog, these exposures can also lead D & O liabilty exposures.

Among the debts underlying the South African company's judgment is a $700,000 obligation allegedly incurred for chartering the yacht Tatoosh, owned by Paul Allen, a Microsoft founder. Tatoosh is 300 feet long, has a crew of 30 and has auxiliary vehicles that include two helicopters, a submarine, and a separate 54-foot racing yacht. It also has its own swimming pool. A September 6, 2006 Times of London article about Obiang that describes the Christmas party for which Obiang hired the use of Tatoosh, entitled "Playboy Waits for His African Throne," may be found here.

Special thanks to a loyal reader for the link to the Financial Times article.

What a Coincidence, Terrorists Have Been Stealing the Beer from My Refrigerator: A New Jersey real estate attorney has sued his malpractice carrier for refusing to reimburse him for amounts he had to pay to make up for lost funds in his client trust account. The attorney claims that because he was "extremely busy" from 2000 through 2002, he "failed to reconcile his trust account on a regular and timely basis." He alleges that he learned in July 2002 "that a terrorist group had over a period of time duplicated checks and forged Plaintiff's signature to obtain the funds in question." When he discovered the missing funds, the attorney used his own and borrowed funds to protect his clients from losses. He settled with his bank for $95,000. His suit seeks to force his insurer to pay the remaining amount. The attorney's complaint, which may be found here, does not name the terrorist group.

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