Search results for: Reverse Merger

Companies that obtained their listings on U.S. exchanges by way of a reverse merger with a publicly traded shell have been the focus of a great deal of scrutiny and even litigation in recent months, particularly with regard to Chinese reverse merger companies, as discussed here.

 

Reverse merger companies are also now the focus of regulatory attention. The following guest post from Anjali C. Das (pictured to the left), a Partner in the Chicago office of Wilson Elser Moskowitz Edelman & Dicker, discusses recent regulatory actions from the SEC and the U.S. stock exchanges with respect to reverse mergers. Anjali’s practice focuses on professional liability insurance coverage. She represents the interests of domestic and foreign primary and excess insurers in connection with a variety of shareholder claims and class actions against directors and officers, financial institutions, investment banks, insurance companies, and ERISA plan fiduciarieues.

 

 

Many thanks to Anjali for her willingness to publish her article here. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Here is Anjali’s guest post.

 

 

 

            For the past year, Chinese reverse merger companies have been the target of numerous shareholder suits, government investigations, and scathing analyst reports for alleged financial and accounting fraud. In some instances, the companies are purported to be a complete sham. In response to Congressional inquiries and public outcry by investors who claim they were duped, the United States Securities and Exchange Commission ("SEC") launched an investigation last year of foreign (non-U.S. based) reverse merger companies ("RMCs") and their auditors. The SEC has since suspended or halted trading of dozens of RMCs due to untimely, incomplete, or inaccurate financial information from these companies. This past summer, the SEC issued a bulletin (here) cautioning investors of the potential pitfalls of investing in RMCs, citing instances of fraud and inadequate audits. 

 

 

            Until now, it has been relatively easy for foreign private companies to access U.S. capital markets by merging with an existing public shell company through a so-called "reverse merger." For instance, a private company located overseas in China might merge into a public shell company listed on a U.S. exchange, whereby the bulk of the company’s control and operating activities remain in China.  As some U.S. investors have discovered, this may pose logistical and other hurdles in terms of obtaining accurate information about the company’s financial and business activities.

 

 

            On November 9, 2011, in an effort to stem the tide of fraud and investor abuse, the SEC unveiled new rules (here) approved and adopted by each of the three major U.S. stock exchanges which impose more stringent listing requirements for RMCs. 

 

 

            NASDAQ’s new rules (here) prohibit an RMC from applying to list unless and until it meets each of the following requirements: (1) the company has previously traded in a U.S. over-the-counter market, on another national securities exchange, or on a foreign exchange for at least one year following the reverse merger (also known as the one-year "seasoning period"); (2) prior to listing, the company must timely file all required periodic financial reports for the prior year with the SEC, including an annual report which contains audited financial statements and information about the reverse merger transaction; and (3) the company must maintain a minimum closing share price of $4 for a "sustained period" — at least 30 of the most recent 60 trading days as of the date of the listing application as well as the date of listing.

 

 

            NASDAQ’s rules identify two exceptions from these new listing requirements for RMCs. First, an RMC that completes a firm commitment underwritten public offering at or around the time of listing with gross proceeds to the company of at least $40 million is not subject to the new listing requirements. The second exception applies to an RMC that has filed with the SEC at least four annual reports containing audited financial statements following the filing of all required information about the reverse merger transaction, in addition to fulfilling the one-year trading requirement.

 

 

            The SEC approved similar new listing requirements for the New York Stock Exchange and the NYSE Amex (here and here). In approving these new rules, the SEC expressed its belief that these enhanced listing requirements were specifically designed to curb the potential for accounting fraud and manipulation associated with RMCs by increasing the transparency of their trading history and financial statements. While it is too early to tell just how effective these new listing requirements will be in preventing future fraud on U.S. investors, the rules underscores regulators’ commitment to fighting these abuses by RMCs. Meanwhile, the SEC’s continues to maintain an aggressive stance against purported fraud by China-domiciled issuers and charged Longtop Financial Technologies on November 10 with failing to file timely and accurate financial statements (here).

 

 

Olympus Garners Securities Class Action Lawsuit After All: In a recent post, I speculated that the reason there had not yet been a securities class action lawsuit filed against Olympus Corp. in the wake of its high-profile accounting scandal is that most of its shareholders acquired their shares on the Tokyo stock exchange and therefore — under the "transaction" standard enunciated by the U.S. Supreme Court in the Morrison case — cannot assert a claim under the U.S. securities laws

 

 

I also noted that, according to news reports, about one percent of its public float trades in the U.S. on the pink sheets in the form of American Depositary Receipts. Well, either the ADRs represent greater value than i understood when I wrote my blog post or some plaintiffs lawyers are going after some fairly small potential recoveeries.

 

 

 

According to their November 14, 2011 press release (here), a plaintiffs’ firm has filed a securities class action in the Eastern District of Pennsylvania against Olympus and certain of its directors and officers The complaint purports to be filed only on behalf of "purchasers of Olympus American Depository Receipts (pinksheets:OCPNY) (pinksheets:OCPNF) between November 7, 2006 and November 7, 2011, inclusive."

 

 

The plaintiffs did not include the Olympus shareholders that had purchased their shares on the Tokyo exchange, in an obvious effort to avoid Morrison problems. The Morrison effect on this case is that it is a much smaller scale case than would have been filed pre-Morrison.    

 

 

Meanwhile, a November 15, 2011 artice in The Asian Lawyer entited "What Will be the Legal Fallout for Olympus Corp." (here) discusses the various legal and cultural reasons why a significant litigation recovery or even regulatory fine involving Olympus Corp. is unlikely in Japan.         

 

 

LexisNexis Top Insurance Law Blogs of 2011: On November 11, 2011, the LexisNexis Insurance Law Community announced the top Insurance Law Blogs of 2011. The D&O Diary is honored to be listed among the 2011 designees.  The LexisNexis press release also lists all of the other designees, with links to their sites. Congradulations to all of the designees, and thanks to the LexisNexis Insurance Law Community for the selection. And thanks to all of the readers out there  who keep this blog alive.

 

According to Cornerstone Research’s recently released mid-year 2011 securities litigation report (here), during the 18 months ending on June 30, 2011, there were a total of 37 securities class action lawsuit filings involving U.S. listed Chinese companies, 33 of which obtained their U.S. listing by way of a “reverse merger” a publicly traded shell company. While some have questioned how these cases will fare, at least one of these cases recently survived a motion to dismiss, a development that an August 4, 2011 memo from the O’Melveny & Myers law firm (here) suggested “could signal the willingness of courts to her reverse merger securities fraud actions.”

 

As discussed here, plaintiffs first filed their complaint against Orient Paper, certain of its directors and officers, and its auditor in the Central District of California in August 2010. Orient Paper had obtained its U.S. listing by way of a reverse merger transaction. The plaintiffs allegations were largely based on an online report by Muddy Waters, a securities analysis firm and known short seller of shares of Chinese companies. The plaintiffs alleged that the company had failed to disclose related-party transactions with its main supplier, and that company misstated its financials in its annual reports in 2008 and 2009. The allegations financial statements were based on alleged differences between its SEC filings and its Chinese regulatory filings. The plaintiffs also alleged that the allegedly misleading financial statements had audited by a disbarred and unlicensed auditor.

 

The defendants moved to dismiss, contending that plaintiffs had not adequately alleged material misrepresentation, arguing that the company’s auditor had not been disbarred and that an internal company investigation conducted by the company’s audit committee determined that there was no evidentiary basis to substantiate the financial misrepresentation allegations. The defendants also alleged that the plaintiffs had not adequately pled scienter.

 

In a July 20, 2011 order (here), Central District of California Judge Valerie Baker Fairbanks denied the defendants’ motions to dismiss. The plaintiffs had provided PCAOB documentation substantiating that the company’s auditor had been disbarred. Judge Fairbanks also found with respect to the company’s internal investigation that it had been conducted by the company’s own audit committee “with no public or signed statements by any of the outside firms” the company had hired for the effort.” She added that “the truth of the Muddy Waters report and the audit committee’s conclusions is a factual dispute not appropriate for resolution at this stage.”

 

With respect to the issue of scienter, she found that “viewed holisitically … the inference of scienter advanced by the Plaintiffs is “at least as compelling as any opposing inference one could draw from the facts alleged.” Her find in this respect was based in part on the related-party transactions which indirectly benefited the company’s CEO. She also found the internal investigation on which defendants’ sought to rely in order to rebut the inference of scienter to be “questionable.”

 

According to the law firm memo, Judge Fairbanks’ ruling in the Orient Paper case is the first opinion involving a corporate defendant in a Chinese reverse merger company securities case. A prior ruling in the China Experts Technology case, discussed here, involved only the company’s auditors and also involved a case filed in 2007, prior to the current round of Chinese reverse merger litigation. The ruling in the China Expert Technology case did not relate to the company, which never responded to the complaint. The Orient Paper decision, by contrast, does not relate to the company’s auditor, who has not yet been served in the case.

 

With respect to Orient Paper decision, the law firm memo noted that Judge Fairbanks denied the motion to dismiss even though the plaintiffs had based “nearly all of their allegations on an Internet report authored by an admitted short seller.” The memo goes on to note that many of the cases filed against the Chinese reverse merger companies were, like that against Orient Paper, “preceded by disparaging reports from self-interested and often anonymous short sellers.”

 

In its assessment of the significance of the Orient Paper decision, the law firm memo says that “if this first motion to dismiss opinion is any view into the future, and defendants are unable to challenge the truth of the short seller reports at the pleading stage, most of these cases appear poised to proceed past the pleading stage, and instead, their issues will most likely be decided on motions for summary judgment.”

 

One obvious concern for these companies if they become involved in protracted U.S. securities litigation is the expense involved. This prospect may be particularly daunting for many of these companies because in many instances with which I am aware, the companies carry very low and in same cases minimal levels of directors and officers liability insurance. (My more detailed view of the D&O liability insurance issues involving the securities litigation exposures of U.S. listed Chinese companies can be found here.)

 

Alison Frankel’s June 21, 2011 report about the Orient Paper decision in Thomson Reuters News & Insight can be found here. My prior discussion about the role of the Muddy Waters firm in raising the allegations asserted in may of these Chinese reverse merger companies can be found here, in a post that also discusses the litigation hurdles that the plaintiffs in many of these cases will face.

 

Many thanks to the loyal reader who forwarded me a copy of Judge Fairbanks’ decision.

 

Securities Litigation in Japan: In a July 2011 publication entitled “Trends in Securities Litigation in Japan: 2010 Update” (here), NERA Economic Consulting provides a status report on the current state of securities litigation in Japan. Among other things the study reports that “the number of judgments related to damages litigation over misstatements has decreased substantially to seven in 2010 from 14 in 2009.”

 

The study also notes that the number of regulatory actions by the Japanese Securities and Exchange Surveillance Commission regarding monetary penalties for misstatement has “increased to a record high of 12 in 2010 from nine in 2009.” In light of the number of enforcement actions “the potential for future misstatement cases is expected to continue to rise.” The study also notes the increase in the number of shareholder petitions “for appraisal of stock purchase price in company reorganizations.”

 

As numerous commentators have noted, one of the most distinctive litigation developments over the last twelve months has been the emergence of U.S. securities litigation against Chinese companies that obtained their listings on U.S. exchanges that a “reverse merger” with a publicly traded U.S. shell company.

 

Given the prominence of these issues, I am very happy to publish the following guest post from Anjali C. Das, who is a partner in the Chicago office of the Wilson Elser law firm. Many thanks to Anjali for her willingness to publish her article here. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly.

 

 

Here is Anjali’s guest post:

 

D&O Spotlight on China: Claims Against China-Based Reverse Merger Companies: A Tempest in a Teapot of Gunpowder Green Tea?

 

 

Introduction

           

These days, nearly everything to do with China has grabbed the spotlight – not least of all the country’s extraordinary and seemingly unstoppable economic growth. Not surprisingly, many U.S. investors have been pouring millions of dollars into Chinese companies with the hopes of gaining super-sized returns. However, naysayers have long predicted a bursting of the China bubble. At least for investors in China-based issuers, perhaps that time is now. Not unlike the bursting of the internet bubble in the 1990s fueled by explosive growth and investment in “dot.com” companies, investors and regulators may now have reason to fear the rapid rise and fall of Chinese companies that have accessed U.S. capital markets through reverse mergers. While short-sellers are publicly denouncing the purported fraud at these companies (and making big bucks shorting the stock), U.S. regulators are investigating the rash of accounting scandals at these companies which have caused some auditors to abruptly resign. Meanwhile, D&O insurers have to contend with the collateral damage resulting from the multitude of claims against China-based issuers and their directors and officers. This article highlights the following topics involving Chinese reverse merger companies: 

 

 

PCAOB’s Research Note on Chinese reverse mergers

SEC’s investigation of China-based issuers and their auditors

NASDAQ’s proposed new listing requirements for reverse merger companies

SEC’s Investor Bulletin on reverse merger companies

Moody’s "Red Flags" report on China-based companies

D&O insurance coverage issues for claims against China-based issuers

 

 

 

PCAOB Issues a Report on China Reverse Mergers

 

 

On March 14, 2011, the Public Company Accounting Oversight Board ("PCAOB") issued a report examining the audit implications for reverse mergers involving China-based companies. A copy of the report can be found here. As explained in the PCAOB report, a reverse merger is an acquisition of a private operating company by a public company shell company. While the public shell company is the surviving entity, the  private company’s shareholders typically control the surviving company or hold publicly traded shares in the company.  A perceived benefit of a reverse merger is that it enables a company to become an SEC reporting company with registered securities without having to file a registration statement under U.S. federal securities laws.

 

 

 

The PCAOB report identified 159 companies from China that accessed the U.S. capital markets in a reverse merger transaction from 2007 through March 2010, representing 26% of all reverse mergers during the period. Reportedly, the market capitalization of these companies was $12.8 billion as compared to a $27.2 billion market cap of the 56 Chinese companies that completed initial public offerings in the U.S. during that same period. 

 

 

Reverse merger entities listed on U.S. exchanges are required to file audited financial statements with the SEC, and the auditors of the financial statements are required to be registered with the PCAOB. According to the PCAOB, U.S. firms audited 116 or 74% of the China-based reverse merger companies, while Chinese registered accounting firms audited 38 or 25 of companies. The PCAOB report raises concerns that some U.S. firms are not conducting proper audits of China-based companies, including handing off the audit work to a local Chinese accounting firm without verifying the accuracy of the results. The PCAOB has identified various "key considerations" to determine the appropriate level of oversight of firms that performs audits of foreign companies with the aid of assistants outside the firm, including:  the ability to supervise outside assistants; whether the outside assistants have appropriate language skills, and whether the auditor would have the ability to comply with the PCAOB’s documentation requirements.

 

 

           

SEC Launches Investigation of China-Based Issuers and Auditors

 

 

In response to a congressional inquiry by House Representative Patrick T. McHenry, Chairman of the Committee on Oversight and Government Reform, SEC Chairman Mary L. Schapiro issued a letter on April 27, 2011 seeking to assure Congress and the public 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" — particularly those companies based in China.  As SEC Chairman Schapiro noted in her letter, there has been a recent marked increase in China-based companies listed on U.S. exchanges through the process of a reverse merger.

 

           

Last summer, the SEC reportedly launched a "proactive risk-based inquiry into U.S. audit firms" which have a significant number of issuer clients based outside the U.S.  Among other things, the SEC has requested auditors to provide information concerning the firms’ compliance with U.S. audit standards for foreign-based reverse merger companies based in China.  Since the SEC launched its investigation, dozens of China-based companies have disclosed auditor resignations and accounting problems.  Since February 2011, Big Four accounting firms have resigned or been dismissed from at least seven Chinese companies listed in the U.S., as reported here. These auditors have reportedly experienced difficulty obtaining independent bank confirmations of a company’s bank accounts, balances, and transactions, as reported here.   In at least one case, the auditor purportedly received false information directly from the bank itself, prompting the auditor to resign. 

 

 

In an effort to protect U.S. investors, the SEC has reportedly suspended trading in several China-based reverse merger entities.  In addition, the SEC has revoked the securities registration of many other China-based reverse merger companies.  In some instances, the SEC is also pursuing these companies’ auditors for improper audits.   As the SEC Chairman observed, the Dodd Frank Wall Street Reform and Consumer Protection Act ("Dodd Frank") has enhanced the SEC’s ability to obtain audit documentation in connection with its investigations of issuers based in China and other countries. 

 

 

NASDAQ Proposes New Listing Requirements for Reverse Mergers

 

 

 

On June 8, 2011, the NASDAQ filed proposed rules with the SEC to adopt additional listing requirements for companies that become public through a reverse merger. Under the proposed rules, which can be found here, a company that is formed by a reverse merger shall only be eligible to submit an application for initial listing if the combined entity can satisfy the following conditions: 

 

 

traded for at least 6 months in the U.S. over-the-counter market, on another national securities exchange, or on a foreign exchange following the filing of all audited financial statements;

 

maintained a bid price of $4 or more per share for at least 30 of the most recent 60 trading days;

 

in the case of a U.S. domestic issuer, the company has timely filed its two most recent financial statements (i.e., Form 10-Q or 10-K);

 

in the case of a foreign based issuer, the company timely files comparable financial statements (i.e., Form 6-K, 20-F or 40-F) that includes an interim balance sheet and income statement presented "in English"

 

 

In support of its proposed enhanced listing requirements, the NASDAQ cited the "extraordinary level of public attention to listed companies that went public via a reverse merger," and "allegations of widespread fraudulent behavior by these companies, leading to concerns that their financial statements cannot be relied upon." The NASDAQ believes that these new listing requirements will protect investors and "discourage inappropriate behavior" by companies. 

 

 

SEC Issues an Investor Bulletin on Reverse Mergers

 

 

 

On June 9, 2011, the SEC issued a bulletin cautioning investors of the potential pitfalls of investing in reverse merger companies. The bulletin can be found here. Among other things, the SEC observed that many reverse merger companies ("RMCs") "either fail or struggle to remain viable following a reverse merger"; there have been instances of fraud and other abuses involving RMCs; and some RMCs have been using smaller U.S. auditing firms that may not have sufficient resources to conduct adequate overseas audits. The SEC bulletin also cited recent examples where it suspended trading of RMCs due to accounting irregularities and/or revoked the securities registrations of RMCs due to the companies’ failure to timely file required periodic financial statements.

 

 

Moody’s Issues its "Red Flags" Report on China-Based Companies

 

 

To address investors’ increasing concerns with the quality of financial reporting from publicly listed Chinese companies, on July 11, 2011 Moody’s credit rating agency issued a "Red Flags" report for China-based companies. The report examines 20 red flags grouped into five categories that identify possible governance or accounting risks for China-based companies, including:

 

 

            Weaknesses in corporate governance: short track record of operations and listing history,         murky shareholders’ background, large and frequent related-party transactions;

 

            Riskier or more opaque business models: unusually high margins compared to peers,     concentration of customers, complicated business structures;

 

            Fast-growing-business strategies: very rapid expansion, big capital investments resulting         in large negative free cash flow and intangible assets;

 

            Poorer quality of earnings or cash flow: discrepancy between cash flows and accounting             profits, disjointed relationship between growth in assets and revenues, large swings in working capital, insufficient tax paid compared to reported profits;

 

 

            Concerns over auditors and quality of financial statements: a switch in auditing firm or    legal jurisdiction of auditor’s office, delay in reporting, or adverse comments from      auditors.

 

 

Moody’s applied its red flags analytical framework to 61 rated Chinese companies. According to Moody’s report, due to the rapid growth of Chinese companies, nearly all Chinese high-yield issuers tripped red flags related to aggressive business and financial strategies and quality of earnings. Moody’s observed that fast-growing companies put pressure on managerial and financial resources. Additionally, these companies may make large capital investments that could negatively impact cash flow for a prolonged period of time. Also, due to the prevalence of strong founding families, many Chinese companies tripped the red flag for concentration of family ownership which may reflect weaknesses in corporate governance.  Moody’s also noted the so-called arms-length related-party transactions were not always transparent. Interestingly, according to Moody’s report, concerns over auditors arose less frequently compared to other red flags. 

 

 

 

Shorts-Sellers Creating Havoc

 

 

 

Meanwhile, short-sellers are wreaking havoc on China-based issuers’ stock and publicly accusing these companies of fraud. In several instances, detailed reports issued by short-sellers have triggered a wave of internal investigations, investigations by regulators, and shareholder litigation against companies. While some companies have gone to lengths to deny short seller’s often unsubstantiated accusations, the damage is done when the investors get spooked and the company’s stock price spirals downward. 

 

 

All of the negative publicity has impacted Chinese companies across the board, regardless of whether specific allegations of fraud have been asserted. Where investors were once rushing to dump huge sums of money into any business with ties to China, they are now rushing to liquidate their stock holdings at the slightest sign of any trouble. The fallout has had a devastating impact on the number of reverse merger transactions of Chinese companies. Not surprisingly, some Chinese companies have postponed plans to sell shares in the U.S., either through reverse mergers or initial public offerings ("IPOs"). As reported here, compared to 47 reverse merger transactions in the first half of 2010, there have been only 29 for the first half of 2011.  At least for now, Chinese companies are no longer the darling of Wall Street.

 

 

The Rise of Shareholder Litigation

 

 

Approximately 30 shareholder suits were filed in the first half of 2011 against China-based companies listed on U.S. exchanges and the companies’ directors and officers. On the surface, many of these suits are classic securities class actions alleging securities fraud and violations of Section 10(b) of the Securities Exchange Act of 1934 ("1934 Act") for materially false and misleading financial statements and related derivative actions.  However, suits against China-based companies may pose unique hurdles and added expense to the defense of shareholder claims in the U.S. For one thing, many or most of the individual defendants, corporate documents, and key witnesses may reside in China. Moreover, testimony and documents may need to be translated from Chinese to English. As such, defense costs can escalate rapidly. Also, given the current regulatory climate and increased suspicion of China-based issuers, the company may also be the subject of parallel proceedings or investigations by the SEC and other regulators. In some situations, the company’s Board may simultaneously launch an internal investigation – particularly if the company’s outside auditor abruptly resigns without issuing a clean audit opinion. That could also trigger a wave of management departures, putting added strain on the company’s already stretched resources. 

 

 

D&O Insurance Coverage Issues

 

 

 

Claims against China-based issuers and their directors and officers may raise a host of coverage issues under traditional Directors and Officers (“D&O”) liability insurance policies including, but not limited to: 

 

 

Reasonable and necessary defense costs

Coverage for parallel proceedings and investigations

Rescission

Known Claim exclusion

Fraud and personal profit exclusions

Severabiity of the policy exclusions and application

 

 

 

D&O policy limits for public companies are typically eroded by defense costs. This may occur more rapidly in suits against Chinese companies in light of the complexities of transnational discovery. As such, it is in the interests of D&O insurers and insureds alike to ensure that these claims are being defended with maximum efficiency to minimize the possibility that the D&O insurance is significantly impaired or even exhausted by defense costs alone. While many large defense firms now have outposts in China, it is still imperative to gain an understanding of the anticipated division of labor between the U.S. based lead defense attorneys and their colleagues in China with respect to discovery, document collection, witness interviews, and other matters. Additionally, there should be an objective assessment to determine whether it is cheaper and more efficient to outsource certain discovery-related tasks such as collection and translation of documents.

 

 

Shareholder litigation against Chinese companies may spawn multiple parallel proceedings and investigations by the government, regulators, the Board, a Special Litigation Committee, and others. A key issue is whether such investigations constitute covered Claims or Securities Claims under the D&O policy. Historically, many D&O policies narrowly limited the availability of coverage for investigations, such as formal investigations by the Securities and Exchange Commission (“SEC”) commenced by service of a subpoena on a director or officer. However, in the past few years, some D&O policies began to offer enhanced coverage, including coverage for both formal and informal investigations by regulators. Nowadays, the definition of a Securities Claim is less standard and may contain many subtle, yet critical nuances impacting coverage. Not surprisingly, there has been a significant amount of litigation and reported decisions with respect to coverage for investigations under D&O policies. However, many of these decisions are fact-specific and driven by now obsolete D&O policy language and definitions which continue to evolve. 

 

 

Recently, on July 1, 2011, the Second Circuit Court of Appeals issued an opinion in MBIA, Inc. v. Federal Ins. Co., 2011 U.S. App. LEXIS 13402 (2d Cir.), that sets forth a comprehensive analysis of coverage for various investigations under a D&O policy. In that case, the policy definition of a covered Securities Claim included “a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document.” First, the Second Circuit held that investigations commenced by the SEC and the New York Attorney General (“NYAG”) were covered under the policy definition of a Securities Claim. The court observed that the issuance of a subpoena by NYAG was, at a minimum, a “similar document” related to a “formal or informal investigative order”. The court also opined that requests for information by the SEC pursuant to oral requests and subpoenas were covered because they were connected to the SEC’s formal order of investigation. The court also concluded that fees incurred by an independent consultant retained by MBIA in the context of negotiating a settlement with the SEC and NYAG were also covered.

 

 

Second, the Second Circuit concluded that legal fees incurred by MBIA’s Special Litigation Committee (“SLC”) to determine whether to pursue or terminate pending shareholder derivative actions were covered and did not clearly fall within the policy’s sub-limit of liability for shareholder derivative demands. Prior to the filing of the derivative actions, a shareholder demand on MBIA’s Board had been made and ultimately rejected. After the shareholder derivative suits were filed, the SLC sought and obtained dismissal of the lawsuits. The Second Circuit determined that the legal fees incurred by the SLC arguably fell within the policy’s coverage for “costs ‘incurred in . . . investigating’ ‘Claims’ or ‘Securities Claims,’ respectively, each of which is defined to expressly include lawsuits.” The Second Circuit also determined that that the insurer had failed to carry its burden of proving that the SLC’s legal fees were not covered under the policy definition of Loss which excluded “any amount incurred by [MBIA] (including its board of directors or any committee of the board of directors) in connection with the investigation or evaluation of any Claim or potential Claim by or on behalf of [MBIA]”. 

 

 

           

To the extent claims against China-based issuers and their directors and officers allege accounting improprieties and false and misleading financial statements, D&O insurers might have a potential rescission argument if the policy was issued in reliance on these false financials. In some instances, D&O policies and/or applications contain a Known Claim Exclusion which might serve as a basis for denying coverage if an insured knew and/or failed to disclose a fact, circumstance, act, error, or omission that might give rise to a Claim under the policy. Also, standard D&O policies contain fraud and personal profit exclusions that might apply; however, these exclusions are usually restricted to a finding “in fact” or “final adjudication” that the insured committed fraud or unlawfully profited. In addition, both the application and the exclusions might be “severable,” such that the knowledge or wrongful acts of one insured cannot be automatically imputed to other insureds except in limited situations.

 

 

 

Conclusion

 

 

 

Some might conclude that the spotlight on China-based reverse merger companies is merely a tempest in a teapot, as compared to the global financial crisis precipitated by the subprime market meltdown and collapse of numerous financial institutions at home and abroad. Nonetheless, the reality is that many China-based issuers have been targeted by regulators and investors alike for purported securities and accounting fraud that could ultimately cost D&O insurers millions in losses. At least for now, this trend seems to be gaining traction. Until the pot is done brewing and the tea leaves are read, D&O insurers should tread carefully in handling claims against their China-based issuers.

 

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.

 

One of the recurring D&O insurance coverage issues is whether or not the so-called “bump-up” exclusion precludes coverage for amounts paid in settlement of post-merger litigation. The outcome of these disputes is often a reflection of several situation-specific factors, including the specific policy language involved, the nature of the underlying transaction, the claims alleged in the underlying litigation, the features of the settlement, and the applicable law. All of these factors came into play in a recent Delaware Superior Court decision in which the court held that the primary policy’s bump-up exclusion does not preclude coverage for the settlement of the lawsuit relating to the 2017 merger of Harman International Industries and Samsung’s American division. The court’s January 3, 2025 opinion, as amended in a January 7, 2025 corrected opinion, can be found here.

Continue Reading Del. Court: Bump Up Exclusion Doesn’t Bar Coverage for Post-Merger Suit Settlement

On March 6, 2024, in a decision that has attracted a lot of attention in the business press, the Eastern District of Virginia, applying Virginia law, held that the bump-up exclusion in Towers Watson’s D&O insurance policy precludes coverage for the $90 million paid in settlement of claims relating to the firm’s January 2016 merger with Willis Group Holdings. As discussed below, the court’s ruling highlights recurring issues concerning the wording of the bump-up exclusion. A copy of the March 6, 2024, opinion can be found here.

Continue Reading Bump-Up Exclusion Precludes Coverage for Merger-Related Claims Settlement

In a series of rulings culminating in the January 2016 decision in Trulia (about which refer here), Delaware’s courts have evinced their hostility to the kind of disclosure-only settlement in which merger objection suits are frequently resolved. Since that time, plaintiffs’ lawyers increasingly have filed merger-objection lawsuits outside of Delaware, either in federal court or courts in other states. The question since then has been whether other jurisdictions’ courts would follow Delaware’s courts’ lead in rejecting disclosure-only settlements. Many courts have followed Delaware, but others have followed a different path. In particular, New York, in an intermediate appellate court decision in Gordon v. Verizon (about which refer here), set a lower standard than Delaware’s courts for accepting disclosure-only settlements.

 

However, the apparently more lenient New York standard did not stop New York Supreme Court Judge Shirley Werner Kornreich from rejecting a proposed disclosure-only settlement of a lawsuit challenging Martin Marietta’s 2014 acquisition of Texas Industries. In a scathing February 8, 2018 opinion (here), Judge Kornreich rejected the proposed settlement as “utterly useless to shareholders.” Her opinion shows that even under New York’s seemingly more lax standard, disclosure only settlements could face significant scrutiny and could be rejected where the additional disclosures do not provide benefits to shareholders. Continue Reading New York Court Rejects “Utterly Useless” Disclosure-Only Merger Objection Suit Settlement

In the following guest post, Delaware partners Edward Micheletti, Paul Lockwood and associate Chad Davis of the Skadden Arps law firm take a look at the Delaware Supreme Court’s December 14, 2017 opinion in Dell, Inc. v. Magnetar Global Event Driven Master Fund Ltd. (here), which examined important appraisal action valuation issues. I would like to thank the authors for allowing me to publish their article. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is the authors’ guest post. Continue Reading Guest Post: Dell Strongly Reinforces Importance of Merger Price

new yorkIn a series of decision culminating in Chancellor Bouchard’s January 2016 ruling in the Trulia case (about which refer here), Delaware’s courts have shown their hostility to disclosure-only settlements in merger objection lawsuits. These Delaware developments led some observers to speculate that we might have seen the end of the litigation trend in which nearly every M&A transaction attracted at least one merger objection lawsuit.

 

However, a February 2017 New York court ruling in the Gordon v. Verizon Communications, Inc. (discussed here), in which an intermediate appellate court reversed the lower court’s rejection of a disclosure-only merger objection lawsuit settlement and remanded the case for an award of plaintiffs’ fees, raised the question of whether or not there might yet be life ahead for disclosure-only settlement in merger objection lawsuits.

 

In a provocative March 20, 2017 post on the CLS Blue Sky Blog (here), Columbia Law School Professor John Coffee takes a look at the New York court’s Verizon decision, concluding that the decision ensures that “the nuisance suit remains alive and well in New York and should bring the worst of the plaintiff’s bar streaming back to New York.” Continue Reading Are New York Courts Keeping the World Safe for Nuisance Value Merger Objection Lawsuits?

new yorkAfter the Delaware courts in a series of decisions culminating in the January 2016 ruling in the Trulia case showed their hostility to disclosure-only settlements of merger objection lawsuits, commentators asked whether this development might mean the end of the merger objection lawsuit curse. Since that Delaware court’s decision in the Trulia case, plaintiffs’ lawyers increasingly are filing merger objection lawsuits outside Delaware, primarily in federal court. This shift in turn raises the question of the extent to which the courts in other jurisdictions will follow the principles the Delaware court set out in the Trulia case. The jurisdictional shift also raises larger cases about the future direction of merger objection litigation. A recent decision from a New York intermediate appellate court provides important perspective on many of these questions.

 

A February 2, 2017 opinion from the New York Appellate Divisions, First Department, applying New York law, reversed a lower court’s rejection of the disclosure-only settlement of a suit that had been filed in connection with Verizon’s proposed acquisition of Vodafone subsidiaries holding ownership interests in Verizon Wireless. The decision expressly considered the Delaware courts’ concerns in Trulia and other cases about disclosure-only settlements, but nevertheless not only reversed the lower court’s rejection of the settlement, but remanded the case for the lower court to consider a fee award for the plaintiffs’ counsel. The New York court’s decision in the Verizon case presents a number of interesting and important suggestions the future direction of merger objection lawsuits.  The New York appellate court’s opinion can be found here. Continue Reading Latest Twist in the Merger Objection Lawsuit Saga: New York Appellate Court Approves Disclosure-Only Settlement