By Mary-Pat Cormier and Gregory Pendleton, Edwards Angell Palmer & Dodge LLP
Securities litigation is a big—and increasingly very busy—business. While federal court dockets continue to be filled with complaints stemming from traditional litigation drivers like mergers and acquisitions, an interesting new trend has emerged: suits against Chinese companies listed on U.S. stock exchanges. 2010 saw an unprecedented twenty-one filings against such companies,1 twelve of which were federal class actions.2 These twelve filings accounted for more than forty percent of all federal class actions against foreign issuers, the highest figure ever observed in a single year.3 2011 has already seen more than twenty-five securities suits filed against Chinese companies.4
Many of these Chinese defendants came to be listed on U.S. exchanges through so-called “reverse merger” transactions. In a reverse merger, as used by these companies,5 a domestic public shell company acquires a foreign private operating company, but effective operating and voting control of the surviving public company is ceded to the foreign owners. In effect, the reverse merger enables the foreign private company to become publicly-listed in the U.S. Thus, reverse mergers can be an attractive capital-raising option for small and mid-sized companies in China, which often face long waits to be listed on the Shanghai or Shenzhen exchanges.
Although reverse mergers seem like a simple, elegant expedient for Chinese business owners, increased scrutiny by the plaintiffs’ bar, short sellers, the U.S. Securities and Exchange Commission (SEC), and Congress suggests otherwise. The market—not to mention court filings—is rife with allegations these companies have engaged in fraudulent accounting practices or have failed to disclose related-party transactions in their SEC filings. The impact on stock prices has been predictable.
Thus, as in history, so in business: a dynasty contains the seeds of an insurgency. As explored in this article, the emergence of Chinese reverse mergers (CRM) has spun off a thriving insurgency of securities litigation, regulatory inquiries and activity, and rampant short sales.
In reverse mergers used in this context, the private operating company seeks what the dormant public shell company has: access to public markets. Thus, in theory, a reverse merger is a happy, symbiotic transaction, where the private company gains access to public capital, and the public company gains operations. In the case of CRM, U.S. investors, including some large hedge funds and mutual funds, have the opportunity to invest in small companies that face minimal regulation in a stable “emerging” market.
The Hegemony of the CRM in Small and Mid-Sized Chinese Companies
The Public Company Accounting Oversight Board’s (PCAOB) Office of Research and Analysis collects statistics on CRM.6 It recently identified 159 companies from China that “accessed the U.S. capital markets by means of a reverse merger transaction” between January 1, 2007 and March 31, 2010.
There are a number of reasons why companies pursue a reverse merger, but chief among these is the perception that it is an efficient way to access funding from a broad pool of public investors. The alternative—an initial public offering (IPO)—is laden with complexities that compound legal and accounting fees, as well as regulatory scrutiny. For example, while a reverse merger requires only the filing of a Form 8-K with the SEC, an IPO must observe strict registration requirements under the U.S. Securities Act of 1933.7
A reverse merger thus seems more attractive to many Chinese companies than an IPO. Indeed, the PCAOB found that as of March 31, 2010, only 56 Chinese companies had completed an IPO; in contrast, 159 companies had completed a reverse merger.
But the PCAOB also found that CRM companies have much smaller market capitalizations than the Chinese companies that completed an IPO. In fact, the aggregate market capitalization of the CRM companies was just $12.8B (USD), while the aggregate market capitalization of Chinese IPO companies was $27B (USD). Based on these figures, reverse mergers are the preferred method of gaining access to the U.S. public capital markets for small and mid-sized Chinese companies.
The plaintiffs’ bar, securities regulators, Congress, and—increasingly—short sellers have become captivated by the growth of CRM.
The House Financial Services Committee, for example, is reportedly planning to hold hearings later this year on Chinese corporate accounting practices. Interesting legal and regulatory developments are likely to follow.8
The SEC is also cracking down on CRM companies for slip-shod accounting practices. Enforcement actions against the U.S. auditors of CRM companies are also anticipated. In a recent Investor Bulletin, the SEC cautions investors that “some foreign companies that access the U.S. markets through the reverse merger process have been using small U.S. auditing firms, some of which may not have the resources to meet its auditing obligations when all or substantially all of the private company’s operations are in another country.”9 The SEC goes on to say that those firms may fail to “identify circumstances where these companies may not be complying with the relevant accounting standards.” Ominously, and rather prophetically, the SEC cautions: “This can result in increased risks for investors.”
There are a couple of reasons for the inability to gauge the accuracy of CRM financial information. First, the PCAOB is effectively barred from inspecting the work of accountants in China because there are no arrangements between it and Chinese authorities. Second, most of the accounting work for the CRM companies is outsourced to Chinese firms. The PCAOB has called this absence of oversight, “a gaping hole in investor protection.”10
In the past three months, the SEC has suspended the trading of more than a dozen CRM companies,11 citing manifest accounting irregularities, lack of current and accurate financial information on file with the SEC, and indices of gross mismanagement. In some cases, the SEC revoked the securities registrations of CRM companies where the companies failed to make required periodic filings.12 A variety of other regulatory alternatives are reportedly being considered to address the SEC’s concerns, including a pre-listing trading period of a CRM company’s stock.13
As discussed below, the plaintiffs’ bar also has seized on the potentially lucrative implications of increased scrutiny of CRM companies. So too have short sellers. While hedge funds and institutional investors have generally been content with long positions in CRM companies, short sellers—ever eager to cash in on potentially over-valued companies—are changing the equation. For example, short sellers hailed a recent report issued by a Hong-Kong based outfit called Muddy Waters LLC, wherein Sino-Forest Corporation was roundly criticized for, among other things, overstating profits. Although the report was flatly denied by Sino-Forest, its stock, which trades on the TSE, went into freefall, plunging over 80% since May. Lawsuits in Ontario and Quebec predictably followed.
A burgeoning number of CRM cases are appearing on federal court dockets. The majority of these suits have been filed in the Southern District of New York (the national hub of securities litigation), the Central District of California, and the District of Delaware. The cases share many common allegations, most notably those involving accounting irregularities and the failure to disclose related-party transactions.
— Suspect Accounting: China MediaExpress
Illustrative of the suspect accounting theme is Starr Investments Cayman II, Inc., v. China MediaExpress Holdings, Inc., et al., No. 11-cv-00233 (D. Del. filed Mar. 18, 2011).14 In this case, Starr Investments Cayman II, Inc. (Starr), an offshore investment firm run by the former CEO of AIG, Hank Greenberg, filed suit against China MediaExpress Holdings, Inc. (CCME),15 its CEO Zheng Cheng, its former CFO Jacky Lam, and Deloitte Touche Tohmatsu (DTT, CCME’s former auditor). CCME is alleged to have represented itself as operating China’s largest advertising network on inter-city and airport buses. Starr first invested in CCME in January 2010, entering into a $30 million securities purchase agreement. At that time, Starr also installed a representative on CCME’s board. In October 2010, Starr purchased an additional $13.5 million worth of CCME common stock.
Starr’s complaint alleges that on January 30 and February 3, 2011, two “analyst firms” issued negative reports about CCME. These reports, respectively, concluded that CCME “does not exist at the scale that they are reporting to the investing public” and that CCME “is engaging in a massive ‘pump and dump’ scheme. . . . significantly inflating its revenue and earnings in order to pay management earn-outs and inflate the stock price so insiders can sell.”16 CCME’s stock price declined significantly following the publication of these reports.17 On March 11, 2011, NASDAQ halted the trading of CCME stock and DTT resigned because it was “no longer able to rely on representations of management.” Events moved rapidly from there: within a week Starr had filed suit and both Jacky Lam and the Starr-installed board member had resigned.18
This case is notable for a number of reasons. First, the plaintiff is a sophisticated institutional investor that invested millions of dollars in CCME’s common stock. In contrast, most other CRM cases have been class actions brought by individual investors. Second, Starr names an external auditing firm as a defendant; this is a trend we are seeing with increasing frequency in CRM cases, providing plaintiffs with an additional potential source of settlement funding. Third, Starr had actually installed a representative member on CCME’s board. Thus, unlike most other CRM plaintiffs, Starr—theoretically at least—had direct and ongoing access to information about the corporate defendant’s financial health and the individual defendants’ management practices. Fourth, the parties are engaged in a concurrent arbitration in Hong Kong involving Starr’s initial $30 million investment in CCME. (The Delaware case concerns only Starr’s second $13.5 million investment). While it is highly unlikely that the results of the arbitration will be made public, it nonetheless adds an interesting forum selection element.
Finally, the case is perhaps most notable for what many CRM cases presently lack: substantive responsive motions from the defendants.19 These motions provide a glimpse of—and a testing ground for—the defenses we can expect to see as other CRM cases advance. First, CCME and Cheng have filed a motion to dismiss, advancing a defensive theory unique to the CRM landscape: accusations that the company’s falling stock prices resulted from intentionally false reports authored by hostile short sellers masquerading as “independent” analysts. In this case, CCME argues that two such reports, which it characterizes as being “[b]ased on assumptions, random alleged phone calls, and . . . otherwise unspecified ‘investigation[s],’” caused CCME’s stock to fall, which caused lawsuits to be filed, which “caused the stock to fall further, and the short sellers had accomplished their goals.”20 CCME calls Starr’s complaint merely a “repetition of conclusory allegations made by third parties [i.e., the short sellers and bloggers].”21 For this reason, CCME and Cheng argue that the complaint fails to satisfy the strict pleading requirements under the Private Securities Litigation Reform Act (PSLRA)—namely, that the complaint specify each allegedly misleading public statement and state with particularity the facts “giving rise to a strong inference that the defendant acted with the required state of mind.”22
Jacky Lam, CCME’s former CFO, has also moved to dismiss Starr’s complaint.23 Like CCME and Cheng before him, Lam argues that the complaint’s adoption and repetition of the short sellers’ unsubstantiated accusations renders it susceptible to dismissal under the PSLRA’s heightened pleading requirements. Lam also states that CCME’s 2009 10-K, “the only annual report Mr. Lam signed,” contained emphatic warnings to investors “that Chinese companies were run differently than U.S. companies and that, as a result, ‘CCME may have difficulty establishing adequate management, legal and financial controls in the PRC.’”24 Lam further points to the fact that he resigned his post on March 11, 2011, just two days after DTT resigned and five days before the resignation of the Starr-installed board member.
Lam’s filing is perhaps most intriguing for its allegations concerning the nature of CCME’s business. According to Lam, CCME does not directly conduct any advertising business; instead, the business is actually conducted by another Cheng-owned company called Fujian Fenzhong (Fujian). Fujian is based in Fuzhou, some 400 miles from CCME’s headquarters in Hong Kong. Lam states that Fujian is not a subsidiary of CCME and CCME has no direct ownership interest in Fujian. “Rather, CCME’s relationship with Fujian has always been governed by a series of agreements among CCME, Fujian, and Fujian’s shareholders – Mr. Cheng and his mother.”25 Lam states that he never held any position with Fujian and, evidencing his lack of motive to defraud Starr, reports that he received only a modest annual salary from CCME ($79,778) and was never compensated with equity in CCME or Fujian.
— Undisclosed Related-Party Transactions: Orient Paper
Undisclosed related-party transactions constitute the other major theme running through the spate of CRM lawsuits. Henning, et al. v. Orient Paper, Inc., et al., No. 10-cv-5887 (C.D. Cal.), is a prime example.26 This case concerns Orient Paper (OPN), a company purportedly engaged in producing and distributing paper products. The amended class action complaint alleges that: (i) OPN failed to disclose that its CEO had a 70% equity interest in OPN’s largest materials supplier, a company called Dongfang Trading (Dongfang); (ii) Dongfang is in fact a shell company with no assets or revenues, meaning that the millions of dollars of related-party transfers to Dongfang in fact went directly to OPN’s CEO; (iii) two of OPN’s purported “Top Ten” customers do not even exist and many others did not purchase the amounts of paper claimed by OPN; and (iv) OPN hired a tiny, “disbarred” firm from Utah called Davis Accounting to fraudulently conduct its legally-mandated public audit.27
As in Starr, the Orient Paper defendants have moved to dismiss the case.28 And, as in Starr, OPN claims to be the victim of aggressive short sellers. OPN states that it was approached in early 2010 by an American expatriate living in China named Carson Block. Mr. Block allegedly “offered to write and publish a positive research report on Orient Paper, in exchange for a large sum of stock and cash.”29 Orient Paper declined Mr. Block’s offer. A few months later, OPN was lambasted in a report authored by none other than Muddy Waters LLC. Mr. Block is alleged to be the principal of Muddy Waters and the OPN report his first publication. OPN claims that the Muddy Waters report caused a 13% single-day decline in its share price. OPN immediately hired independent auditors and law firms to investigate Muddy Waters’ accusations. These outfits reportedly concluded that the accusations were baseless. Furthermore, OPN argues that the claimed discrepancies in its financial statements are “the result of Plaintiffs incorrectly copying the actual reported figures that appear in those reports” and that OPN has never restated its financials. Moreover, OPN claims that it was not required to report purchases from Dongfang as a related-party transaction because OPN’s CEO sold his interest in Dongfang back in 2004. Finally, OPN asserts that Davis Accounting remains on PCAOB’s list of approved auditors (albeit under a different name), that a simple internet search reveals that all of OPN’s Top Ten customers do exist, and that none of those customers dispute the sales reported by OPN.
Interestingly, the same legal defenses are raised in Orient Paper as in Starr. Specifically, the defendants argue that the amended complaint fails to satisfy the heightened pleading requirements applicable to securities fraud cases, fails to point to specific alleged misstatements by each defendant, fails to raise allegations giving rise to a strong inference that the OPN defendants acted with scienter, and fails to plead loss causation.
The plaintiffs responded on April 28, 2011, standing by their allegations. The plaintiffs contend that Davis Accounting was “unlicensed” by the State of Utah, and therefore ineligible to conduct OPN’s public accounting; accordingly, OPN’s 2008 financial statements are considered unaudited and need to be restated. The plaintiffs further allege that OPN’s Chinese filings show that its CEO did not, in fact, dispose of his stake in Dongfang until August 2010, and that the purportedly independent “audit” was mere whitewash conducted by “investigation” firms rather than actual auditors. A hearing on the motion is set for July 11, 2011. Suffice it to say, CRM plaintiffs and defendants alike—not to mention the market—will be watching the Starr and Orient Paper cases closely to see how the courts rule on the pending motions to dismiss.
Another critical aspect of CRM cases is the availability and limits of the defendants’ D&O insurance coverage. This will be important both with respect to the defendants’ exposure above the policy limits and to the plaintiffs’ ability to negotiate meaningful settlements or collect judgments. For example, plaintiffs’ firms may not consider such suits worthwhile in the event the CRM companies carry meager D&O policy limits. Similarly, the policies may not be written to cover the initial public shell company, the pre-merger private Chinese company, and/or the surviving public company. The timing of the “wrongful acts” alleged in the complaints may also be important as it is possible that a D&O policy would cover only acts that occurred after the merger transaction took place.
Mary-Pat Cormier is a Partner and the co-Chair of the Coverage & Claims Practice Group of the Insurance and Reinsurance Department of EAPD. Greg Pendleton is an attorney in the Insurance and Reinsurance Department of EAPD.
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