Are Short Sellers Fabricating the Accounting Fraud Allegations Involving U.S.-Listed Chinese Firms?

Are Short Sellers Fabricating the Accounting Fraud Allegations Involving U.S.-Listed Chinese Firms?

The wave of new securities class action lawsuits involving accounting scandals at U.S-listed Chinese firms is already a well-established phenomenon. But in the latest twist on the tale, Deer Consumer Products, one of the U.S.-listed Chinese companies most recently sued based on allegations of accounting fraud, has gone on the warpath and is publicly alleging that the lawsuit against the firm is part of an elaborate scheme by "illegal" short sellers to manipulate the company's share price. And according to press reports, a different  Chinese firm that also  has been hit with a lawsuit also have raised the question whether short sellers might be behind the accounting fraud allegations.

The latest story involving Deer Consumer Products began on April 30, 2011, when plaintiffs' lawyers announced in a press release that they had filed a securities class action lawsuit in the Central District of California against the company and certain of its directors and officers. Among other the plaintiffs' attorney's press release states that:

Deer misrepresented its financial performance, business prospects, and financial condition to investors, citing inconsistent Chinese regulatory filings. The Complaint also alleges that Deer improperly recognized revenue in violation of Generally Accepted Accounting Principles ("GAAP"). On March 9, 14, and 17, 2011, analyst Alfred Little issued a series of reports disclosing defendants' alleged fraud, which caused the stock price to drop, damaging investors.

On May 2, 2011, Deer Consumer Products issued its own  press release (here) in which the company asserted that it has "evidence of continuing illegal short selling" in its stock, and also  asserted that its "common stock has been manipulated in collusion among 'naked' short sellers." The press release goes on to assert that the class action lawsuit itself is "part of the attempted manipulation."

Now, it is nothing new for companies to assert that the bad news circulating about them is based on rumors from profit-motivated short sellers. But the Deer Consumer Products takes this common gripe quite a bit further. The company asserts that the supposed analyst, Alfred Little, whose reports are the source of the rumors and are relied on in the complaint is "a fictitious character" whose phony identity is "a disguise used by one or more illegal short sellers in the short sale scheme." The purported reports of Alfred Little were "published in collusion with short sellers" to "intentionally create fear in the general public to drive down DEER's share price."

The press release goes on to assert that all of the allegations in the supposed Alfred Little reports are false and that the company intends to seek sanctions against the law firm that filed the lawsuit.

Deer is not the first U.S.-listed Chinese company to charge that the allegations of accounting fraud originated with short sellers. U.S. shareholders in another U.S- listed Chinese company that has also been hit with a securities class action lawsuit, China Agritech, are also alleging that stories circulating about the company and that are behind the lawsuit are the result of the actions of short sellers. (Background on the China Agritech lawsuit can be found here).

A very interesting April 26, 2011 Bloomberg article entitled "Wall Street Scion Lost in China Agritech as Shorts Cry 'Scam'"(here) contains the allegations of one U.S. investor in China Agritech that "someone blatantly lied to short the stock." The U.S. investor, Jesse Glickenhaus, troubled by an analyst's report that the company was a scam with no real operations, went to China himself and toured company facilities with company executives, to verify the existence of claimed business operations and facilities.

Or at least Glickenhaus thinks he toured company facilities. In yet another twist to the story, after Glickenhaus published his account of his Chinese factories tours on his own investment company's website, other short sellers  asserted that Glickenhaus  had been duped, and that rather than touring the company's factory, Gliockenhaus had been taken to a state-owned plant at a different address than the one listed in China Agritech's filings.

With all of these levels of confusion and disinformation, it is hard to tell who is scamming whom and what version of the truth actually corresponds to reality. Are the Chinese companies scamming investors by misrepresenting their true financial condition? Or are investors being misled by short sellers who have an incentive to cast doubt on the companies and drive down the share price?

You do start to wonder why any investors would invest in U.S.-listed Chinese companies. The Bloomberg article about Glickenhaus provides some of the answers. Glickenhaus is the 29-year old grandson of his investment firm's founder, who invested in China Agritech without even knowing that the company had obtained its U.S. listing through a reverse merger. He seemed particularly persuaded by the fact that the Carlyle Group had previously invested in the company.

Even if he was not duped during his recent China visit about China Agritech's operations, Glickenhaus seems like a remarkably uncritical investor. He remains committed to the company and to his investment even though the company has fired two auditors in four months and still has not filed its 2010 financial data. Carlyle's representative on the company's board has also resigned.  Glickenhaus does concede that "in the future, if I find a company in China, I'll probably stick to those that have had a major, well-known auditor for several years." 

Whether the accounting fraud allegations have substance or are the product of short-sellers' profit-motivated imaginations, it is clear that the existence of the allegations is continuing to drive securities class action litigation against U.S.-listed Chinese companies. In addition to the new lawsuit against Deer, plaintiffs' lawyers have in the last week and a half also filed lawsuits against these other U.S.-listed Chinese companies: Gulf Resources (refer here); ZST Digital Networks (refer here); and SkyPeople Fruit Juice (refer here). Interestingly, the same law firm that filed the Deer lawsuit filed these three others as well.

Another U.S.-listed company with its fish farming operations in China but its headquarters in Washington State, HQ Sustainable Maritime Operations, was also hit with a securities lawsuit last week (refer here).

With the arrival of these latest lawsuits, a total of 19 new securities class action lawsuits have been filed against Chinese companies so far in 2011. That is out of a total of about 79 lawsuits  this year, meaning that the China-related lawsuits represent about one-quarter of all2011 YTD  class action securities lawsuits. That is on top of the ten lawsuits that were fled against Chinese companies in 2010.

Signs are that there are more lawsuits yet to come, as well. Plaintiffs' firms have issued press releases that they are investigating other China-linked companies, including Longtop Financial (refer here) and Sino-Clean Energy (refer here). Interestingly, the press release announcing the Sino-Clean investigation was issued by the same law firm that filed the Deer lawsuit described above, and the press release also references an analyst report by Alfred Little (the same analyst whom Deer claims is fictitious).

In addition to the securities class action lawsuit describe above, investors have also filed at least one shareholder derivative recently involving a Chinese company. On April 27, 2011, plaintiffs filed a derivative lawsuit in the District of Wyoming against Duoyuan Printing, as nominal defendant, and certain of its directors and officers, alleging that the individuals breached their fiduciary duties b, among other things, issuing false and misleading statements regarding the company's financial results. A copy of the complaint can be found here. The company itself is a Wyoming corporation with its principal place of business in China.

An April 4, 2011 speech by SEC Commissioner Luis Aguilar (here) reported that there were 150 reverse merger transactions between 2007 and the present in which Chinese companies merged with U.S.-domiciled shells to obtain a listing on a U.S. exchange. I am sure not all of these 150 companies have accounting problems (or will otherwise be targeted by short sellers). But I am guessing that before all is said and done, a lot more of them may wind up as defendants in class action lawsuits filed in U.S. courts.

In any event, it does seem like the SEC is finally getting around to doing  something about all of this. On April 29, 2011, the SEC announced (here) that it had halted a Ponzi scheme involving China Voice Holding Company in which company officials were using proceeds from later offerings to pay off those who invested in earlier offerings.

Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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