Last summer, I noted on this blog the filing of what turned out to be a total of four separate securities class action lawsuits that were filed against Chinese internet-business firms following a crackdown on their activities by the Chinese cybersecurity regulator. I noted at the time that though these four cases involved circumstances arguably unique to China the cases nevertheless represented examples of the ways in which regulatory risk could translate into securities class action litigation risk.
Last week, two more securities suits were filed against Chinese companies – both involved in the business of providing private educational and tutoring services, a sector that during the past year has been the target of a governmental crackdown – underscoring the extent to which regulatory exposures can lead to securities litigation risk. As discussed below, these latest cases, along with the four prior cases filed last summer, also arguably demonstrate the ways in which securities litigation risk can arise out of political risk.
Both of these two companies are involved in providing educational services through classroom sessions and online learning to Chinese students. They are essentially in the business of providing extracurricular tutoring services. Both are organized under the laws of the Cayman Islands and have their principal place of business in China. Both have American Depositary Shares (ADSs) that trade on the NYSE. Until recently, providing private tutoring services to Chinese students was big business. New Oriental, for example, at its peak employed more than 50,000 teachers. New Oriental had fiscal year 2021 revenues of over $4.3 billion.
Since at least 2018, the provision of private tutoring services in China has been the subject of regulatory directives and government scrutiny, arising out of concerns over excessive fees and supposedly fraudulent claims about the qualifications of the tutors involved in providing services. In March 2021, China held its annual “Two Sessions” parliamentary meetings. Among other things, participants in the meetings proposed stricter regulations to further rein in the online education industry, with particular focus on fee scams as well as trying to reduce stress that after-school tutoring placed on students.
Following the March Sessions, a number of local governments took actions to enforce the regulatory crackdown. For example, on April 25, 2021, the City of Beijing fined four online education firms (including units of both New Oriental and TAL) for allegedly misleading customers with false advertising. Then on May 12, 2021, news reports appeared that the government crackdown would be further reaching and more drastic than previously known; among other things, the the-pending new rules would ban on-campus tutoring and impose industry wide fee-limitations. Then on July 23, 2021, China unveiled its overhaul of the education sector, banning companies that teach school curriculums from making profits, raising capital, or going public.
As a result of these developments, the price of each of the two companies’ ADSs declined significantly, in a stairstep progression as each of these various events described above unfolded. In both companies’ cases, by the time of the July 23 announcement, the price of their ADSs had decline 90% or more for their market trading highs.
On February 4, 2022, each of the two companies and certain of their directors and officers were sued in securities class action lawsuits that were filed in the Southern District of New York. The same law firm filed both complaints. Both of the complaints alleged that the defendants had violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Both complaints refer in detail to the common factual background described above.
The complaint against New Oriental purports to be filed on behalf of investors who purchased the company’s ADSs between April 24, 2018 (when the company filed its financial statements for its fiscal third quarter ended February 28, 2018) and July 22, 2021 (the day before the July 23 announcement described above).
The New Oriental complaint alleges that during the class period the defendants, in a variety of financial reports and public statements the complaint cites, misrepresented and failed to disclose adverse facts about the company’s business, operations, and prospects, including:
(a) that New Oriental’s revenue and operational growth was the result of deceptive marketing tactics and abusive business practices that flouted Chinese regulations and policies and exposed the Company to an extreme risk that more draconian measures would be imposed on the Company;
(b) that New Oriental had engaged in misleading and fraudulent advertising practices, including the provision of false and misleading discount information designed to obfuscate the true cost of the Company’s programs to its customers;
(c) that New Oriental had falsified teacher qualifications and experience in order to attract customers and increase student enrollments;
(d) the New Oriental had defied prior government warnings against linking school enrollments with the provision of private tutoring services;
(e) that, as a result of the foregoing, New Oriental was subject to an extreme undisclosed risk of adverse enforcement actions, regulatory fines and penalties, and the imposition of new rules and regulations adverse to the Company’s business and interests; and
(f) that, as a result of the foregoing, defendants’ positive statements about the Company’s business, operations, and prospects were materially misleading and lacked a reasonable factual basis.
The complaint that was filed against TAL purports to be filed against a class of investors who purchased the companies ADSs during the period April 26, 2018 (that date the company filed its financial statements for the period fourth quarter and fiscal year ended February 28, 2018) and July 22, 2021 (the day before the government’s July 23 announcement described above).
The complaint cites a variety of statements the company and the defendants made in financial reports and various public announcements. The complaint alleges that in these reports and statements, the defendants misrepresented and failed to disclose the adverse facts about TAL’s business, operations, and prospects, including:
(a) that TAL’s revenue and operational growth was the result of deceptive marketing tactics and illicit business practices that flouted Chinese laws, regulations and policies, and exposed the Company to an extreme risk that more draconian measures would be imposed on the Company;
(b) that TAL had engaged in misleading and fraudulent advertising practices, including the provision of false and misleading discount information designed to obfuscate the true cost of the Company’s programs to its customers, the creation of fake customer reviews designed to fraudulently lure new customers to TAL programs, the misrepresentation of teacher qualifications and course qualities, and the marketing of rigged promotional events;
(c) that TAL had defied Chinese policies designed to alleviate the burden imposed by tutoring services on students and their families, including by imposing hefty advances and recurring debt payments on course enrollees, by offering courses designed to give affluent students an unfair advantage, by holding courses outside of allowable tutoring hours, and by linking for-profit courses to government-mandated schooling;
(d) that, as a result of the foregoing, TAL was subject to an extreme undisclosed risk of adverse enforcement actions, regulatory fines and penalties, and the imposition of new rules and regulations adverse to the Company’s business and financial interests; and
(e) that, as a result of the foregoing, TAL’s historical growth was not sustainable or the result of legitimate business tactics as represented, and defendants’ positive statements about the Company’s business, operations, and prospects were materially false and misleading and lacked a reasonable factual basis.
Given the nature of some of the allegations asserted against the private tutoring services businesses, the industry sounds like it was a sector primed for a regulatory crackdown. Certainly, the allegations of abusive fees or misrepresentations about teacher qualifications are the kind of things that might draw regulatory action in any jurisdiction. But just as the phenomenon of private tutoring itself was the reflection of circumstances and cultural conditions that are arguably distinct to China, the nature and extent of the regulatory crackdown on the industry arguable is distinct to China as well. The Chinese regulator not only targeted deceptive or unfair business practices; the Chinese regulator in effect put the entire sector out of business, at least as far for-profit ventures.
As recent press coverage shows (for example, here), both the prior crackdown by the cybersecurity regulator that I alluded to above and the recent suppression of the for-profit educational tutoring sector arise out of larger efforts, orchestrated by Chinese Premier Xi Jinping, to “rectify” the boundaries of business and society in order (among other things) to tackle income inequality. The press reports suggest that restricting the private tutoring industry was meant to level the playing field in China’s highly competitive schools and lessen the financial burden on families.
I will leave it to others to try to sort out the moral and political judgments behind the crackdown on the tutoring sector. But the fact is that essentially with nothing more than the stroke of a pen the Chinese government has essentially banished an entire business sector. Not only did the sector employee tens of thousands of people, who now look to be out of their jobs, but the involved companies were constituted ofthe invested capital of their shareholders, all of which was essentially rendered worthless by the government’s actions.
The latest lawsuits against the two Chinese companies, at a minimum, illustrate a point that I previously made about the lawsuits that followed the Chinese cybersecurity regulator’s crackdown; that is, regulatory risk can translate into securities class action risk. But there is more to this situation than just the implications of regulatory risk; what we are really talking about here is not just regulatory risk – what is involved here is political risk.
Governments can and of course do regulate businesses. And of course regulation can be imposed in a way that it makes it difficult or even impossible for businesses to operate. But there is more going on here than just harsh regulation; the Chinese government’s actions in shutting down the private tutoring business is not merely a reflection of governmental regulation of business. It is, in my view, the draconian action of an authoritarian government that goes beyond controlling business; it is an autocratic action designed to control culture and society.
Regardless of how the government’s actions are perceived or described, the fact is that the Chinese government has the demonstrated ability and willingness to permit or prohibit entire business sectors. These facts not only have enormous implications for the businesses involved, they also have important implications for prospective investors. The fact is political risk is an inherent circumstance for any firm doing business in China. And as these new lawsuits demonstrate, political risk can translate into securities litigation risk.
In thinking about this concept of political risk as a form of securities litigation risk, one question I immediately ask myself is whether this relationship is distinct to business located in China. China clearly matters because its economy is so big. But China is far from the only autocratic state. And it is far from the only country where political risk can mean securities litigation risk. I thought about these issues this weekend, when I read in the Wall Street Journal about the plans by the Saudi state oil company, Aramco, to sell as much as a $50 billion stake in the company to investors. I am sure I am not alone in thinking that this offering, should it take place, would entail an element of political risk. I am sure readers can think of other companies and other jurisdiction where investment activities entail a certain amount of political risk.
I have emphasized these points at such length here in order to try to develop the thought that securities litigation risk can arise out of political risk. In our increasingly global economy, this proposition could be a very important concept, perhaps increasingly so – particularly, but not exclusively, in China.