Chinese companies with U.S.-listed shares have come under attack this year. Short-sellers and Internet-based research analysts are leading the charge with reports challenging the credibility of these companies’ financial reporting and disclosures. Plaintiffs’ lawyers have taken up the cause and filed more than 30 securities fraud class action lawsuits in the United States this year against Chinese companies. And the U.S. Securities and Exchange Commission (SEC) is focusing its regulatory and enforcement attention on China-based companies listed in the United States. The pattern that played out in the United States during 2011 is now taking hold in Canada. Factors specific to Chinese companies are combining with a renewed emphasis generally on securities class action litigation in Canada. These forces already have led to the filing of a multi-billion dollar securities class action against Sino-Forest Corporation, a China-based forestry company. Following the pattern seen in the United States, other Chinese companies listed in Canada are facing similar challenges to their financial reporting and business ethics. There are several reasons to believe that in the months ahead more China-based companies listed in Canada will draw the scrutiny of short-sellers, regulators, and the plaintiffs’ securities class action bar.
A Year to Forget for Chinese Companies Listed in the United States
Hundreds of Chinese companies have listed securities on U.S. exchanges in the past several years to tap U.S. investors’ desire to own a piece of China’s economy. Many of these companies listed using a reverse merger process where a privately owned business merges into a publicly listed shell corporation. Following the merger, the name of the public shell corporation is changed and the private business is now a listed public company. As compared to an initial public offering underwritten by an established investment bank, the reverse merger process is a quick, easy, and inexpensive method for going public. The ease of listing, however, may contribute to the instances of alleged fraud or noncompliance by these companies, and the SEC and U.S. exchanges are beginning to modify the reverse merger listing process.1 During 2011, many China-based companies listed in the United States found themselves under attack from Internet-based short-sellers and online analysts dedicated to publishing negative reports and exposing instances of alleged fraud and financial mismanagement. Muddy Waters Research, LLC and Citron Research exemplify this new breed of investor and investigator, but others are launching similar offensives. Some market observers initially dismissed these Internet reports, but investors sold shares in the targeted companies, causing significant stock price declines. Efforts by corporate executives in China to rebut the allegations generally failed to restore market confidence. Regulators, auditors, and plaintiffs’ class action lawyers also were following developments closely. After an SEC initiative directed at the auditing of U.S.-listed companies with principally foreign operations, more than two dozen Chinese companies listed on U.S. exchanges reported the resignations of their auditors this year. Auditor resignations are a tremendous catalyst for securities litigation because they drive down stock prices and generate public filings that try to explain the reasons for the auditor’s resignation. A big-four auditing firm explained its resignation from a U.S.-listed Chinese company by claiming that company management threatened its audit staff if they tried to leave the company’s premises and then seized the auditor’s working papers.2 These public disclosures further undermined investor confidence and gave lawyers additional foundation for lawsuits. An SEC Commissioner acknowledged in April that, “[w]hile the vast majority of these Chinese companies may be legitimate businesses, a growing number of them are proving to have significant accounting deficiencies or being vessels of outright fraud.”3 The true extent of the problem remains unclear. It is hard to separate the facts from the hysteria. But the uncertainty, instability, and fear have generated a wave of securities fraud lawsuits against U.S.-listed Chinese companies. Most of the lawsuits follow publication of a negative Internet report and build on the claims originally made by the analyst or short-seller. These lawsuits often allege that the company’s auditor is unqualified, or was replaced or resigned due to disagreements with management. Other common allegations include: (1) misrepresentations about operations and assets, such as factory outputs, ownership of property, or customer relationships; (2) discrepancies in income or assets reported in SEC filings as compared with China State Administration for Industry and Commerce filings; and (3) undisclosed related-party transactions. The vast majority of these lawsuits remain in the preliminary stage.
The Same Patterns Are Emerging in Canada for Chinese Companies
By all indications, the pattern that has targeted Chinese companies in the United States is now developing in Canada. The operator of the Toronto Stock Exchange (TSX) and the TSX Venture Exchange claims listings for more than 50 Chinese companies with an aggregate market capitalization that has exceeded C$12 billion (US$11.6 billion). The reverse merger process is also popular in Canada, where 44 percent of the companies that went public in 2010 on the TSX Venture Exchange did so through a reverse merger.4 This is a target-rich environment for short-sellers and Internet research companies that have put publicly listed Chinese companies in the United States under intense scrutiny. Following the U.S. pattern, Muddy Waters already targeted Sino-Forest Corporation, a company that was once the largest publicly traded forestry company listed in Canada. Muddy Waters claimed that the Hong Kong-based company grossly overstated the extent and value of its forestry holdings in China and did not properly report and disclose transactions with related parties. And as the Sino-Forest case is proving yet again, it is particularly difficult for China-based companies to refute these allegations to the satisfaction of investors and regulators. Sino-Forest has struggled to satisfy skeptical investors and regulators that it controls hundreds of thousands of hectares of timber-land in rural China acquired through intermediaries and other transactions outside North American norms. The Ontario Securities Commission (OSC) promptly started to investigate Muddy Waters’ claims. In August, the OSC suspended trading in Sino-Forest shares and accused the company’s Chairman and CEO of participating in a possible fraud. The OSC called for the chief executive’s resignation, which he soon tendered. Sino-Forest’s auditors at Ernst & Young, however, have not resigned or signaled that they no longer stand behind the accuracy of the company’s audited financial statements. The auditor’s willingness to stand behind Sino-Forest’s financial statements is a somewhat unusual development in light of the pattern seen in the United States, where the intense pressure of such allegations has often compelled auditors to resign. In November, the Independent Committee of Sino-Forest’s Board of Directors issued a report that rejected and tried to refute the charges levied by Muddy Waters.5 Despite the comprehensive nature of Sino-Forest’s independent committee report, investors and regulators appear wary. Sino-Forest bonds continue to trade at deep discounts reflecting a lack of investor confidence, according to published reports.6 And in November, Sino-Forest confirmed that the Royal Canadian Mounted Police had opened a criminal investigation into whether the company defrauded investors.7 Muddy Waters triggered more than the OSC and Mounted Police investigations. Its report also was the impetus for a massive multi-billion dollar securities class action lawsuit filed in Ontario. Two Canadian investment funds represented by Milberg LLP, one of the most accomplished securities class action law firms in the United States, sued Sino-Forest, its officers and directors, Ernst & Young, and more than a dozen well-established financial institutions that served as underwriters for Sino-Forest’s 2007 and 2009 securities offerings. The Sino-Forest experience is not unique. Zungui Haixi Corporation, a China-based clothing and footwear company listed in Canada, is under investigation by the OSC. Following the U.S. pattern, the regulatory action in this case was prompted by the announcement that Zungui Haixi’s auditors had halted work on their audit due to unresolved issues with the company. The OSC suspended trading in Zungui Haixi shares and launched administrative proceedings against the company. According to the OSC staff allegations, Zungui Haixi representatives have failed to appear to contest the OSC charges.8 In addition to the regulatory action, a Canadian law firm announced that it filed a securities class action against Zungui Haixi.9 Another China-based company listed in Canada, Cathay Forest Products Corp., is the subject of both an OSC investigation and a securities class action lawsuit in Canada.10 Other China-based companies listed in Canada, including Migao Corp. and Silvercorp Metals Inc., have seen their share prices come under attack following speculative or anonymous challenges to their operations and financial reporting.11 Following the SEC’s example, the OSC initiated a regulatory review focused broadly on the listing of foreign-based companies in Canada and possible abuses of the reverse merger listing process.12 The environment in Canada for China-based companies is increasingly similar to the environment in the United States.
A Renewed Emphasis on Securities Litigation in Canada
Until recently, the United States was home to almost every international securities class action lawsuit. Its procedural and substantive rules, compared with those of other countries, are largely favorable to investors. Historically, U.S. courts were receptive to exercising jurisdiction over cases involving foreign companies and foreign shareholders so long as the alleged fraud had a sufficient effect on U.S. investors and markets. The U.S. Supreme Court’s June 2010 ruling in Morrison v. National Australia Bank Ltd.13 changed that practice. The decision has effectively closed U.S. courts to securities class action litigation involving shares traded on non-U.S. exchanges. Companies that list their shares only in Canada, for example, now have nearly complete immunity from lawsuits in the United States under federal securities laws. The Morrison decision forces investors to consider other venues for bringing international securities class action claims. Canada has emerged as one of those jurisdictions. Although each province in Canada imposes its own securities regime, Ontario—as home to the TSX, the nation’s most active exchange—is the primary Canadian jurisdiction for enforcing securities laws. Ontario’s class action proceedings statute has been in place for almost two decades, but in December 2005, the provincial government made significant amendments to the Ontario Securities Act (OSA). These amendments introduced a statutory right of action against issuers and related parties for misrepresentations in secondary market disclosures like annual reports, quarterly earnings filings, and press releases.14 The OSA also provides statutory rights of action for primary market misrepresentations in prospectuses, offering memoranda, and other disclosures related to direct offerings.15 The OSA’s rights of action do not require a showing that investors relied on the misrepresentation, and the OSA also does not preclude an investor from bringing a common law action based on negligent or reckless misrepresentation.16 Intended as a barrier to meritless suits, the OSA imposes unique procedural “leave” requirements for bringing secondary market misrepresentation claims under the statute. No action for secondary market misrepresentations can commence without leave, or permission, of the court.17 The court can grant leave when the action is being brought in good faith, and there is a “reasonable possibility that the action will be resolved at trial in favour of the plaintiff.”18 Significantly, the OSA imposes limits on the damages that can be recovered in cases involving misrepresentations in the secondary market. In the absence of deliberate fraud, damages in cases against individual company officers for secondary market misrepresentations are capped at the greater of C$25,000 (US$24,100) or 50 percent of the company officer’s compensation. The cap on damages is more generous for claims against the company. An issuer’s potential liability for secondary market misrepresentation claims is capped at the greater of C$1 million (US$965,000) or 5 percent of the company’s market capitalization.19 No damage cap exists for common law misrepresentation claims, but traditionally it has been difficult to certify these claims as class actions due to the individual reliance requirement. The OSA created new opportunities for securities class action litigation, but many questions about how the statute would be interpreted and applied remained unanswered. Then came Silver v. IMAX Corporation, a case where the Ontario Superior Court certified Canada’s first global securities class and articulated lenient procedural standards for allowing securities class action claims to proceed.20 IMAX held, for example, that individual reliance did not need to be established at the class certification stage for the common law misrepresentation claim. The court’s decisions make it easier for investors to secure the necessary leave to proceed with a secondary market claim under the OSA and also set a framework for certifying transnational investor classes that included common law claims not subject to the OSA’s limit on damages. IMAX is a reporting issuer with the OSC and listed shares on the TSX and NASDAQ. Although the representative plaintiffs were two Ontario residents who purchased IMAX shares on the TSX, they proposed to represent a global class, including all persons who acquired securities of IMAX on the TSX and NASDAQ during the class period.21 The complaint alleged a statutory claim under the OSA for secondary market misrepresentations, and common law claims of negligence, negligent and reckless misrepresentation, and conspiracy.22 In December 2009, the Superior Court issued two separate decisions in the case—one granted the plaintiffs’ motion for leave to proceed with its class action under the OSA, and the other certified the global class under Ontario’s Class Proceedings Act. Both decisions were viewed as highly favorable to investors and the plaintiffs’ securities bar. The IMAX case suggests that Ontario will prove to be a popular jurisdiction for investors to file international securities class action cases if there is some nexus to Canada. Canadian securities class action law remains unsettled, however. The decisions since IMAX have been few and mixed, and important questions about the jurisdictional reach of Ontario courts have yet to be resolved. This fluid environment, nonetheless, is likely to generate new case filings. Investors and plaintiffs’ class action lawyers want to test the OSA’s limits and build on the favorable IMAX decision. Global leaders in securities class action litigation, such as Milberg, have established a high-profile presence in Canada. Milberg’s move doubtlessly is intended to provide the firm a springboard for Canadian securities class action cases like the one against Sino-Forest.
The Signs Point to More Securities Litigation in Canada for Chinese Companies
Heading into 2012, Chinese companies with publicly traded shares in Canada face a challenging environment. Following the U.S. pattern, short-sellers and online research analysts are now targeting Chinese companies listed in Canada. The slightest hint of bad news or negative research can prompt substantial stock price drops for China-based companies. The OSC is following the SEC’s example and responding aggressively to credible allegations of fraud or auditor resignations. This is the perfect combination of factors to generate a wave of securities litigation against the dozens of China-based companies listed in Canada. The Sino-Forest case is the paradigm. These trends are unfolding in an environment where Canadian investors and class action lawyers are motivated to file new cases in order to shape the development of Canadian securities class action jurisprudence. Institutional investors and established plaintiffs’ law firms are seeking new forums for international securities litigation to replace or supplement the more limited access to U.S. courts. Canada’s proximity to the United States makes it a natural jurisdiction for expansion by U.S. plaintiffs’ law firms. Given this climate—and the pattern established against U.S.-listed companies—China-based companies in Canada are likely to become even more enticing targets for short-sellers, regulators, and plaintiffs’ securities class action lawyers.
Matthew Close is a partner in O'Melveny & Myers' Securities Litigation Practice and a member of the Firm’s China-Based US-listed Company Litigation Task Force. He has a diverse litigation practice with a major focus on representing corporations and their directors and officers in securities fraud, derivative, and breach of duty litigation, as well as in internal investigations and merger, acquisition, and asset sale disputes. Close is a recognized thought leader on securities litigation trends and a regular author and commentator on the globalization of securities litigation. Close is a highly sought out public speaker and a faculty member for the Practising Law Institute's Securities Litigation program.
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