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

In a January 22, 2013 opinion (here), Southern District of New York Judge J. Paul Oetken has dismissed one of the many securities class action lawsuits that were filed against U.S.-listed Chinese companies in 2011. Though the primary interest in the case may be that it involves U.S. securities suit against a Chinese company, Jinkosolar Holdings, the case is also interesting with respect to the alleged misrepresentations on which the suit is based, which relate to the environmental problems in one of the company’s manufacturing facilities.

Jinkosolar is a manufacturer of solar technology products with operations based in China. In May 2010, the company conducted an Initial Public Offering of American Depositary Shares on the New York Stock Exchange. In November 2010, the company completed a secondary offering.

In April and May 2011, the company had a series of communications with the Chinese environmental authorities regarding hazardous waste disposal issues at its Zhenjian plant. The company did not disclose these communications to its shareholders. However, as the Court later put it, a “kerfuffle” at the company’s plant “forced Jinkosolar’s hand.” In August and September 2011, Residents living near the plant became concerned about a large scale fish-kill near the plant. In mid-September, the media began reporting on locals’ demonstrations outside the company’s plants. In two press releases in late September, the company announced that it had suspended operations at the plant and also revealed the earlier communications with the environmental authorities. As the news came out, the price of the company’s ADSs declined 41%

In October 2011, holders of the company’s ADSs filed a securities class action lawsuit in the Southern District of New York against the company, eight directors and officers of the company; and the company’s offering underwriters. The plaintiffs’ complain asserted claims under both the ’33 Act and the ’33 Act. In support of their allegations, the plaintiffs relied on three statements in the company’s offering prospectus in which the company explained its environmental compliance efforts and the consequences to the company if it were found to be in violation of the applicable environmental requirements. The defendants moved to dismiss.

In his January 21, 2013 order, Judge Oetken granted the defendants’ motions to dismiss. Judge Oetken found with respect to two of the three statements from the prospectus on which the plaintiffs sought to rely that he could “easily dispense” with the allegations. He noted with respect to these two statements that:

These paragraphs do, of course, explain to shareholders that Jinkosolar is obliged to follow certain regulations. But if anything, they weigh the pluses and minuses of following such regulations with a disquieting frankness. The first paragraph, for instance, explicitly balances the costs of “compliance” with safety regulations with the “adverse publicity and potentially significant monetary damages” stemming from “non-compliance.” Similarly, the second paragraph notes that Jinkosolar is “subject” to Chinese regulations, but – particularly when read alongside the first paragraph – does nothing to indicate any sort of commitment on the part of Jinkosolar to follow those regulations.

The third Prospectus statement on which the plaintiffs sought to rely presented, Judge Oetken found, “a more complicated matter.” The statement indicates, among other things, that the “we generate and discharge chemical waste, waste water, gaseous waste, and other industrial waste,” reiterates the company’s monitoring efforts and adds that “we are required to comply with all PRC national and local environmental protection laws and regulation.”

With respect to these statements, the plaintiffs argued that these statements “falsely imply that Jinkosolar had an effective pollution treatment system and a good pollution record, suggesting that the company had put the environmental issues “in play” and creating an obligation to keep shareholders updated.

Judge Oetken said that was “a close call” whether the statements on which the plaintiff’s sought to rely are materially misleading. In particular one sentence “does give the court pause”: the sentence stated that “We also maintain environmental teams at each of our manufacturing facilities to monitor waste treatment and ensure that our waste emissions comply with PRC environmental standards.” Judge Oetkin said that one way the sentence could be read is to signify that the company is able to “ensure that our waste emissions comply with PR environmental standards. “ But read another way, the statement is merely saying that the environmental teams are “maintained” with the purpose or function to “monitor and to ensure” compliance.

The Court found that the second of these two alternative readings is “the more sensible one.” The Court went on to say that it “cannot say that a reasonable investor would, or even could, read this one ambiguous sentence as a pronouncement that Jinkosolar is ‘ensuring’ environmental standards were met.” This, the court said, is “all the more true given how cautious Jinkosolar was in it Prospectus.” The company “carefully laid out the plusses and minuses” of abiding by the Chinese regulations and “underscored to investors that fines due to pollution are a real possibility.” These warnings, “taken together with the overall weakness of the instances f material misstatements and omissions proffered by Plaintiffs, indicate that no reasonable investor coul d have believed that the Prospectuses ensured a positive environmental record.”

In granting the defendants’ motions to dismiss, Judge Oetken did not expressly indicated whether or not the dismissal was with prejudice. However, in his final line of his opinion, he did direct to Clerk to “close this case.”

Discussion

For many readers, the primary interest of this case will be that it involves a U.S.-listed Chinese company. However, unlike many of the U.S.-listed Chinese companies that have been hit with securities class action lawsuits in recent years, this company did not obtain its listing by way of a reverse merger transaction. This company completed a full-blown IPO, which may have made a difference in the outcome of this case.

It was only as a result of the company’s IPO that the company completed a full and detailed Prospectus. (The company also completed a full Prospectus in connection with its secondary offering.) The Prospectus contained extensive and detailed precautionary statements. It was the detail and extent of these statements that seemed to have made a difference to Judge Oetken. Thus, in his opinion, Judge Oetkin refers to what he calls the “disquieting frankness” of the company’s disclosures regarding its environmental compliance risks.” He also noted “how cautious” the company was in its environmental compliance risk factors in its Prospectuses.

Because of the depth of the disclosures in its offering documents, Jinkosolar was able to make arguments and raise defenses in reliance on the detailed Prospectus disclosures. Because so many of the U.S.-listed Chinese companies did not complete a full-blown IPO, but rather obtained their U.S. listings through reverse merger transactions, they likely did not create offering documents with similarly precautionary disclosure. For that reason, the outcome of this dismissal motion ruling may not be all that helpful to many of the other U.S.-listed Chinese companies involved in U.S. securities suits. Indeed, most of those other companies are unlikely to be able to raise the kinds of arguments that Jinkosolar raised here, and certainly seem unlikely to be able to cite disclosure statements that a court might describe as reflecting “disquieting frankness.”

For me, the most interesting thing about this case is not that it involves a Chinese company defendant, but rather that it involves alleged misrepresentations with respect to environmental liabilities and exposures. As I have previously noted on this blog (refer, for example, here), these kinds of cases, involving alleged misrepresentation of environmental issues do arise periodically. The possibility of this kind of claim is often a key concern at the time of D&O insurance policy placement, as the question often arises whether the standard policy’s pollution exclusion will preclude coverage for a securities claim based on environmentally-related disclosures.

As this case demonstrates, it is critically important for the standard pollution exclusion to be revised to carve back coverage for securities claims and derivative claims based on environmental disclosures. (It is worth noting that many of the modern Excess Side A DIC insurance policies often have no environmental or pollution exclusion. In addition, some carrier’s primary D&O insurance forms omit the standard pollution exclusion and simply provide that the policy’s definition of “Loss” does not include costs of environmental remediation. Unless the insured company’s primary D&O insurance policy omits the environmental exclusion in this way, it will be indispensable for the standard environmental liability exclusion be revised in order to preserve coverage for securities claims and derivative claims based on alleged misrepresentations or misconduct relating to environmental issues. These considerations are likely to become increasingly important as environmental disclosure issues become of greater regulatory concern (about which refer here).

The one final thing I will say about this case and the fact that it does involve a U.S.-listed Chinese company is that it is yet another case involving a Chinese company in which the plaintiffs have struggled. Although some of the U.S. securities suits have managed to survive motions to dismiss, others (like this one) have not. Even the cases that have survived motions to dismiss have proved challenging for plaintiffs as they have faced numerous procedural hurdles (refer for example here). In addition, in other cases involving U.S.-listed Chinese companies that have reached the settlement stage, the settlement amounts have proved to be modest. (On the other hand, as noted here, E&Y did recently agree to settle a Canadian securities case relating to Sino-Forest, and a Hong Kong arbitration panel did just make a more than $70 million award based on its determination that China MediaExpress Holdings is a “fraudulent enterprise.” Notably, and arguably ironically, neither of these big recoveries involved one the many U.S. court securities suits filed against Chinese companies.)

Special thanks to a loyal reader for sending me a copy of Judge Oetken’s opinion in this case.  

Upcoming Event: Readers of this blog may be interested to know about a seminar that will be held at the St. John's School of Risk Management in New York on February 5, 2013 entitled "A Day at Lloyd's: An Introduction to the Lloyd's Market Structure and the Use of ADR to Manage Disputes Involving Lloyd's."  The event will be moderated by my good friend Perry Granof and includes a number of distinguished speakers, among them another good friend, Nilam Sharma of the Ince & Co. law firm. The event, which will take place on the day prior to the beginning of the PLUS D&O Symposium, runs from 12:30 to 5:00 pm. Further information about the event can be found here. You can register for the event here.

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In what is as far as I know the first determination of liability in connection with the recent wave of litigation filed against U.S. listed Chinese companies, a Hong Kong-based arbitration panel has entered an award in favor of an investment unit of C.V. Starr of over $77 million against China MediaExpress Holdings and related persons and entities, based on the panel’s determination that the company was a “fraudulent enterprise.” The panel’s December 19, 2012 award, which can be found here, makes for fascinating reading. (Hat tip to Jan Wolfe, who reported the award and related U.S.-court filings in a January 16, 2013 Am Law Litigation Daily article, here.)

In October 2010, China MediaExpress obtained a U.S. listing through a reverse merger with a U.S. listed publicly traded shell corporation. Prior to the reverse merger, the predecessor entity was owned by Zeng Cheng (“Cheng”) and Ou Wen Lin and Lin’s brother. China MediaExpress allegedly was in the business of providing advertising on inter-city busses. The company’s financial statements showed growing profits and large cash reserves. Starr invested a total of $53.4 million in China MediaExpress in two private transactions in January 2010 and October 2010. 

In early 2011, online analysts published reports questioning China MediaExpress’s financial statements. Shortly thereafter, China MediaExpress’s auditor and CFO resigned, as well as members of its board of directors. (Refer here for background.) Trading in China MediaExpress’s shares was halted. Pursuant to provisions in its stock purchase agreements with China MediaExpress, Starr initiated two Hong Kong arbitration proceedings against China MediaExpress, as well as Cheng, the Lin brothers and related entities. Separately, Starr initiated a securities fraud class action against China MediaExpress, its principals and related entities, and the company’s auditor in the District Court of Delaware. (In addition, certain other shareholders separately filed a securities class action lawsuit against China Media Express in the Southern District of New York, about which refer here.)

The arbitration panel, which was chaired by former Delaware Supreme Court Justice Andrew Moore II, heard evidence in the two consolidated arbitrations in May 2012. On December 19, 2012, the panel delivered its Award.  A copy of the arbitration award was filed in the District of Delaware lawsuit on January 13, 2013 (refer here).

The 49-page award makes for some fascinating reading. Among other things, the panel concluded that the company was “a fraudulent enterprise that caused Starr to lose the total value of its investment.” Cheng, the panel concluded, has “no credibility whatsoever”. Ou Wen gave the impression on the witness stand that “he would say whatever he thought would advance his case.” 

Among many things that troubled the panel was what had happened to the supposedly thriving business that had been represented to Starr. The company attempted to argue that the business had been destroyed by short sellers, a contention the panel described as “ridiculous,” observing that:

To put it bluntly, this claim of Cheng and CME that short sellers destroyed his business is nonsense. It is a fabrication evidently designed to hide the fact that CME never had the business it represented to the world that it had or that, if it did, it has been ravished by dishonest conduct on the part of those who conducted the business. Coupled with the conduct when challenged with the matters raised by [the company’s auditors] and other matters, Cheng’s claim that the short sellers destroyed his business indicates that Starr was correct with it contended that CME was a fraudulent enterprise.

The one specific transaction Cheng offered to explain what happened to all of the cash that the company had reported on its balance sheet was “a land transaction at Shoushan Waterfall.” However, the “evidence concerning this transaction was so implausible and contradictory that it is impossible to accept his claim that any money invested in that transaction was for the benefit of CME and its shareholders even if money of CME was used to finance this transaction.” Overall, the evidence Cheng offered regarding this transaction (which had not been approved by the Board or reported to shareholders and involved a company in which Cheng had an ownership interest) established that Cheng was “in breach of his fiduciary duty.” The evidence concerning the transaction “simply reinforces the conclusion that Cheng was both an unreliable witness and a dishonest businessman.”

As Jonathan Weil said in his January 11, 2013 Bloomberg column about the latest accounting scandal involving a Chinese company, “Chinese stocks may not make for trustworthy investments, but they sure can be entertaining to watch from a distance.”

The arbitration panel’s award represents a devastating judgment against China MediaExpress and its key officials. It remains to be seen how Starr will be able to use this judgment in its separate U.S. securities fraud suit and whether it will be able to collect on the Hong Kong panel’s award. It will also be interesting to see what the claimants in the separate securities class action lawsuit will be able to make of the arbitration award. On the one hand, the panel’s brutally worded conclusions about the company and its principals are damning. On the other hand, the issue preclusive effect of these determinations in separate proceedings involving separate parties and separate evidentiary standards is the kind of thing good lawyers could argue about for a long time.

In any event, whatever the ultimate effect of the arbitration’s panel’s determinations may prove to be, the fact is that, according a statement by Starr’s lawyer quoted in the Am Law Litigation Daily article linked above, the panel’s ruling represents the “first time any of these issues concerning Chinese reverse mergers have been adjudicated.” The implication for other companies involved in these cases – many of which involve allegations even more sensational than were raised here – is ominous.

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On August 24, 2012, in a decision involving a U.S.-listed Chinese company that is of particular interest because of the significance the court attached to the discrepancies between financial figures the defendant company reported to the Chinese government and the figures it reported to the SEC, Southern District of New York Judge George Daniels denied in part the motions to dismiss of the company and two of its senior officials. He did grant the dismissal motions of the company’s outside auditor and principal outside investor, as well as the control person allegations against the company’s directors. A copy of Judge Daniels opinion can be found here.

Background

Duoyuan Global Water (DGW) listed its American Depositary Shares on the NYSE through a June 24, 2009 IPO. In its initial reports following the IPO, DGW reported positive financial results. The first indication of trouble arose when accounting concerns surfaced concerning a separate but affiliated company Duoyuan Printing (which is itself now the subject of a separate securities suit, refer here). Because of the close relationship between the companies (they operate in the same location, and have the same Chairman, among other things), questions arose about DGW. In September 2010, the board’s audit committee retained Skadden Arps to review DGW’s accounting.

In April 2011, an online report critical of DGW appeared on the Muddy Waters research analysis website. Among other things, the report accused DGW of replacing the 2009 report to the Chinese State Administration for Industry and Commerce (SAIC) with a forged version to cover up the fact that revenues had been “astronomically inflated.” That same day the company’s CFO resigned. Shortly thereafter, four members of the board resigned to protest the lack of access that Skadden was being given to company documents. Skadden withdrew its representation as well. As detailed here, securities litigation ensured.

The plaintiffs based their allegations that the company’s IPO documents and subsequent filings contained financial misrepresentations were based largely on discrepancies between financial figures that two of DGW’s subsidiaries had reported in China to the SAIC and figures the company reported in its SEC filings. The plaintiffs also alleged other misrepresentations, including alleged misstatements concerning the number DGW’s distributors and the number of its employees. The plaintiffs asserted claims under both Section 11 of the ’33 Act and Section 10(b) of the ’34 Act. The defendants moved to dismiss.

The August 24 Opinion

In his August 24 opinion, Judge Daniels granted the plaintiffs’ motions to dismiss as to a number of the alleged misrepresentations on which the plaintiffs sought to rely, including the allegations concerning the number of distributors and the number of employees. He denied the motions of the company and its CEO and CFO to dismiss with respect to plaintiffs’ claims of financial misrepresentation based on the discrepancies between the company’s reports to the SAIC and its reports to the SEC.

The defendants had argued that the discrepancy in figures did not mean that the SEC reports were false or misleading, particularly given that the SAIC reports were separately filed by each of two of DGW’s Chinese subsidiaries and the SEC reports were consolidated, and given the difference s between accounting conventions involved in the different reporting protocols.

Judge Daniels found that:

Although Plaintiffs have not proven that the filings were in fact false, the extreme discrepancies alleged in the financial reports, coupled with the logical inference that can be made regarding these figures, at this stage of the proceedings, sufficiently alleges that the statements made in the SEC filings are false. Defendants merely maintaining that the discrepancies are explainable is an insufficient reason to discredit the [amended complaint]. Assuming that that the SAIC filings are true, the CAC states sufficiently that the SEC filings are false. Based on the fact that DGW had more negative disclosures in China and positive disclosures with the SEC, the reasonable conclusion is that there is a fraudulent motive to overstate the numbers yet no fraudulent motive to understate them.

In concluding that the plaintiffs’ allegations in this respect were sufficient not only for purposes of their Section 11 claims but also with regard to their Section 10(b) claims, Judge Daniels further concluded that the plaintiffs had satisfactorily alleged scienter.

In reaching this conclusion, he noted that the company’s CEO and CFO respectively “knew or should have known that the U.S. reported revenues, operating income and net income were much greater than those in the SAIC filings.” In response to the defense objection that the plaintiffs’ have not alleged that the CEO and CFO even had access to the SAIC reports that DGW’s Chinese subsidiaries had filed, Judge Daniels noted that the two officers “were CEO and CFO of a multinational corporation, and as such, were required to be aware of the Company’s financials.”

Judge Daniels noted further that in addition to the two officials’ “executive positions and the large discrepancy between the SEC and SAIC figures,” he also relied on the Muddy Waters report as evidence of the two officials’ scienter, because statements the two provided were “in complete opposition to the alleged facts that were uncovered about DGW by Muddy Waters.” Judge Daniels did note that the Muddy Waters report, while not dispositive, may be relied on as evidence of the two officials’ scienter.

Discussion

Because so many of the suits filed against U.S.-listed Chinese companies involved allegations, like those made here against DGW, of discrepancies between figures reported to the SAIC and to the SEC, Judge Daniels’ opinion potentially could boost the plaintiffs in many of those other cases.

On the other hand, other courts have been less willing than Judge Daniels to assume that the discrepancies meant the lower figures were false. For example, as noted here, in November 2011, the court in the China Century Dragon Media securities case granted the defendants motions to dismiss in a case alleging similar discrepancies between SAIC and SEC reports. The court in that case did allow the plaintiffs leave to amend, in part to provide further explanation what the discrepancies meant the SEC filings were false. The court said that though the SAIC 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.”

Other courts may be more reluctant that Judge Daniels to conclude, based on individual corporate officers’ positions alone, that the officers were aware of the figures reported in China. Judge Daniels seemed particularly willing to make this assumption, even though the figures were filed by separate Chinese subsidiaries. These assumption would be much more convincing if accompanied by allegations concerning the purpose and significance of SAIC reports, in order to show that they were, for example of equal importance as the SEC reports or otherwise so significant that the two officials would have had to have known of their content.

It is also worth noting that it is entirely plausible that, contrary to Judge Daniels assumption, that there might be good reasons to falsify the SAIC reports. Although not many defendants would want to make this argument, it is possible that the SAIC reports were falsified for reasons having to do with the purposes of the SAIC reports – for example if they determine taxes due.

Perhaps the most interesting aspect of Judge Daniels opinion is his willingness to rely on the Muddy Waters research report as support for his conclusion that the plaintiffs has sufficiently pled scienter. Many of the other securities suits involving U.S. listed Chinese companies also rely on reports of online research analysts like Muddy Waters – indeed, some of the complaints in these cases consist of little more that a recapitulation of the analysts’ reports. The plaintiffs in those other cases will certainly take heart from Judge Daniels’ reliance on the Muddy Waters report in this way.

I must confess that I find Judge Daniels reliance on the Muddy Waters report in this regard troublesome. It is well-known that many of the online research analysts also maintained short positions on the shares of the companies they were analyzing and therefore were financially motivated to drive down the company’s share price. There are certainly plausible inferences that might be drawn about motivations of the analysts, but I am uncomfortable with the notion that content from one of these financially motivated third-party online analysts can serve as a basis to establish the state of mind of officials inside the company.

In any event, however, and even though a number of the plaintiffs’ claims and a number of the defendants have been dismissed, the plaintiffs’ case against the company and its two senior executives will be going forward. How the plaintiffs will fare remains to be seen, as they, like other plaintiffs in this case will have to overcome procedural hurdles (refer for example here). As I have previously noted, in other cases involving U.S.-listed Chinese companies that have reached the settlement stage, the settlement amounts have proved to be modest. It remains to be seen if these plaintiffs will be an exception to this pattern.

Special thanks to a loyal reader for providing me with a copy of the August 24, 2012 opinion.

Delaware Supreme Court Affirms Massive Judgment, Attorneys’ Fees in Southern Peru Case: On August 27, 2012, the Delaware Supreme Court affirmed the more that $2 billion judgment and more than $300 million attorneys’ fee awarded in the Southern Peru case. A copy of the Supreme Court’s opinion can be found here (Hat Tip: Delaware Corporate and Commercial Litigation Blog).

As discussed here, the lawsuit relates to Southern Peru’s April 2005 acquisition of Minerva México, a Mexican mining company, from Groupo México, Southern Peru’s controlling shareholder. In October 2011, Chancellor Leo Strine concluded that as a result of a “manifestly unfair transaction,” Southern Peru overpaid for Minerva Mexico. A copy of Chancellor Strine’s 106-page opinion can be found here. Chancellor Strine later adjusted the award applying prejudgment interest and awarded attorneys’ fees. Groupo Mexico appealed.

There are a number of very good write-ups about the Delaware Supreme Court’s opinion affirming the lower court ruling, particularly Alison Frankel’s August 27, 2012 post on here On the Case blog (here) and David Bario’s August 27, 2012 Am Law Litigation Daily article (here).

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