In October 2011, when Southern District of New York Judge Miriam Goldman Cedarbaum dismissed the securities class action lawsuit that had been filed against China North Petroleum Holdings, Ltd, it was the first of the many cases recently filed against U.S.-listed Chinese companies to be dismissed (as discussed at length here). However, in an August 1, 2012 opinion (here), the Second Circuit vacated the dismissal and remanded the case to the district court for further proceedings.
The Second Circuit held that the plaintiffs may still pursue their claims even though they had bypassed the opportunity to sell their shares at a profit shortly after the alleged misrepresentations had been disclosed. In reaching this conclusion the Second Circuit rejected a line of lower court decisions that had reached a contrary conclusion on the issue of whether or not price recovery following a stock price drop negates the inference of economic loss and loss causation.
As detailed here, the plaintiffs first filed their action in June 2010. According to their amended complaint, during the class period, the defendants inflated the amount of the company’s proven oil reserves, overstated reported earnings inflated profits and misrepresented the company’s internal controls. An allegedly “bizarre series of events” followed the company’s February 23, 2010 announcement that it would be restating prior financials, including “revelation of illicit bank transfers” made to company officials and “a dizzying number of resignations and replacements” of top executives. Over the next few months additional details were revealed regarding the transfers, ultimately resulting in the resignation of the CEO and several members of the board. The NYSE had halted trading on the company’s shares on May 25, 2010, but when trading resumed on September 9, 2010, the company’s share price “plunged.”
The defendants moved to dismiss the plaintiff’s complaint on loss causation grounds, arguing that the plaintiff had several opportunities to sell its shares at a profit following the allegedly corrective disclosure at the end of the class period, and contending that had the plaintiff “chosen to sell at those post-disclosure dates, it would have turned a profit.”
Judge Cedarbaum agreed. Even though the plaintiff ultimately sold its shares at a loss, she concluded that “that loss cannot be imputed to any of NEP’s alleged misrepresentations,” adding that “a plaintiff who forgoes a chance to sell at a profit following a corrective disclosure cannot logically ascribe a later loss to devaluation caused by the disclosure.” Because she found that the plaintiff “has not suffered any loss attributable to the misrepresentations alleged in the complaint,” and in reliance on a line of district court cases that had reached a similar conclusion, she granted the defendants’ motion to dismiss. The plaintiff appealed.
In an August 1, 2012 opinion for a three-judge panel written by Judge Chester Straub, the Second Circuit vacated Judge Cedarbaum’s ruling and remanded the case to the district court. The Second Circuit rejected the reasoning of the line of cases on which Judge Cedarbaum had relied in dismissing the case, and held that the fact that the price of the stock recovered soon after the price dropped does not negate the inference of economic loss and loss causation at the pleading stage. The court said that the reasoning on which Judge Cedarbaum had relied was inconsistent with both the traditional measure of securities fraud damages and the 90 day “look back” provision in the PSLRA. The court said:
At this stage in the litigation, we do not know whether the price rebounds represent the market’s reactions to the disclosure of the alleged fraud or whether they represent unrelated gains. We thus do not know whether it is proper to offset the price recovery against [plaintiff’s] losses in determining [plaintiff’s] economic loss. Accordingly the recovery does not negate the inference that [plaintiff] has suffered an economic loss.
The Second Circuit’s ruling is obviously significant in that it establishes that a stock price rebound following a corrective disclosure does not in and of itself eliminate the possibility that the plaintiff might be able to prove an economic loss and loss causation. The plaintiff’s law firm’s August 1, 2012 press release about the Second Circuit’s ruling and its significance can be found here.
The Second Circuit’s ruling is also significant because it revives one of the securities suits filed against a U.S.-listed Chinese company that had been dismissed. Observers have been watching these cases closely, and counted the dismissal as one of the important early milestones in the development of these cases. It should be noted that on remand to the district court, the defendants will still have the ability to assert the many defenses they have raised in the case and which have not yet been ruled upon because of the district court’s prior dismissal on loss causation grounds. The case has a long way to go yet. Nevertheless, the Second Court’s ruling at least allows this plaintiff to live for another day.
As I noted at the time of Judge Cedarbaum’s ruling, because of the unusual movement of this company’s share price, the rulings on loss causation issues here are unlikely to have a significant impact on the other cases involving U.S.-listed Chinese companies. That observation remains true with respect to the Second Circuit’s ruling. However, the Second Circuit’s ruling could prove to be very significant amongst cases in general in which a defendant company’s share price rebounded following an initial price decline..
A group of former executives of a Lehman Brothers subsidiary is seeking to block the bid by senior Lehman executives to use $90 million of the remaining D&O insurance proceeds to settle the cases pending against them. As discussed here, on August 24, 2011, the senior executives filed a motion with the Lehman bankruptcy court seeking access to $90 million in insurance funds to settle the securities suits pending against them. On September 8, 2011, seven executives of Lehman’s Structured Asset Securities Corp. (Sasco) objected to the requested $90 million drawdown, arguing that it would leave the Sasco executives without sufficient insurance funds remaining to settle the claims pending against them. A copy of the Sasco executives' opposition papers can be found here.
The Sasco executives, like the senior Lehman executives who seek the $90 million, are defendants in a number of securities class action lawsuits involving events leading up to Lehman’s collapse. As I detailed in my prior post about the senior Lehman executives request for the $90 million in insurance proceeds, defense expenses and other costs (including an arbitration settlement) have already significantly eroded the $250 million insurance tower. The Sasco executives claim they now have an opportunity to settle the $4 billion claims pending against them for $45 million. They contend that if the senior executives draw down the $90 million they seek, there will be insufficient remaining insurance funds to settle the claims against them.
In their opposition papers, the Sasco executives argue that the $90 million drawdown would represent a “disproportionate and inequitable portion” of the remaining funds. They argue that “permitting one class of insureds to use such tactics to divert a disproportionate share of insurance proceeds for their benefit to the exclusion of other classes of insureds is inequitable, contrary to the purpose of the available D&O insurance and would have an adverse economic impact on the Debtors’ estate.”
The Sasco executives note that the fight is with respect to Lehman’s 2007-2008 tower of insurance, which originally totaled $250 million. (This tower is described in detail in an earlier post about Lehman’s D&O insurance, here.) The Sasco executives contend that their claim actually implicated the separate $250 million 2008-2009 tower, as it was during that policy period that the claims were first made against them. However, the carriers in the 2008-2009 D&O insurance tower apparently contend that the claims against the Sasco executives relate back to claims first made during the 2007-2008 insurance tower’s policy period, and therefore it is the 2007-2008 tower that is implicated with respect to the claims against the Sasco executives. The Sasco executives dispute this position of the insurers, but they note in the motion papers that they cannot establish their entitlement to the proceeds of the 2008-2009 tower without protracted and expensive coverage litigation.
It is worth noting that the senior executives request for the $90 million drawdown would not in and of itself deplete the amounts remaining in the $250 million 2007-2008 tower. As discussed in my post about the settlement, it looks as if the drawdown would leave about $50 million remaining, which would seem to be enough to fund the Sasco executives’ proposed $45 million settlement. In their motion papers, however, the Sasco executives assert that the senior Lehman executives “will quickly attempt to settle other claims asserted against them, exhausting the remaining limits under the 2007-08 D&O policy,” contending that the senior executives “seek to appropriate all of the remaining proceeds …for their own benefit, to the exclusion of the Sasco defendants.”
The Sasco executives argue that they have “an equal right to insurance protection” as the senior executives and that it “would be inconsistent with the purpose of D&O insurance to permit one class to monopolize the protection.” The Sasco defendants seek to have the bankruptcy court deny the senior executives’ motion for the $90 million drawdown and to enter an order adopting an “allocation scheme” that more equitably divides the remaining proceeds. They note that they are not arguing that the proposed $90 million settlement is “unreasonable,” they simply object to the fact that the senior executives’ requested drawdown would leave them using the remaining proceeds to enter a settlement of the claims against them.
This situation represents a classic example of the too-many-insured, too-many-claims, not-enough-insurance problem. These problems come up in all sorts of contexts, although rarely in cases as high profile as this. The most basic problem is that even with $250 million in insurance, there is not nearly enough insurance to defend and settle all of the claims involving insured persons. The question is how the insufficient insurance proceeds should be applied.
There are procedural mechanisms available to deal with these types of situations, such as interpleader, where the insurer(s) simply deposit the insurance with the court and the court sorts out the entitlements. The insurers themselves would have to initiate an interpleader action. The Sasco executives are hoping to enlist the bankruptcy court to perform an equivalent allocation on an equitable basis. In their motion papers, they reference an earlier bankruptcy case where the D&O insurance policy proceeds were allocated in a pro rata basis. This type of scheme might well be equitable, but the problem is that given the number of individuals involved and the seriousness of the claims against them, a per capita allocation might leave everyone with insufficient funds to settle any of the claims against them.
The one thing that seems likely if the Sasco executives are unable to secure for themselves a portion of the 2007-08 insurance tower to settle the claims pending against them, they will be under pressure to try to establish that they are entitled to proceeds of the 2008-09 tower. Such a bid would involve very significant questions regarding the interrelatedness of the claims made against them with the prior claims on which the carriers are relying to argue that the claim against the Sasco executives do not involve 2008-09 insurance tower, but instead relate back to the 2007-08 tower.
It will in any event be interesting to see how the bankruptcy court responds to these competing claims to the proceeds of the D&O insurance coverage. The situation certainly underscores the fundamental tension that arises from the fact that the D&O insurance must provide protection for a significant number of individual directors and officers, and the fact that in the event of a catastrophic claim, the various individuals can find themselves in competition for the D&O insurance policy proceeds. One way to address this problem of course is to buy more insurance. But as the Lehman example shows, there may be limits to how much can be accomplished simply by buying more insurance. If $250 million is not enough insurance, higher limits is not going to solve much for most companies.
This may be one of those problems that may not be susceptible to solution, but one possible approach to ameliorate this situation is through program structure. For example, if the outside directors had their own separate tower of insurance, those amounts could be applied toward defending and settling the claims against them while the proceeds of the main policy could be applied toward the settlement of the claims against the officers. Of course, even this arrangement would not have eliminated the possibility of the kinds of problems that have arisen here. It is at least one way to try to address problems due to the fact that so many individuals are entitled to and would want the benefit of the proceeds of the main D&O insurance policy’s protection.
A September 10, 2011 Wall Street Journal article about the Sasco executives’ motion can be found here.
SEC Seeks to Enforce Subpoena Against Longtop Financial Auditor: The SEC is going on the warpath to try to enforce a subpoena that it served on Longtop Financial’s former auditor, Deloitte Touche Tohmatsu (DTT), which is the Shanghai-based affiliate of the global accounting firm, Deloitte Touche. As discussed here, Longtop is one of the many U.S.-listed Chinese companies to be caught up in accusations of accounting impropriety in recent months. DTT resigned as Longtop’s auditor earlier this year.
The allegations surrounding Longtop attracted the attention of the SEC, and at least according to news reports, the company recently received a Wells Notice from the SEC. The SEC also apparently tried to subpoena DTT in connection with its investigation of Longtop. As reported in the SEC’s Sept. 8, 2011 press release (here), DTT failed to produce the requested documents and so the on September 8 the SEC filed a motion with the United States District Court for the District of Columbia requiring DTT to comply with the subpoena. The SEC’s motion papers can be found here.
The SEC’s motion papers report that DTT’s U.S. counsel had sent a letter to the SEC asserting that (1) the firm could not be compelled to produce documents created prior to July 21, 2010, the effective date of the Dodd-Frank Act, and (2) that in any event producing any documents could subject the firm to sanctions for violations of Chinese secrecy laws.
The SEC contends that DTT’s arguments are “apparently based on a misunderstanding of the legal basis for the subpoena,” arguing further that the subpoena was not dependent on the additional powers given the SEC in the Dodd-Frank Act but rather was based on the SEC’s long standing subpoena power. The SEC argued further DTT’s “vague assertions of possible conflicts with a foreign law provide no justification” for DTT’s “continued non-compliance with the Subpoena.” The SEC argued that DTT’s “speculative” assertion that compliance would subject it to sanctions is “illusory” and furthermore a risk DTT “knowingly accepted by availing itself of the U.S. securities markets.”
As detailed in Nate Raymond’s September 8, 2011 Am Law Litigation Daily article about the SEC’s motion to enforce the subpoena (here), this situation represents something of a test case for the SEC, as (according to one commentator quoted in the article) “the SEC for obvious reasons wants to know if it can get to these documents in the future.” Another commentator in a September 10, 2011 Wall Street Journal article (here) said that the SEC’s move to enforce the subpoena represents a “major escalation.” The Journal article also notes that the dispute also “highlights the shortcomings of regulation in China, which is complicated by vague laws, competing regulatory agencies and a tight rein on information.”
Whatever the significance of the SEC’s action ultimately may prove to be, it is clear that the SEC has ramped up its activity levels in seeking to take action in connection with the U.S.-listed Chinese companies caught up in the accounting scandals. In addition to the Wells notice recently served on Longtop, the SEC also recently served a Wells notice on the Chairman of another Chinese company, Puda Coal (about which refer here).
The other thing about the challenges the SEC is facing in trying to enforce its subpoena is that it shows how difficult it will be for any party to pursue legal action against many of these Chinese companies. If the SEC can’t even enforce a subpoena against an audit firm that is registered with the PCAOB, it obviously is going to be a challenge for private litigants to try to pursue discovery from China-based firms and individuals. Indeed, because many claimants have recognized these limitations, they have tried to focus their actions against the outside professionals (underwriters, auditors, attorneys) that have facilitated the Chinese companies’ entries into the U.S. securities markets. But as the SEC’s struggles to enforce its subpoena show, some of these professionals may also be difficult to pursue.
Lawyers’ Relief Act: If you have not had a chance to read Eric Dash’s September 8, 2011 New York Times article “Feasting on Paperwork” (here), I recommend taking a few minutes now to read it. Unbeknownst to the rest of us, the Dodd-Frank Act was actually a stimulus package intended to rescue lawyers from the impact of the economic crisis on their profession. The Act is, in the words of one commentator quoted in the article, “a full employment act” for lawyers and consultants. The article goes on to note that new regulation “has long been one of Washington’s unofficial job creation tools.”
I don’t know whether to be appalled at the brazen profit-extracting presumption that the lawyers quoted in the article unapologetically express or to be impressed by their naked opportunism. There is little wonder, as the article states, that lawyers and consultants “are salivating at the prospect of even more business opportunities.” The firms are, as noted by one lawyer quoted in the article, “only getting started.”
The overwhelming impression is the main consequence of the Act is the enrichment of a small number of professionals at the expense of the entire economy. And lawyers wonder why they do not enjoy a higher regard in our society. The article reminds me of the old joke about how research scientists are now going to use lawyers rather than rats in their scientific experiments -- there aren’t enough rats; there is no danger that the scientists will become emotionally attached to the lawyers; and there are some things that rats just won’t do.
The Moral of the Ducks: Even when you are completely blown away by unexpected events, the thing to do is to regroup, quickly get it back together, and march on.
During the twelve months ending June 30, 2011, at least 32 Chinese companies were hit with U.S. securities suits. In addition, the U.S. Securities and Exchange Commission has initiated a number of enforcement actions and other proceedings against U.S.-listed Chinese companies, issued a formal bulletin warning investors about the risks of investing in Chinese companies that have gone public through reverse merger transactions, and launched a task force to investigate U.S.-listed Chinese companies that have sold stock to investors in the U.S.
These developments have significant D&O insurance implications for the directors and officers of these firms. In a July 14, 2011 Client Advisory from the Pillsbury Winthrop law firm, Pillsbury partner Peter M. Gillon and I review the current litigation exposure facing U.S.-listed Chinese companies and examine the questions that officials at these firms should be asking about their D&O insurance.
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.
The wave of new securities class action lawsuits involving accounting scandals at U.S-listed Chinese firms is already a well-established phenomenon. But in the latest twist on the tale, Deer Consumer Products, one of the U.S.-listed Chinese companies most recently sued based on allegations of accounting fraud, has gone on the warpath and is publicly alleging that the lawsuit against the firm is part of an elaborate scheme by “illegal” short sellers to manipulate the company’s share price. And according to press reports, a different Chinese firm that also has been hit with a lawsuit also have raised the question whether short sellers might be behind the accounting fraud allegations.
The latest story involving Deer Consumer Products began on April 30, 2011, when plaintiffs’ lawyers announced in a press release that they had filed a securities class action lawsuit in the Central District of California against the company and certain of its directors and officers. Among other the plaintiffs’ attorney’s press release states that:
Deer misrepresented its financial performance, business prospects, and financial condition to investors, citing inconsistent Chinese regulatory filings. The Complaint also alleges that Deer improperly recognized revenue in violation of Generally Accepted Accounting Principles (“GAAP”). On March 9, 14, and 17, 2011, analyst Alfred Little issued a series of reports disclosing defendants’ alleged fraud, which caused the stock price to drop, damaging investors.
On May 2, 2011, Deer Consumer Products issued its own press release (here) in which the company asserted that it has “evidence of continuing illegal short selling” in its stock, and also asserted that its “common stock has been manipulated in collusion among ‘naked’ short sellers.” The press release goes on to assert that the class action lawsuit itself is “part of the attempted manipulation.”
Now, it is nothing new for companies to assert that the bad news circulating about them is based on rumors from profit-motivated short sellers. But the Deer Consumer Products takes this common gripe quite a bit further. The company asserts that the supposed analyst, Alfred Little, whose reports are the source of the rumors and are relied on in the complaint is “a fictitious character” whose phony identity is “a disguise used by one or more illegal short sellers in the short sale scheme.” The purported reports of Alfred Little were “published in collusion with short sellers” to “intentionally create fear in the general public to drive down DEER’s share price.”
The press release goes on to assert that all of the allegations in the supposed Alfred Little reports are false and that the company intends to seek sanctions against the law firm that filed the lawsuit.
Deer is not the first U.S.-listed Chinese company to charge that the allegations of accounting fraud originated with short sellers. U.S. shareholders in another U.S- listed Chinese company that has also been hit with a securities class action lawsuit, China Agritech, are also alleging that stories circulating about the company and that are behind the lawsuit are the result of the actions of short sellers. (Background on the China Agritech lawsuit can be found here).
A very interesting April 26, 2011 Bloomberg article entitled “Wall Street Scion Lost in China Agritech as Shorts Cry ‘Scam’”(here) contains the allegations of one U.S. investor in China Agritech that “someone blatantly lied to short the stock.” The U.S. investor, Jesse Glickenhaus, troubled by an analyst’s report that the company was a scam with no real operations, went to China himself and toured company facilities with company executives, to verify the existence of claimed business operations and facilities.
Or at least Glickenhaus thinks he toured company facilities. In yet another twist to the story, after Glickenhaus published his account of his Chinese factories tours on his own investment company’s website, other short sellers asserted that Glickenhaus had been duped, and that rather than touring the company’s factory, Gliockenhaus had been taken to a state-owned plant at a different address than the one listed in China Agritech’s filings.
With all of these levels of confusion and disinformation, it is hard to tell who is scamming whom and what version of the truth actually corresponds to reality. Are the Chinese companies scamming investors by misrepresenting their true financial condition? Or are investors being misled by short sellers who have an incentive to cast doubt on the companies and drive down the share price?
You do start to wonder why any investors would invest in U.S.-listed Chinese companies. The Bloomberg article about Glickenhaus provides some of the answers. Glickenhaus is the 29-year old grandson of his investment firm’s founder, who invested in China Agritech without even knowing that the company had obtained its U.S. listing through a reverse merger. He seemed particularly persuaded by the fact that the Carlyle Group had previously invested in the company.
Even if he was not duped during his recent China visit about China Agritech’s operations, Glickenhaus seems like a remarkably uncritical investor. He remains committed to the company and to his investment even though the company has fired two auditors in four months and still has not filed its 2010 financial data. Carlyle’s representative on the company’s board has also resigned. Glickenhaus does concede that “in the future, if I find a company in China, I’ll probably stick to those that have had a major, well-known auditor for several years.”
Whether the accounting fraud allegations have substance or are the product of short-sellers’ profit-motivated imaginations, it is clear that the existence of the allegations is continuing to drive securities class action litigation against U.S.-listed Chinese companies. In addition to the new lawsuit against Deer, plaintiffs’ lawyers have in the last week and a half also filed lawsuits against these other U.S.-listed Chinese companies: Gulf Resources (refer here); ZST Digital Networks (refer here); and SkyPeople Fruit Juice (refer here). Interestingly, the same law firm that filed the Deer lawsuit filed these three others as well.
Another U.S.-listed company with its fish farming operations in China but its headquarters in Washington State, HQ Sustainable Maritime Operations, was also hit with a securities lawsuit last week (refer here).
With the arrival of these latest lawsuits, a total of 19 new securities class action lawsuits have been filed against Chinese companies so far in 2011. That is out of a total of about 79 lawsuits this year, meaning that the China-related lawsuits represent about one-quarter of all2011 YTD class action securities lawsuits. That is on top of the ten lawsuits that were fled against Chinese companies in 2010.
Signs are that there are more lawsuits yet to come, as well. Plaintiffs’ firms have issued press releases that they are investigating other China-linked companies, including Longtop Financial (refer here) and Sino-Clean Energy (refer here). Interestingly, the press release announcing the Sino-Clean investigation was issued by the same law firm that filed the Deer lawsuit described above, and the press release also references an analyst report by Alfred Little (the same analyst whom Deer claims is fictitious).
In addition to the securities class action lawsuit describe above, investors have also filed at least one shareholder derivative recently involving a Chinese company. On April 27, 2011, plaintiffs filed a derivative lawsuit in the District of Wyoming against Duoyuan Printing, as nominal defendant, and certain of its directors and officers, alleging that the individuals breached their fiduciary duties b, among other things, issuing false and misleading statements regarding the company’s financial results. A copy of the complaint can be found here. The company itself is a Wyoming corporation with its principal place of business in China.
An April 4, 2011 speech by SEC Commissioner Luis Aguilar (here) reported that there were 150 reverse merger transactions between 2007 and the present in which Chinese companies merged with U.S.-domiciled shells to obtain a listing on a U.S. exchange. I am sure not all of these 150 companies have accounting problems (or will otherwise be targeted by short sellers). But I am guessing that before all is said and done, a lot more of them may wind up as defendants in class action lawsuits filed in U.S. courts.
In any event, it does seem like the SEC is finally getting around to doing something about all of this. On April 29, 2011, the SEC announced (here) that it had halted a Ponzi scheme involving China Voice Holding Company in which company officials were using proceeds from later offerings to pay off those who invested in earlier offerings.
It's All There in Black and White: The illustration at the outset of this post of course depicts the characters from the classic Spy v. Spy comic that first appeared in Mad Magazine. For those so culturally deprived as to be unfamiliar with the comic, the basic premise was that the two spies were identical, except that one was dressed in while and one was dressed in black, and they were endlessly trying to take each other out. The comic incorporated all of the requisite cartoon elements – bombs, blond bombshells, missiles, anvils, rocket ships, trapdoors, dynamite, electrified door knobs and so on. Here’s a short video clip capturing a classic moment from the comic:
For several years, Friday has been the day when the latest bank closures are announced (about which see further below). More recently, Friday also seems to be the day when the latest securities class actions involving Chinese companies are announced. This past Friday alone, three more securities suits involving Chinese companies were announced. Signs are that there are more to come. A brief description of the three latest cases follows.
Puda Coal: The first of the three latest Chinese suits involves Puda Coal, Inc., an NYSE company that is a Delaware corporation but which has its headquarters in Shanxi Province in China. There have actually been two separate lawsuits filed against Puda, one in the Southern District of New York (refer to the complaint here), and one in the Central District of California (here).
As reflected in plaintiffs’ counsel’s press release (here), the allegation is that Puda’s assets were transferred to a subsidiary of which Puda’s Chairman of the Board obtained control through a series of transactions, enabling the Chairman to profit personally from the sale of a minority interest in the subsidiary to a private equity firm. Following an internet website’s disclosures of the transactions, the company’s share price declined. In an April 11, 2011 press release (here), the company announced that its board had adopted the recommendation of the company’s audit committee to investigate the Chairman’s “unauthorized” transactions involving the subsidiary.
Subaye, Inc.: According to their April 15, 2011 press release (here), plaintiffs’ lawyers have initiated a securities class action lawsuit in the Southern District of New York against Subaye, Inc. and certain of its directors and officers. Subaye is a Delaware Corporation with its headquarters in Guangdong, China.
According to the press release, the complaint (which can be found here) was filed in the wake of the company’s April 7, 2011 announcement that its auditor PricewaterhouseCoopers Hong Kong had withdrawn and that prior to its resignation the audit firm had identified matters that might affect the fairness of the company’s previously issued financial statements. The press release states that
PwC’s was unable to obtain information and supporting documentation to verify: (a) cash settlements from sales agents to Subaye, (b) the end customer subscriptions for the Company’s services and the services rendered to the end customers, (c) marketing and promotion activities performed by sales agents in return for fees paid to such agents and recorded as expenses of the Company. PwC also stated that Subaye provided insufficient explanations regarding commonalities between certain customers and vendors. Lastly, PwC could find no evidence of any business tax payments by the Company for services rendered in China.
Universal Travel Group: According to their April 15, 2011 press release (here), plaintiffs’ lawyers have filed a securities class action lawsuit in the District of New Jersey against Universal Travel Group and certain of its directors and officers. Universal Travel is a Nevada corporation based in Shenzen, China.
The Universal Travel group lawsuit follows a March 2011 securities analyst’s report raising questions about the company’s business, its reported cash balances and revenues, and its relationship with an online travel service. The report stated that there were large differences between the revenues that a newly acquired subsidiary had reported to Chinese authorities and the revenues that Universal Travel reported.
In an April 14, 2011 press release (here), the Company announced that it had hired a new auditor after its prior auditor resigned because “it was no longer able to complete the audit process” due to “the Company’s management and/or the Audit Committee being non-responsive, unwilling or reluctant to proceed in good faith and imposing scope limitations on [the auditor’s] audit procedures.”
These three new securities class action lawsuits follow closely on the heels of the four accounting-related lawsuits involving Chinese companies filed earlier this month, as I noted in a prior blog post (here). With these three latest lawsuits, there have now been a total of 14 securities class action lawsuits filed against Chinese and China-liked companies in 2011, out of a total of about 61 securities lawsuits that have filed so far this year, meaning that the suits against Chinese companies represent about 23% of all securities lawsuits filed so far this year. Ten of these have been filed just in the last 30 days.
The signs are that this recent outburst of new lawsuit filings involving Chinese companies will likely continue. Plaintiffs’ law firms continue to publish press releases that they are “investigating” still other Chinese companies (refer for example, here and here) For that matter, the cascade of news raising questions about accounting practices involving some Chinese companies shows no signs of abating.
As Walter Pavlo notes on his White-Collar Crime blog on Forbes.com (here), many of the Chinese companies involved in this rash of lawsuits obtained their U.S. listings through reverse mergers with a publicly traded U.S. shell company. In a later post (here), he also noted that many of these firms have the same auditors and used the same investment bank in their reverse merger transaction.
In an April 4, 2011 speech (here), SEC Commissioner Luis Aguilar noted that the problems arising involving Chinese companies that have obtained U.S. listing are a serious concern and that the SEC in cooperation with other organizations including the PCAOB is investigating the concerns that have arisen. Among other things, he noted that “a growing number” of these companies “are proving to have significant accounting deficiencies or being vessels of outright fraud.”
According to Commission Aguilar, since January 2007 over 150 Chinese companies have obtained U.S. listings using what he characterized as “backdoor registrations.” While not all of these companies are engaged in the kinds of activities described in the case summaries above, there definitely seems to be a pattern of involvement in conflicts of interest or accounting issues. The rash of recent resignations of the outside auditors from these companies suggests that the audit firms have had their consciences raised about the dangers of becoming associated with these kinds of firms and accounting issues they may be having.
In any event, it seems likely that there will be further lawsuits involving these Chinese companies. David Bario’s April 4, 2011 Am Law Litigation Daily article profiling the plaintiffs’ lawyer behind many of these lawsuits can be found here.
Bank Failures Not Over Yet: Speaking of bank failures (as I was at the outset of this post), it now appears that my recent prediction that the bank failure wave may finally be over might have been premature. This past Friday night, the FDIC closed six more banks, bringing the year to date total number of bank closures to 34. While that is fewer than the 49 banks that had been closed at this point last year, the closure of six banks at one time does cut against the suggestion that the FDIC is winding down its bank closure activities.
With the addition of the latest six bank closures, the total number of banks that have failed since January 1, 2008 stands at 356. Of this total, 51 involve banks located in Georgia (including two of the six banks closed this past Friday night). After a while you do start to wonder if there how there could be any banks left in Georgia.
As I have noted elsewhere, the FDIC has still only brought a total of six lawsuits involving former directors and officers of the bank. However, on April 13, 2011, the FDIC did update the Professional Liability Lawsuits page on its website, to indicate the number of persons against who lawsuits have been authorized has been increased by 187 (up from the prior month’s total of 158). However, the six lawsuits filed to date involved only 42 individual defendants, which suggests that there are quite a number of lawsuit in the pipeline and yet to be filed. The updated page also notes that the FDIC has also authorized “11 fidelity bond, attorney malpractice, and appraiser malpractice lawsuits.”
Special thanks to the loyal readers who alerted me to the most recent bank closures and to the recent update to the FDIC website.
105 Years Ago Today: A rare 35 mm film of San Francisco just four days before the April 18, 1906 earthquake has been “found.” The person that send me a YouTube link to the file reports that “This film was originally thought to be from 1905 until David Kiehn with the Niles Essanay Silent Film Museum figured out exactly when it was shot --from New York trade papers announcing the film showing, to the wet streets from recent heavy rainfall & shadows indicating time of year & actual weather and conditions on historical record, even when the cars were registered (he even knows who owned them and when the plates were issued!).”
The film, which was shot by mounting a camera on the front end of a cable car, is simply amazing. The clock tower at the end of Market Street at the Embarcadero wharf is still there. The number of automobiles on the road in 1906 is staggering. The absolute chaotic traffic suggests that rules of the road were a later invention.
There is an element of sadness too in the film, as so much of the city was destroyed days later and as many as 3000 people died in the quake and in the fire that followed. The film is a remarkable piece of history. Special thanks to the loyal reader who sent me the link.
According to their December 2, 2010 press release (here), plaintiffs’ lawyers have filed a securities class action lawsuit against China Education Alliance, Inc. and certain of its directors and officers. The complaint, which was filed in the Central District of California, can be found here.
According to the complaint, the company provides educational resources and training through its Internet websites and training facilities in China. The complaint seeks to hold the defendants liable for misrepresenting the company’s financial performance. According to the press release, the complaint alleges that
contrary to the Company’s annual reports filed with the SEC for fiscal 2008, which reported $24.9 million of revenue, an annual report for the Company’s main operating subsidiary filed with the Chinese authorities reported less than a million of revenue for 2008. This discrepancy, along with other accounting inconsistencies, and contradictions about the Company’s online education and training center operating segments, has raised red flags of fraud. When this adverse information was released to the market on November 29, 2010 the price of China Education Alliance stock fell substantially damaging investors.
In my prior post discussing the recent outbreak of securities suits targeting Chinese companies, I noted that a recurring theme in the suits is the allegation that the companies had reported different financial information to Chinese authorities than they reported in their SEC filings. The new complaint against China Education Authority echoes this recurring allegation.
The complaint also cites sources reporting that the company’s Internet sites are not functional and its training centers appear to be inactive, suggesting that the company may not even be an operating business as claimed in its U.S. public filings. (These allegations, which make for rather interesting reading, are detailed in paragraph 37 of the complaint.)
In any event, the plaintiffs’ firm that filed the suit against China Education Alliance apparently has concluded that suing Chinese companies is a growth business. In addition to the new suit against China Education Alliance, the same firm also filed a separate lawsuit in the Southern District of New York last week against Mecox Lane Limited, a Chinese company that just completed its U.S. debut in an IPO on Nasdaq in October 2010.
According to the plaintiffs’ firm’s December 4, 2010 press release (here), the online apparel company’s share price declined significantly on November 29, 2010 when the company disclosed that "contrary to the company’s registration statement filed with the SEC, the company’s gross margins had been adversely impacted by increased costs and expenses, which made it impossible for Mecox to achieve the results defendants projected at the time of the IPO."
The extent to which the plaintiffs’ firm that filed these suits perceived an opportunity in suing Chinese companies is underscored in firm’s press release about the new Mecox Lane lawsuit. Among other things the press release cites about the firm, it also states that the firm "has substantial experience litigating matters involving companies based in the People’s Republic of China."
In any event, of the roughly 162 new securities class action lawsuits filed so far this year, nine of them (or about 5.5%) have involved Chinese companies. Seven of these nine have been filed just since September 17, 2010.
Ten of the 162 YTD 2010 securities suits (or about 6%) have involved for-profit education companies. All of those suits have been filed since mid-August.
The plaintiffs’ firm that filed these suits may well be on to something, as all signs suggest that problems involving Chinese companies may continue to emerge. According to a December 3, 2010 Audit Integrity memo (here, registration required), "many U.S.-listed Chinese companies have little to no intrinsic value."
The Audit Integrity memo adds that "many of these companies have relied on the ‘China’ brand in order to go public," but "the vast majority of these companies are thinly capitalized and are in lines of business that are neither unique nor innovative." Many of the Chinese company stocks "may prove to be valueless" and in many cases the companies "appear to be manipulating their financial results."
Even though the U.S. Supreme Court’s June 2010 decision in the Morrison case may restrict the scope of suits that may be filed against foreign domiciled companies in certain respects, foreign companies may still be sued under U.S. securities laws in connection with securities transactions taking place in the U.S.
Since many Chinese companies have pursued U.S. listings in recent years, these companies are susceptible to securities suits in the U.S., at least as to investors who purchased their shares on U.S. exchanges. The Audit Integrity analysis suggests that many more Chinese companies could well find themselves as U.S. securities suit targets, in addition to the nine companies that have been sued so far this year.
Message From the Fringe: Our San Francisco correspondent filed this report via text message Friday evening: "There’s a wookie in the BART station."
Kevin M. LaCroix is an attorney and Executive Vice President, RT ProExec, a division of R-T Specialty, LLC. RT ProExec is an insurance intermediary focused exclusively on management liability issues. KevinMore...
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