Long-time readers of this blog will recall that in 2011, there was a rash of U.S. securities class action lawsuits filed against U.S.-listed Chinese companies. Many of these companies had obtained their U.S.-listings by way of a reverse merger with a U.S.-listed public shell. The 39 securities suits filed in 2011 against U.S.-listed Chinese companies represented 18% of all securities class action lawsuits filed in the U.S. that year. While the number of lawsuit filed against Chinese reverse-merger companies has abated since the peak in 2011, U.S. securities lawsuits continue to be filed against Chinese companies at a significant rate.
According to an October 27, 2015 article from Meg Utterback and Melissa Anderson of the King & Wood Mallesons law firm entitled “Rise in Securities Class Actions Against US-Listed Chinese Companies” (here), “the last two years have witnessed a significant upswing in the number of securities class action lawsuits levelled against Chinese firms listed on US markets.” As discussed below, the article discusses the characteristics that make certain Chinese companies more susceptible to securities suits, as well as the steps that companies can take to try to avoid litigation. (A slightly longer and more detailed version of the article can be found here.)
At the memo’s authors note, this recent upswing in the number of suits filed against Chinese companies is part of a larger trend in which foreign domiciled U.S.-listed companies with disproportionately greater frequency than their representing among U.S.-listed companies would suggest. My own statistics confirm this; of the 157 securities class action lawsuits filed year to date in 2015, 30 suits, or about 19.1%, have been filed against foreign companies, though foreign companies represent only about 16% of U.S. listed companies. Of these 30 suits against foreign companies so far in 2015, 14 have been against Chinese companies, with one more filed against a Hong Kong company.
According to the authors’ memo, Chinese companies have sought U.S. listings in order to “take advantage of more readily available capital, less stringent listing criteria” and to achieve “the greater recognition and prestige that comes with a listing” on the U.S. exchanges. The prestige can be a particularly valuable asset for Chinese companies in dealing with domestic clients, banks, and government officials. However, with the listing comes “additional financial disclosure requirements” and “increasing levels of scrutiny and general oversight,” for which some companies are not prepared.
A frequent source of trouble for Chinese companies with U.S. listings has to do with the fact that these companies must file financial reports both in China and in the U.S. As the authors note, “inconsistencies can often arise between the two.” These discrepancies may be minor and simply represent differences in accounting protocols between the two countries. However, these discrepancies “may be a sign of fraudulent activities.” The problem is that “domestic filings may be drafted with an eye toward tax minimization” while the U.S. filings, the authors smoothly observe, “may be drafted to make investors feel good about the company.” A material difference in revenues reported “is likely to be a red flag.”
These concerns have been compounded by the rise in recent years of short-selling research firms who are “notorious” for “trawling through companies’ filings and outing companies for accounting irregularities.” If discrepancies are discovered, share price declines could follow, and possibly an SEC investigation as well.
Chinese companies that have certain features or characteristics are, according to the authors, “at a higher risk of a class action lawsuit in the US”; these characteristics include:
- “weak corporate governance,” and in particular insufficient internal controls that allow company managers to manipulate the financials or engage in other corrupt acts;
- “overstating revenue,” with respect to which the authors note that a significant percentage of all class action lawsuits filed against U.S.-listed Chinese companies involved overstated revenue;
- “frequent change of auditors or late filings,” both of which may signal “the presence of unresolved financial irregularities.”
The authors conclude by suggesting a number of steps Chinese companies can take to try to reduce their risk of securities class action litigation including: establishing a robust system of corporate governance; educating Chinese directors about their fiduciary duties and the U.S. legal regime; encouraging positive auditing practices; avoiding overly optimistic forecasts; and establishing a crisis management team.
From my perspective, it is important to note that after the ramp up of significant litigation activity against U.S.-listed Chinese companies in 2011, the number of filings against Chinese companies declined in 2012 and again in 2013. After the 39 securities lawsuit filed against U.S.-listed Chinese companies in 2011, there were only 17 in 2012 (counting Hong Kong companies), representing 10 percent of all filings overall and 53% of all filings against foreign companies. In 2013, there were only seven U.S. securities suit filings against Chinese companies, representing only about 4% of all securities suits overall, representing about 26% of all suits that year against foreign companies. But after dropping to only seven Chinese companies sued in 2013, the number of filings against U.S.-listed Chinese companies in 2014 increased to ten, and in 2015 so far there have been 15 Chinese companies sued YTD (including the lawsuit against a Hong Kong company).
Accordingly, I concur with the authors that the numbers of lawsuits against Chinese companies rebounded in 2014 and again so far in 2015, compared to 2013, though not all the way to the levels seen in 2011 or even 2012. The recent uptick is sufficient to suggest the need to raise concern among Chinese company officials, so that they understand that the risk of securities class litigation in the U.S. was not just a one time anomaly confined to the 2011-12 time frame. Indeed, given the uptick in lawsuits against Chinese companies, the officials at these companies would be well advised to consider the loss management suggestions in the authors’ memo, as well as other guidance from their outside U.S. legal counsel.
The uptick in litigation against the Chinese companies is noteworthy for D&O insurance underwriters as well. The underwriters, like the company officials, should not be under any illusion that the securities litigation risk for Chinese companies was basically a historical artifact confined to a narrow period in the past. To be sure, as a result of the surge of litigation during the 2011-12 time frame, underwriters are appropriately cautious when it comes to U.S.-listed Chinese companies. However, the recent uptick in litigation against Chinese companies underscores the fact continued vigilance may be advisable.