Contributed by Paul R. Bessette, Mike Piazza, David M. Rhodes, and R. Adam Swick, Greenberg Traurig LLP
China is growing and its companies need capital. One way for a Chinese company to raise capital is by listing on a U.S. stock exchange. While this is not a completely new phenomenon, U.S.-listed Chinese companies have faced a dramatic increase in securities class actions and regulatory investigations in the past year and a half. In 2010, there were 12 securities class actions against Chinese companies—more than in any previous year. But, according to NERA, an economic consulting firm, in 2011 that number more than tripled to 39, representing approximately 18 percent of all securities class actions in 2011.1 This increase particularly is alarming because suits against all foreign issuers combined totaled only 11.4 percent of all securities class actions filed in 2010.2 The upswing in cases partially is accounted for by the increase in the number of China-based issuers in U.S. markets. But the surge is attributable more to relatively new concerns by U.S. regulatory authorities and shareholders that certain Chinese companies have accounting improprieties and/or ineffective internal controls. These concerns have arisen primarily because of recent delistings and the fact that numerous Chinese companies went public in the U.S. through "reverse mergers," a process that has been characterized as a "back door" and less credible method of going public. This article discusses Chinese companies' use of reverse mergers, potential U.S. regulatory actions and shareholder litigation that Chinese companies should be aware of, triggers for these risks, and how to minimize risk before and after a regulatory investigation or shareholder lawsuit has been filed.
In a reverse merger or reverse takeover, a private company gains control of a "shell" company listed on a U.S. stock exchange. The private company then merges into the listed shell company, allowing the combined entity to raise new capital while remaining on the stock exchange. The shell company is referred to as such because it is usually defunct, and does not have any operations, assets, or liabilities. Its value is merely in its listing. A reverse merger allows the private company to get a quick and inexpensive public listing while the listed company's shareholders obtain shares in a new and potentially successful company. There are two very legitimate procedural reasons to list by reverse merger as opposed to an initial public offering (IPO). First, the process can be completed much faster and much less expensively than an IPO. An IPO can take over a year to complete whereas a reverse merger can be accomplished in as little as a week. Second, a reverse merger avoids the time and cost involved with retaining an underwriter and preparing and filing a registration statement and prospectus. A reverse merger need be disclosed only through a U.S. Securities and Exchange Commission (SEC) Form 8-K. Many Chinese companies have begun using reverse mergers to gain access to U.S. capital markets. Brokers and other professionals from the U.S. actively have marketed listed, but defunct U.S. companies as reverse-merger candidates to Chinese companies. As a result, the Public Company Accounting Oversight Board found that 159 companies from the China region have conducted a reverse merger from January 1, 2007 to March 31, 2010.3 While reverse mergers are becoming more popular, the combined entity can sometimes become subject to manipulation and fraud. The advantages of a reverse merger—speed, cost, and lack of third-party and regulatory oversight—are also what make a reverse merger dangerous. It can allow a company to go public that otherwise could not because of cost or the inability to satisfy underwriter, investor, or regulatory inquiries. As stated by SEC Commissioner Luis A. Aguilar in a speech to the Council of Institutional Investors, a reverse merger "gives the formerly private company the credibility and access to capital of being registered as a public company, without any of the vetting from underwriters and investors that companies undergo when they perform a traditional IPO." 4 Unlike China or Hong Kong, a listing candidate is not vetted independently by U.S. regulatory authorities before being allowed to list. This is why Commissioner Aguilar refers to reverse mergers as "backdoor registration" as compared to the traditional IPO, which he calls "the gold standard."5 The perceived "back-door" nature of many Chinese companies' listings has contributed to an inherent distrust by regulators and private plaintiffs. This distrust, however, also has carried over to Chinese companies listed through the traditional IPO process, such as Longtop Financial Technologies Limited, which is facing regulatory and private shareholder litigation.6
Regulatory Investigations and Private Shareholder Litigation against U.S.-Listed Chinese Companies
Increased investment by U.S. investors in U.S.-listed Chinese companies has led to heightened concern by a number of regulatory agencies, primarily the New York Stock Exchange (NYSE), NYSE Amex, the National Association of Securities Dealers Automated Quotations (Nasdaq), and the SEC.
— Major U.S. Exchange Markets
NYSE, NYSE Amex, and Nasdaq generally halt, suspend, and eventually delist a company's stock when they suspect foul play or when a company simply refuses to meet their disclosure requirements. As of September 2011, approximately 26 Chinese companies have been delisted from U.S. exchanges, including Fuqi International (FUKI), China Agritech (CAGC), China Media Express Holdings (CCME), Jiangbo Pharmaceuticals, Inc. (JGBO), China Integrated Energy, Inc. (CBEH), Duoyan Printing (DYNP), and Longtop Financial Technologies (LFT). With the approval of the SEC on November 8, 2011, the exchanges have adopted new rules that toughen the standards all companies going public through a reverse merger must meet to become listed on those exchanges.7 Under the new rules, a reverse-merger company cannot apply to list on an exchange until the company has (a) completed a one-year "seasoning period" during which the company traded in another market, such as the U.S. over-the-counter market, or a foreign stock exchange following the reverse merger; and (b) filed all required reports with the SEC, including audited financial statements. A company also must maintain the minimum share price for at least a 30-60 day period immediately before its listing application and the exchange's decision to list. Among the reasons given by the exchanges for these new rules was the recent widespread allegations of fraudulent behavior by Chinese companies that have gone public through a reverse merger and the consequent concern that their financial statements cannot be relied upon. In fact, Nasdaq stated on its website that it is "aware of situations where it appeared that promoters and others intended to manipulate prices higher to satisfy Nasdaq's initial listing bid price requirement."8
— The SEC
With the increased concern over U.S.-listed Chinese companies, it comes as no surprise that the SEC has stepped up its investigations into Chinese companies listed on U.S. stock exchanges and in particular those that listed by a reverse merger. In September 2010, the Financial Services Committee of the U.S. House of Representatives sent a letter to the SEC questioning the lack of rigor in auditing Chinese companies.9 The SEC responded by stating that it had created an internal task force to investigate fraud in overseas companies with listings on U.S. stock exchanges, with emphasis on companies engaging in reverse mergers to achieve "backdoor SEC registration."10 According to a May 2011 statement by Howard Scheck, the Chief Accountant of the SEC’s Enforcement Division, the SEC is keeping a close watch on filings by reverse-merger companies, particularly where such companies' auditors have resigned and there are allegations about inability to confirm cash balances or customers.11 One SEC Commissioner even has asserted that "[w]hile the vast majority of . . . [U.S. listed] Chinese companies may be legitimate businesses, a growing number of them are proving to have significant accounting deficiencies or being vessels of outright fraud."12 In the wake of accounting questions and investor losses at some Chinese companies, the SEC issued a public Investor Bulletin this summer that warns investors about the risks of investing in companies that have gone public by reverse merger.13 Following this warning, the SEC has more actively initiated formal investigations as well as informal inquiries of Chinese companies for accounting violations and lax auditing practices. As a result, since March 2011, more than 24 Chinese companies have filed public disclosures announcing auditor resignations and accounting problems.14 Many of these disclosures concern issues regarding cash and accounts receivables, and auditors' difficulties in confirming these amounts. Beyond initiating investigations and inquiries, the SEC also has suspended trading in multiple Chinese companies, including Rino International, China Changjiang Mining and New Energy, and Heli Electronics. Further, the SEC has revoked the securities registration of at least eight Chinese companies that became U.S. issuers through reverse mergers for failure to make required periodic filings that contain information of critical importance to U.S. investors. One of the SEC’s powerful new enforcement tools is its enhanced "whistleblower" program, which gives current and former employees and other insiders a financial incentive to report perceived securities violations directly to the SEC.15 If a whistleblower provides original information to the SEC that contributes to it obtaining monetary sanctions of $1 million or more, then the whistleblower will receive 10-30 percent of the sanctions (a minimum of $100,000). Many would-be whistleblowers are taking advantage of this bounty. In an annual report on the program, the SEC stated that between August 12 and September 30, 2011 the SEC received 334 tips, including 10 tips from China, which was the largest foreign-country source of tips.16 This program already has been funded by the U.S. Congress and the SEC has set up an entire new group dedicated to administering it, suggesting that this program likely will become a major tool in the SEC's enforcement arsenal. The SEC also has started to use wiretaps of telephone conversations in its enforcement efforts. For instance, billionaire hedge fund manager Raj Rajratnam was recently convicted—based in part on recordings of his conversations with traders and corporate executives—of 14 counts of criminal securities fraud relating to insider trading. He was sentenced to 11 years in prison.
— Private Shareholder Litigation
Besides regulatory action from the NYSE, Nasdaq, and SEC, Chinese companies and their officers and directors have been subject to private securities litigation (that is, suits by individual holders of the Chinese company's shares). There are two main types of actions brought against Chinese companies. First, there is the class action for violations of the federal securities laws. Class actions have had the most impact, by far, on Chinese companies listed on U.S. stock exchanges. As noted above, securities class actions against Chinese companies rose dramatically in 2011—accounting for approximately 18 percent of all securities class actions—while last year suits against all foreign issuers combined accounted for only about 11 percent of securities class actions. Second, there is the shareholder derivative suit, which is brought under a particular state's laws by one or more shareholders acting on behalf of the corporation against the corporation's officers and directors primarily for breaches of fiduciary duty. The most common allegation in these suits is that the company reported higher revenue and profit to the SEC than to Chinese authorities. To date, no defendant has argued that reporting lower figures to the Chinese government is not a securities law violation in the United States. Other common allegations include improper reporting of bank balances, receivables, revenues, and related-party transactions, as well as a general lack of internal controls.
Triggers for Regulatory Investigations and Private Shareholder Litigation
Chinese companies can attract the notice of regulatory authorities or shareholders in a number of ways. One main trigger is when an auditor discovers fraud, forgery, or other discrepancies. This usually results in the auditor's resignation or termination, and a publicly-filed document announcing the reasons for the resignation. Another trigger for lawsuits is when independent third parties or short sellers announce an "investigation" of a company. A good example of a short seller triggering a lawsuit is the case of Henning v. Orient Paper, Inc.17 The research group Muddy Waters issued a report on Orient Paper, Inc. indicating that the company's U.S. financial statements overstated its revenue by 2,700 percent and the value of its assets by 200 percent, as compared with the company's filings in China. Shortly thereafter, shareholders filed a lawsuit based almost entirely on the information contained in the report. Short-seller reports must be taken with a grain of salt. A short seller, by definition, is a trader that sells borrowed shares on speculation that the price will drop and the stock can be replaced at a much lower cost. Thus, short sellers, while sometimes providing valuable data and insight, sometimes purposefully try to lower a stock's value. On its website, Muddy Waters proclaims to "see through appearances to a Chinese company's true worth" based on a blanket statement that the value of Chinese companies on U.S. stock exchanges are inflated to levels greater than reality.18 In addition to triggering attention from regulators and private plaintiffs, short sellers also can have a devastating effect on a company's stock price. For example, according to a Bloomberg article, a Muddy Waters report on Sino-Forest Corp.—a Chinese commercial forest plantation operator—wiped out $3.25 billion in market capitalization in only two days.19
Given the increased negative attention on U.S.-listed Chinese companies, directors and officers of those companies should ensure that they are using the best possible corporate practices to prevent any type of action from succeeding. Common strategies include:
Directors and officers also should make sure that their company has procured appropriate directors' and officers' insurance. A top-tier insurance broker can help identify and obtain adequate insurance. Once a regulatory action is initiated or a lawsuit is filed, a company and its directors and officers, should take swift action. U.S. securities litigation counsel should become involved immediately. If allegations are made regarding the company's reverse merger or IPO, then it is wise to involve a law firm separate from the one that handled the company's reverse merger or IPO. Further, a company should begin preserving documents immediately since destruction of any relevant materials could subject the company to greater scrutiny than the investigation or lawsuit itself. It also is wise to quickly retain a prominent investor relations firm to advise on any public statements. Chinese companies have taken varying paths in responding to events that frequently trigger investigations and lawsuits. Some have settled immediately. But others have fought back to preserve stock value. For example, in June 3, 2011 Allen Chan, Sino-Forest’s CEO, issued a public release calling the Muddy Waters negative research report on the company "inaccurate and unfounded" as well as "self-interested."20 Sino-Forest also started an internal investigation and opened up a data room overnight to investors to show the authenticity of its operations as well as offering securities analysts tours of its Chinese tree plantations.21 Similarly, Deer Consumer Products, Inc. also chose to strike back at short sellers issuing negative reports about the company by vehemently refuting the allegations in press releases and filing a libel lawsuit in the Supreme Court of the State of New York to "defend itself and its shareholders against illegal short selling and market manipulation."22 While press releases from a company refuting negative allegations, internal investigations, and lawsuits against short sellers that have issued negative reports or firms that have redistributed such reports may help preserve stock value in the short term, they generally will not stop regulatory investigations or private lawsuits, both of which frequently come hard on the heels of negative allegations. Consequently, in generating these kinds of responses, a company should consider the almost inevitable upcoming investigations and lawsuits and involve securities litigation counsel.
While perhaps not completely warranted, the bottom line is that there is a huge increase in negative attention on Chinese companies that have listed on U.S. stock exchanges. Not only are Chinese companies' practices being questioned, but so too are the laws and regulations governing how Chinese companies become public in the United States and are monitored. Many Chinese companies now subject to intense scrutiny were introduced to the reverse-merger backdoor by U.S. broker-dealers and other professionals that emphasized the speed, ease, and low cost of entering the U.S. capital markets without also emphasizing the strictness of regulatory controls that come with the entry ticket. Chinese companies and their officers and directors are learning quickly both the advantages and disadvantages of listing on a U.S. exchange and in developing their corporate, auditing, and legal practices.
Paul Bessette serves as Co-Chair of the firm's Securities Litigation Group. He has a national securities litigation practice with clients ranging from established Fortune 100 companies to the newly public. Paul has been lead counsel in scores of cases nationwide, defending companies, officers and directors, underwriters, and accountants in shareholder class action lawsuits, derivative litigation, Securities and Exchange Commission (SEC) proceedings, M&A litigation, and other complex commercial litigation. He also has experience in litigation involving breaches of fiduciary duty and representing board committees in various types of corporate investigations. Paul can be reached at 877.557.7250 or email@example.com.
Michael Piazza is a Shareholder in GT's Orange County office. He focuses his practice on securities and white collar litigation, business litigation, and complex commercial litigation. Mike regularly handles the defense of individuals and companies faced with allegations of wrongdoing asserted by U.S. regulators (SEC, CFTC, FTC), the U.S. Department of Justice, state attorneys general, and foreign regulators. He is experienced with internal SEC policies concerning the Federal Corrupt Practices Act, as well as the SEC's perspective on FCPA compliance programs. Mike can be reached at 949.732.6568 or firstname.lastname@example.org.
Adam Swick is an Associate in GT's Austin office. He focuses his practice on securities litigation matters as well as internal investigations and regulatory enforcement actions. Adam has been involved in several recent securities cases, proceedings, and investigations involving Chinese companies listed in the U.S. He also has wide-ranging experience representing Asian companies in matters related to bankruptcy, international insolvency proceedings, reorganizations, and creditor's rights. Adam can be reached at 512.320.7233 or email@example.com.
David Rhodes is an Associate in GT's Orange County office. His practice focuses on securities and complex commercial litigation and arbitration for U.S. and international clients. He has represented clients in matters involving claims of securities fraud, breach of fiduciary duty, breach of contract, negligence, FTC Act violations, and unjust enrichment as well as in internal and governmental investigations. David can be reached at 949.732.6581 or firstname.lastname@example.org.
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