International Law

Fulbright & Jaworski L.L.P. Launches Task Force To Address Problems Facing Chinese Companies With U.S.-Traded Securities

By: Gerard G. Pecht, Jeffrey A. Blount, Stephen Mark Dollar, Peter Stokes and Mark Thomas Oakes

Fulbright Briefing

Chinese companies with securities traded in the United States are facing mounting scrutiny from U.S. regulators, plaintiff's lawyers, and short sellers. Fulbright & Jaworski L.L.P. has launched a task force to assist Chinese companies, as well as their directors, officers, affiliates, bankers, auditors, and insurers, with the numerous regulatory and litigation challenges arising from this increased scrutiny. With a substantial on-the-ground presence in Hong Kong and Beijing and a strong U.S. securities litigation and enforcement practice, Fulbright is uniquely situated to help Chinese companies navigate this increasingly challenging environment. 

U.S. Regulatory Enforcement

U.S. regulators have launched numerous enforcement actions against Chinese companies with U.S.-traded securities. Last week, the SEC announced the commencement of stop-order proceedings against two Chinese companies, China Intelligent Lighting and Electronics, Inc. and China Century Dragon Media, Inc., following the resignations of their outside auditors. The SEC previously filed enforcement actions against several other Chinese companies, including China Holdings, Inc., China Yuchai International, Heli Electronics Corp., China Changjiang Mining & New Energy Co., and RINO International Corporation. 

In addition, the SEC issued a June 9 bulletin warning investors about the risks of investing in Chinese companies that enter U.S. securities markets through reverse mergers, in which an existing U.S. public shell company acquires a private operating company. The Wall Street Journal reported in December that the SEC has launched "a wide-scale investigation" regarding the role of "U.S. accountants, lawyers, and bankers" in facilitating reverse mergers of Chinese companies, as well as multiple investigations of accounting practices at specific companies. The SEC confirmed in an April 27, 2011 letter to U.S. Representative Patrick T. McHenry that it has "launched a proactive risk-based inquiry into U.S. audit firms that have a significant number of domestic issuer clients with primarily foreign operations, including in the [People's Republic of China]," and that the Division of Enforcement made inquiries to several U.S.-based auditing firms in connection with foreign-based reverse merger companies. The SEC noted that after Enforcement made these inquiries, more than two dozen Chinese companies filed 8-Ks announcing accounting problems or auditor resignations. Many of those companies are now embroiled in shareholder litigation. SEC Chairwoman Mary Schapiro stated yesterday that the Commission is considering several options for regulating reverse mergers.   

In addition to the SEC, the NYSE and NASDAQ have also brought numerous enforcement actions against Chinese companies.  Earlier this year, the NYSE initiated suspension or delisting proceedings against NIVS Intellimedia Technology Group, Duoyan Printing, China Intelligent Lighting, and China Century Dragon Media. Nasdaq has likewise halted trading in ChinaBiotics, China Media Express Holdings, China Electric Motor, China Agritech, and Fuqi International. In addition, Nasdaq has proposed new listing requirements for reverse merger companies. It appears highly likely that additional SEC and stock exchange enforcement actions will be filed against Chinese companies in the months and years ahead. 

Shareholder Lawsuits

Private securities lawsuits are another major source of liability risk for U.S.-traded Chinese companies. Shareholder plaintiffs' lawyers have filed more than 20 securities class actions against China-based companies in the past 12 months, as well as numerous derivative suits. According to Cornerstone Research, securities class actions against foreign issuers with securities traded in the United States accounted for nearly 16 percent of all securities class action filings in the United States during 2010, which was among the highest rates ever observed. Suits against Chinese companies accounted for a substantial portion of these filings.

Recent class actions targets have included Longtop Financial, Puda Coal, Fushi Copperweld, Inc., and China MediaExpress, which were accused of filing inaccurate financial statements and/or failing to disclose related-party transactions.  Class action lawyers have also pursued U.S. companies with significant business operations or investments in China, including a recent shareholder suit against a leading U.S. digital media company alleging that the company misrepresented the value of its investment in a Chinese partnership.  Because securities class actions are driven by stock price declines, a moderation or slowdown of the Chinese economy could significantly increase the number shareholder suits by U.S. investors against China-based companies. 

Short Sellers

Short sellers are also aggressively targeting Chinese companies. As noted in a Reuters story last Friday, average short interests in U.S.-traded Chinese companies have increased sharply during 2011.  One of the companies cited by Reuters, AutoChina International Ltd., currently has more than 85 percent of shares available to be borrowed out on loan, up from just five percent in March. Chinese companies that have yet to file their Form 20-F with the SEC are drawing particular interest from short sellers, with the anticipation that some or many of these companies will be unable to meet the upcoming June 30 filing deadline. 

Chinese companies have also faced scrutiny from private websites affiliated with short sellers, including Citron Research and Muddy Waters. Citron, which touts itself as "the source that exposed Longtop Financial . . . and the first to write on China MediaExpress," recently launched a series of reports accusing another Chinese company, Harbin Electric, of making false statements in its SEC filings. Harbin's stock price declined sharply after Citron issued its reports, and several shareholder plaintiffs firms issued press releases last week trolling for potential plaintiffs to file suit. Many companies featured on these websites have experienced the same fate.  Earlier this week, Harbin announced that it has signed an agreement to be acquired by its CEO for $24 per share, which is more than three times greater than the share price immediately before the transaction was announced.  

Director and Auditor Liability

Regulators and private litigants are also targeting outside directors, bankers, and auditors.  Outside directors are frequently named as defendants in shareholder derivative suits for allegedly failing to exercise sufficient oversight. Directors who reside in the United States may be particularly attractive targets for plaintiff's lawyers due to difficulty of serving or collecting judgments against directors who reside in China. Securities lawsuits also create significant risks for D&O insurers. 

Regulators and plaintiffs lawyers have also targeted outside auditors that approved allegedly inaccurate financial statements.  While securities fraud class actions against auditors are frequently dismissed at the pleading stage, the Ninth Circuit recently reversed the dismissal of a Rule 10b-5 class action against an outside auditor that allegedly gave an unqualified audit opinion despite allegedly knowing that the company had engaged in options backdating. This opinion could embolden plaintiffs' lawyers to pursue auditors more aggressively in future cases.  In addition, as stated above, the SEC reportedly is probing the conduct of bankers and audit firms involved in Chinese company reverse mergers. Auditors may also be named in shareholder derivative suits and in actions by creditors' committees and bankruptcy trustees when the issuer becomes insolvent. 

Bottom Line: Fulbright is well positioned to guide Chinese companies and their outside directors and auditors through the minefield of U.S. litigation and enforcement activity. Led by partner-in-charge Jeffrey Blount, our Hong Kong and Beijing offices have substantial experience advising Chinese companies on cross-border transactions and their responsibilities under U.S. law.  Our firm has more than two decades of experience working in China. In addition, our acclaimed U.S. securities litigation and enforcement group, which is led by partners-in-charge Gerry Pecht and Rodney Acker, has extensive experience defending shareholder suits and counseling clients on minimizing future litigation risks. Please contact Jeffrey Blount (Hong Kong: +852 2523 3200; Beijing: +86 8513 5888) or Gerry Pecht (512-536-5287) if you would like further information. 


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