One of the most noteworthy stories over the past several months has been the flurry of accounting fraud allegations involving Chinese companies that obtained listings on U.S. securities exchanges through a reverse merger with a publicly traded domestic shell company. The emergence of these allegations has certainly been one of the securities class action litigation stories so far this year (as discussed most recently here). One of the recurring questions I have been asked about these developments is whether the SEC is going to step in and take action at some point. Signs are that the SEC is now getting into the action.
As discussed in a May 9, 2011 CFO.com article entitled “SEC Cracking Down on Foreign Shell Cos.” (here), the SEC has “become increasingly proactive” with respect to reverse merger companies—and not just with respect to the Chines companies that obtained their U.S. listings through reverse mergers.
The SEC heightened interest in this topic was specifically detailed in an April 27, 2011 letter that SEC Chairman Mary Schapiro sent to the House Committee on Oversight and Government Reform. In her letter, Schapiro stated that “the SEC has moved aggressively to protect investors from the risks that may be posed by certain foreign-based companies listed on U.S. exchanges.” She added that “while the majority of foreign-based issuers are engaged in legitimate business operations, others may take advantage of the remoteness of their operations to engage in fraud.”
Schapiro’s letter notes that last summer the SEC launched a “proactive risk based inquiry” into U.S. auditing firms that have a significant client base of companies whose principal operations are located outside the U.S. She notes that since the SEC launched this inquiry, 24 China-based companies have filed reports on Form 8-K disclosing auditor resignations, accounting problems or both. Many of these disclosures have noted the accountants’ concerns with cash and accounts receivable and the accountants’ inability to confirm these amounts.
Schapiro’s letter also notes that in the last several weeks the SEC has suspended trading in the securities of three China-based companies, HELI Electronics Corp., China Changjiang Mining & New Energy Co.; and RINO International Corp. The SEC has also revoked the securities registration of eight Chinese companies that obtained U.S. listings through reverse mergers. Schapiro’s letter also details enforcement actions the agency has pursued against auditors and individuals associated with the management of Chinese-based companies.
In addition to these actions by the SEC, the trading exchanges have also halted trading in more than a dozen Chinese reverse merger companies, which apparently has been a source of some frustration to investors, according to a May 10, 2011 Wall Street Journal article (here).
According to Schapiro’s letter (citing data from the PCAOB), there were a total of 159 Chinese-based companies that engaged in reverse merger transactions between January 1, 2007 and March 31, 2011. If Schapiro’s remarks in her April 27 letter are any indication, these companies’ disclosures are likely to be the source of heightened scrutiny. Indeed, SEC officials cited in the CFO.com article make it clear that all reverse merger companies, not just those linked to China, may face this same level of scrutiny.
The number of accounting-related concerns disclosed alone suggests the need for this heightened scrutiny. Schapiro’s letter and the SEC’s recent actions suggest that the SEC is gearing up for even greater enforcement and regulatory action.
In the meantime, private litigants are pressing ahead. In the last several days, investors have filed securities class action lawsuits against two more Chinese companies in U.S. courts. The first was filed on May 6, 2011 in the Central District of California against Sino Clean Energy Inc. and certain of its directors and officers. A copy of the plaintiffs’ counsel’s May 6 press release can be found here. The second was filed on May 8, 2011 in the Southern District of New York against Fushi Copperweld and certain of its directors and officers. A copy of the complaint can be found here. Both allege accounting and financial reporting misrepresentations.
With the filings of these latest two lawsuits, there have now been a total of 21 securities class action lawsuits filed against Chinese and China-linked companies so far this year. That is out of a total of about 85 new securities class action lawsuits YTD in 2011. That is, the Chinese-related suits represent almost one quarter of all new securities class action lawsuits this year.
The SEC may be becoming increasingly proactive with respect to non-U.S. reverse merger companies, and it may even have taken some very specific concrete actions in recent weeks. But at least so far it seems that the SEC is lagging not leading the effort. That said it does appear that the SEC is focused on the issue and further action seems likelier in the future.
Long-Running Alstom Securities Class Action Suit Settles: On May 9, 2011, the parties to the long-running Alstom securities class action lawsuit pending in the Southern District of New York filed their agreement to settle the case. As noted at greater length here, the plaintiffs first filed their action in 2003. Readers of this blog may recall that in September 2010, Judge Victor Marrero entered a significant ruling in the case, in which he granted the defendants’ motion, in reliance on the Morrison v. National Australia Bank case, to dismiss from the action the claims of the Alstom shareholders who had bought their shares in the France-based company outside the United States.
According to the parties’ settlement agreement (which can be found here), the parties have agreed to settle the case for $6.95 million dollars. The agreement itself does not specify whether or not this amount is to be funded by Alstom’s insurers; however, the agreement does specify that the funds are to be paid into escrow by the company or its insurers, and the released parties include the company’s insurers.
It seems fair to say that the size of the settlement reflects the drastic reduction in the size of the class as a result of Judge Marrero’s Morrison-related ruling. The settlement seems to indicate the extent to which Morrison may operate to reduce the magnitude of securities class action lawsuits filed against non-U.S. companies, even those whose shares or ADRs trade on U.S. exchanges. At least where only a small portion of the company’s shares trade in the U.S., the size of the lawsuit class will be substantially narrowed and the potential damages and settlement exposure may be substantially reduced.
Twelve Steps to Good Corporate Governance: In light of the changes wrought by the Dodd-Frank Act and other developments, the corporate governance landscape has been transformed. Many companies are struggling to come to grips with the requirements of the new environment. In recognition of the changing governance environment, the Latham & Watkins law firm has published an interesting memo entitled “12 Steps to Truly Good Corporate Governance” (here). This memo is readable and worth reading. It contains a number of valuable insights and useful suggestions for companies to come to grips with the demands and requirements of the new era of shareholder empowerment.