Expert Commentary

Chinese D&O Claims—Has the Tide of Claims Crested?

While securities class actions were filed in the first half of 2011 at roughly the same pace as in prior years, the rate at which securities class action claims were brought against Chinese companies in that same period has risen significantly. 


Professional, D&O, and Fiduciary Liability
December 2011

In 2010, only 12 of the 176 securities class action claims filed were brought against directors and officers of Chinese companies.1 Through the first 10 months of 2011, the number of Chinese companies sued by securities class plaintiffs shot up to 33, just under 20 percent of the 169 securities class action suits filed in 2011, with the majority of the filings in the first half of 2011.2

Notably, all but 6 of the 45 U.S. listed Chinese companies sued in 2010 and 2011 gained access to U.S. equity markets through a reverse merger. A reverse merger is an acquisition of a private operating company by a public shell company in which the public shell is the surviving entity and the private company's shareholders typically control the surviving company. This article discusses some common themes underlying the Chinese companies' access to U.S. equities through the reverse merger process and the accounting issues that have since arisen, the regulatory response to the accounting problems with many of these companies, and the status of the pending securities litigation.

The Inflow of Chinese Reverse Mergers

A reverse merger offers unique benefits to a non-listed company. First, a reverse merger offers a non-listed company quicker access to U.S. equity than through an initial public offering (IPO). The time to effect the merger and become a public company is brief, typically 3 to 8 weeks.3 Second, the legal and accounting fees associated with a reverse merger tend to be lower than for an IPO as there are no registration requirements under the Securities Act of 1933.4 Not surprisingly, companies that pursue equity access through a reverse merger tend to be smaller.

According to the Public Company Accounting Oversight Board (PCAOB), between January 1, 2007, and March 31, 2010, at least 159 companies from the China region accessed the U.S. capital market through reverse merger transactions.5 These 159 Chinese companies represented 26 percent of all reverse mergers between January 2007 and March 2010.6 In keeping with what might be expected of a company that chose to access U.S. equity through a reverse merger, many of the Chinese reverse merger companies were small: 33 percent had a market capitalization of less than $10 million, 59 percent had annual revenues of less than $50 million, and 58 percent had assets below $50 million. According to the PCAOB, U.S. firms audited 73 percent of the China-based reverse merger companies (116), while Chinese registered accounting firms audited 24 percent of those companies (38).

As early as June 2010, short sellers started raising concerns about accounting practices at Chinese reverse merger companies. One of the first Chinese reverse merger companies heavily criticized by short sellers, Orient Paper, a producer and distributor of paper products, was the subject of a "Short Sell" report released by Muddy Waters Research on June 28, 2010, sharply criticizing financial statements by the reverse merger company.7 Orient's stock plunged, and a securities fraud class action followed. In the following months, a number of short sellers criticized accounting practices at other Chinese reverse merger companies.8

The Regulators Respond

In July 2010, the PCAOB weighed in, raising concerns about auditing practices for public companies with substantially all of their operations in another country, such as Chinese reverse merger companies. In Staff Audit Practice Alert No. 6, the PCAOB reminded auditors of their obligations when engaging assistants from outside the firm to audit companies with substantially all of their operations in another country.9 The Alert noted that, although registered public accounting firms located in the United States were issuing the audit report for many such companies, the audit procedures were largely being performed by auditing firms or individuals outside of the United States. This raised concerns that auditors were not properly applying AU Sec. 543, which states that where other auditors have performed significant parts of an audit, the principal auditor's own participation must be sufficient to enable him or her to serve as the principal auditor and to report as such on the financial statements. The Alert noted an instance in which PCAOB inspectors observed that a U.S. audit firm issued an audit report on the financial statement of an issuer in the China region, even though none of the U.S. firm's partners or employees traveled to the China region or planned, performed, supervised, or meaningfully reviewed the audit work of consultants it retained to serve as assistants on the audit.

On March 14, 2011, the PCAOB released a research note that further discussed audit implications for reverse mergers involving companies from the China region.10 The PCAOB again expressed concern that some U.S. accounting firms were not conducting audits of Chinese reverse merger companies in accordance with PCAOB standards, in some cases using local Chinese firms to complete the audit without verifying the results. The Note reiterated its prior observations from Staff Audit Practice Alert No. 6 that "key considerations" for appropriately overseeing auditing outside assistants included whether:

  • the auditor had adequate information about the knowledge, skill, and ability of assistants;
  • the auditor was able to plan and supervise the work of the assistants engaged;
  • the auditing procedures performed by the outside assistants in combination with the auditor's own work provided sufficient competent evidence for an audit opinion;
  • the assistants had appropriate language skills; and
  • the auditor had the ability to comply with the board's documentation requirements.11

More recently, the Securities and Exchange Commission (SEC) has focused its attention on the auditing companies of firms that underwent reverse mergers. In an early April 2011 speech, SEC Commissioner Luis Aguilar expressed concern over possible reverse merger accounting deficiencies and fraud.12 Later in April 2011, SEC Chairman Mary Schapiro informed the House Committee on Oversight and Government Reform that the SEC had launched a "proactive risk-based inquiry into US audit firms" that had a significant number of domestic issuer clients with primarily foreign operations. In connection with this, the SEC has requested that U.S. auditors provide information concerning audit practice and compliance with U.S. auditing standards for foreign-based reverse merger companies, including those based in China. More than 24 China-based companies have disclosed auditor resignations and accounting problems since the SEC inquiry began.13

The SEC has reportedly suspended trading in at least six China-based reverse merger companies.14 In addition, the SEC has revoked the securities registration of at least 15 other China-based reverse merger companies. On June 9, 2011, the SEC issued an investor bulletin warning investors about the risks associated with investing in companies that have undertaken reverse mergers.15

In addition, on July 11, 2011, Moody's credit rating agency issued a "Red Flags" report for China-based companies. The report screened 61 rated Chinese companies against 20 red flags. The red flags were grouped into five categories: weak corporate governance, risky business models, fast-growth strategies, poor earnings quality, and audit concerns.16 Forty-nine of the 61 companies triggered at least 3 red flags, with 7 firms tripping 9 red flags or more. Common red flags were high levels of negative free cash flow, found at 43 companies, and aggressive growth (i.e., total asset or revenue doubling over 3 years), found at 41 companies.17 Remarkably, only a few of these 49 companies have been named as defendants in the securities class action suits filed in 2010 and 2011.

In mid-2011, the NASDAQ, NYSE, and NYSE Amex proposed new rules to the SEC to tighten listing standards. On November 9, 2011, the SEC announced the new rules.18 The new rules would prohibit a reverse merger company from applying to be listed until it has: (1) completed a 1-year "seasoning period" by trading in the U.S. over-the-counter market or on another regulated U.S. or foreign exchange following the reverse merger; (2) filed all required reports with the SEC, including audited financial statements since the consummation of the reverse merger; and (3) maintained a requisite minimum share price for a sustained period, including at least 30 of the 60 trading days immediately prior to its listing application and the exchange's decision to list. However, the reverse merger company would be exempted from these requirements if listed in connection with a substantial, firm commitment, underwritten public offering or if the reverse merger occurred after at least four annual reports with audited financial information have been filed with the SEC.

Concerns about the adequacy of financial disclosures by China-based companies have not been limited to reverse merger companies but have also extended to some China-based companies that came to the U.S. equity market through IPOs. The SEC recently initiated an administrative proceeding against Longtop Financial Technologies, Ltd., whose American depository receipts had traded on the NYSE since October 2007. The SEC's complaint alleged that Longtop failed to file a current financial report for the fiscal year ending March 31, 2011, and failed to file accurate financial reports for 2008, 2009, and 2010.19

The potential fraud at Longtop came to light on May 23, 2011, when Longtop reported to the SEC that its auditor, Deloitte Touche Tohmatsu, had resigned. The letter of resignation revealed that Deloitte had learned of a number of serious defects in the records for Longtop at its banks, including unrecorded transactions, false confirmation replies, significant differences in reported cash balances, and significant unreported borrowings. According to the letter, when Deloitte sought confirmations from the bank headquarters, "within hours" the confirmation process was stopped following "calls to the Bank by the Company asserting that Deloitte was not their auditor." Deloitte indicated that its reasons for resigning included "deliberate interference by the management in our audit process." Following the report, Longtop stock ceased trading. On August 29, 2011, the NYSE delisted Longtop American depository shares, and the SEC served a Wells Notice20 on the company. Securities class action suits also have been filed against Longtop and its directors and officers.

The Wave of Securities Class Action Suits

In the wake of these developments, the stock prices for Chinese-based reverse merger companies have fallen precipitously. According to the Bloomberg Chinese Reverse Mergers Index, the average trading price for stock in such firms has dropped nearly 55 percent since the beginning of 2011 and nearly 66 percent from the index's high in January 2010.21

Since January 2010, 45 securities class action suits have been filed against China-based companies and their directors and officers. These suits are fairly standard securities class action complaints that allege securities fraud and violations of Section 10(b) of the Securities Exchange Act of 1934 for materially false and misleading financial statements, with tagalong derivative claims.

Although it is very early in these class action suits, a July 2011 ruling by the U.S. District Court for the Central District of California suggests that courts may be receptive to such claims against Chinese reverse merger companies.22 In the first reported opinion involving a complaint against a Chinese reverse merger company, Orient Paper, the District Court for the Central District of California rejected the company's motion to dismiss, ruling that the plaintiffs had sufficiently pleaded fraud even though the plaintiffs based their allegations largely on Muddy Waters' Internet criticisms. The complaint repeated many of the short seller's assertions, such as that Orient failed to disclose material related-party transactions with its main supplier and materially misstated its financials in its 2008 and 2009 annual reports. The complaint also alleged that Orient's auditor was unlicensed, rendering its financial statements unreliable. Defendants moved to dismiss, arguing that the plaintiffs failed to allege a material misstatement or omission with particularity and therefore failed to satisfy the Private Securities Litigation Reform Act's heightened pleading requirements.

The district court held that "[v]iewed holistically ... the inference of scienter advanced by the Plaintiffs is 'at least as compelling as any opposing inference one could draw from the facts alleged.'" The court determined that the alleged related-party transaction between Orient and a supplier in which Orient's Chief Executive Officer allegedly held a 70 percent interest throughout the class period created an indirect benefit to the defendants that presented a strong inference of scienter. The court noted that scienter was not negated by the defendants' failure to sell company stock during the class period and Orient's independent investigation, which the court observed was "questionable," in part because the outside firms hired by the audit committee did not submit any public or signed statement. The court also found that an inference of scienter was supported by the plaintiffs' submission of a request for judicial notice that the auditor who had prepared Orient's 2008 10–K, which had failed to reveal the related-party transaction, had been disbarred by the PCAOB and therefore was unlicensed.

Since the district court ruling in Orient Paper, one other district court has granted a motion to dismiss a securities class action complaint against a Chinese reverse merger company, although the ruling likely will have limited applicability to other securities suits against Chinese reverse merger companies and their directors and officers. In In re China North East Petroleum Holdings, Ltd. Securities Litigation,23 the plaintiffs alleged that the defendants committed securities fraud by inflating the amount of the company's proven oil reserves by 25 percent, failing to account for substantial losses associated with warrants issued to an investor, overstating reported earnings, substantially inflating profits in 2008 and 2009, and misrepresenting the company's internal controls. The defendants moved to dismiss on the ground that the plaintiff could not prove that it suffered any loss because the plaintiff did not act on several opportunities to sell its shares for a profit following the corrective disclosure at the end of the class period. The district court agreed that the plaintiff's subsequent sales at a loss could not be imputed to the alleged misrepresentations, noting that a "plaintiff who forgoes a chance to sell at a profit following a corrective disclosure cannot logically ascribe a later loss to devaluation caused by the disclosure." This ruling on loss causation was factually specific, involving the unique circumstances of a bounce back in stock price not typical of the stock performance of other Chinese reverse merger companies, and thus does not seem to be relevant to other pending securities suits against Chinese reverse merger companies or to signal that courts will be less receptive to claims against Chinese reverse merger companies.

If the Orient Paper ruling is any indication as to how receptive courts may be to such cases, it seems likely that many cases will survive the motion to dismiss stage and proceed to discovery. In that event, the legal fees and costs to address discovery and, ultimately, motions for summary judgment or even trial likely will be very substantial. At the same time, seeking discovery from companies whose principal operations, documents, and witnesses are located in China will present unique hurdles and likely increase the costs of litigation. The experience of counsel in the securities class action claim against Duoyuan Printing, Inc., and its directors and officers illustrates some of the unique problems that may arise in claims against China-based reverse merger companies and their directors and officers.24 In that case, the shareholder plaintiffs served process on Duoyuan but found it difficult to serve process on five of the defendant directors and officers. According to press reports, the plaintiffs' counsel argued that the court should permit service through the Duoyuan's U.S. office because serving process on individuals in China is arduous and costly and requires a central Chinese authority to forward any requests to local Chinese courts. On July 8, 2011, the court denied the plaintiffs' request to order service of individual defendants through Duoyuan's U.S. registered agent without prejudice and ordered that the plaintiffs first attempt service under the Hague Convention.25

Will the Wave Continue To Rise?

With increasingly higher barriers to entry being adopted in the United States, Chinese companies appear to be postponing plans to seek equity in the United States, as some commentators have noted.26 In the first half of 2011, only 29 Chinese reverse merger transactions were consummated, continuing at the same pace as the period from 2007 through 2009.27 This number is down from the 47 Chinese reverse mergers completed in the first 6 months of 2010.28

In addition, U.S. regulatory concerns over accounting standards within Chinese companies likely will slow the pace of reverse mergers. In July 2011, representatives of the SEC and PCAOB met in Beijing with Chinese counterparts at the Ministry of Finance and the China Securities Regulatory Commission to address the financial scandals of Chinese companies listed in the United States. Although the PCAOB had expressed hope that the two countries would reach a bilateral agreement this year on cross-border auditing regulations, they failed to agree on cross-border auditing standards. According to press reports, the U.S. delegation submitted a list of public companies it sought to investigate, but the Chinese insisted that this would breach China's sovereignty and rejected the request. There apparently were several impediments to reaching agreement, including the differing approaches of the countries to regulation, the lack of agreement in areas such as law enforcement and money laundering, and differences in domestic regulatory and auditing capabilities.29 Since then, progress in reaching an agreement with Chinese authorities on a joint inspection arrangement of China-based issuers has been slow.30 The delay in reaching agreement on inspections, combined with tightened listing standards on NASDAQ, NYSE, and NYSE Amex, likely signify that Chinese companies will find it more difficult to access the U.S. equity markets in the near future.

Although the pace of reverse mergers may wane for some time, additional securities class action claims likely will continue to be filed against Chinese reverse merger companies, in part due to the number of Chinese reverse merger companies formed since 2007. In addition to the 159 Chinese reverse mergers identified in the PCAOB Note from January 2007 to March 31, 2010, 69 Chinese reverse mergers were reportedly completed in the last 9 months of 2010.31 Thus, in the 4½ year period from January 2007 through June 2011, 257 Chinese reverse merger companies were formed.

Given the typical profile of companies that enter the U.S. equity market through the reverse merger process, many of these emerging companies likely are smaller and unused to the heightened reporting requirements of listed companies. While the rate at which securities class action suits have been filed against Chinese reverse merger companies has slowed somewhat in the second half of 2011, announcements by some plaintiffs' securities firms of pre-suit investigations of Chinese reverse merger companies suggest that additional class action suits may still be coming.32


1"Securities Class Action Filings: 2011 Mid-Year Assessment." Cornerstone Research.

2Id.; see also Stanford Law School Securities Class Action Clearinghouse, 2011 QIII and QIV Filings. Accessed November 21, 2011.

3SEC Investor Bulletin: "Reverse Mergers," June 9, 2011. Accessed August 21, 2011; see also "Reverse Mergers: The Pros And Cons." Investopedia, May 21, 2009. Accessed August 24, 2011.

4Id.

5PCOAB. Research Note #2011–P1, March 14, 2011.

6Id.

7"Report on Orient Paper, Inc.: Muddy Waters Initiating Coverage on ONP – Strong Sell," June 28, 2010. Accessed November 11, 2011.

8See, generally, Trading China Blog; "A Short History of Short Attacks, Part Two," blog entry by The Traveller, May 31, 2011. Accessed November 11, 2011; various articles at Seeking Alpha, Chimin Sang. Accessed November 11, 2011; various research reports at Muddy Waters Research. Accessed November 11, 2011.

9Audit Practice Alert No. 6, Auditor Considerations Regarding Using the Work of Other Auditors and Engaging Assistants from Outside the Firm.

10PCAOB. Research Note #2011–P1. "Activity Summary and Audit Implication for Reverse Mergers Involving Companies from the China Region: January 1, 2007 through March 31, 2010."

11Id.

12Aguilar, Luis A. "Facilitating Real Capital Formation," Council of Institutional Investors Spring Meeting, Washington, D.C., April 4, 2011. Accessed August 21, 2011.

13Id.

14The SEC has suspended trading in: (1) Heli Electronics Corp. (HELI); (2) China Changjiang Mining & New Energy Co. (CHJI); (3) RINO International Corporation (RINO); (4) Advanced Refractive Technologies, Inc. (ARFR); (5) HiEnergy Technologies, Inc. (HIET); and (6) Digital Youth Network Corp. (DYOUF). See SEC Investor Bulletin: "Reverse Mergers," June 2011.

15Id.

16"Moody's Report Sparks Selloff in Chinese Firms." CNBC, July 17, 2011. Accessed August 25, 2011.

17"Moody's raises red flags at 49 Chinese companies." Reuters, July 11, 2011. Accessed August 25, 2011.

18"SEC Approves New Rules to Toughen Listing Standards for Reverse Merger Companies," SEC press release no. 2011–235, November 9, 2011. Accessed November 10, 2011.

19Administrative Proceeding File No. 3–14622 Before the Securities and Exchange Commission, Order Instituting Administrative Proceedings and Notice of Hearing Pursuant to Section 12(j) of the Securities Exchange Act of 1934. Accessed November 21, 2011.

20A letter sent by the SEC to people or firms it plans to bring an enforcement action against.

21Bloomberg Chinese Reverse Mergers Index (CHINARTO:IND) through close of business November 9, 2011.

22Henning v. Orient Paper, Inc., CV 10–5887–VBF (AJWx), 2011 U.S. Dist. LEXIS 79135 (C.D. Cal. July 20, 2011).

23In re China N. E. Petroleum Holdings Ltd. Sec. Litig., 10 Civ. 4577 (MGC) (S.D.N.Y. Oct. 6, 2011).

24"Plaintiffs hit first roadblock in China fraud case." Thompson Reuters News & Insight, June 15, 2011. Accessed August 25, 2011.

25Perry v. Duoyuan Printing, Inc., 1:10–cv–07235–GBD (S.D.N.Y. 2010).

26Xiang, Li. "Reverse-merger fallout to hurdle Chinese listings." China Daily, June 24, 2011. Accessed August 25, 2011.

27PCOAB. Research Note #2011–P1, March 14, 2011.

28Baldwin, Clare. "Insight: For short sellers of Chinese stocks, it's time to reap." Reuters, June 16, 2011. Accessed August 25, 2011.

29"US and China Fail to Agree on Cross-Border Auditing Standards." Business Insider, August 8, 2011. Accessed August 25, 2011.

30Doty, James R. Keynote Address at the 43rd Annual Securities Regulation Institute, November 10, 2011. Accessed November 11, 2011.

31Reverse Merger and SPAC Blog; "2010: Big Year for Reverse Mergers," blog entry by David Feldman, February 5, 2011. Accessed August 25, 2011.

32See, e.g., "Pending investigation of China Gerui Advanced Materials Group, Ltd." Accessed November 11, 2011.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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