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.
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.
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).