Even though the story has been brewing
for months, the mainstream media and the SEC suddenly seem to have decided
that the alleged accounting frauds involving certain U.S.-traded Chinese
companies are the central story of the moment. You can hardly pick up the
business papers or turn on the television these days without encountering some
coverage of this issue. One problem with this sudden torrent of
coverage is that there are now so many items and events that it is easy to fall
behind. To make sure that everyone is on top of the latest, here is a round up
of the most recent news and developments about this continuing story.
Time to Hit Pause on the Litigation
Onslaught?: Plaintiffs' lawyers seem to be engaged in an
old-fashioned race to the courthouse in connection with each new Chinese
company swept up in this story. But when it comes to trying to litigate against
companies based in China, there arguably are some practical reasons to move
with greater deliberation, at least given problems that are likely to arise.
Here, I have in mind not only the distances involved and language barriers, but
even more basic issues - like service of process, for instance.
According to a June 15, 2011 ThompsonReuters News
& Insight article entitled "Plaintiffs Hit First Roadblock in China
Fraud Case," (here)
the plaintiffs in the Duoyuan Printing Inc. securities class action lawsuit
(about which refer here)
have not been able to effect service of process on five of the company's
current and former directors and officers named as defendants in the suit.
The plaintiffs lack the personal addresses for the individuals, who
reside in China. As the story notes, "serving individuals in China is an
arduous and costly process and requires a central Chinese authority to forward
any requests to local Chinese courts."
From the article's account of a recent hearing in the
case, it appears that there may be procedural alternatives available that could
help address this issue in that case. But even if plaintiffs in this and other
cases can overcome the service of process hurdle, there are other issues. As
the article notes, "plaintiffs face numerous obstacles, such as difficulty in
pursuing evidence-gathering in China and limitations on their ability to
collect judgments or legal awards."
This latter point, about the ability to collect any
awards, seems particularly salient. As this wave of accounting scandals has
unfolded, I have frequently wondered whether the plaintiffs' lawyers who are
now rushing into court will see any reward for their labors. Earlier securities
class action lawsuits filed against Chinese companies have hardly resulted in
any sort of massive bonanza. For example, earlier this week, NYSE-traded and
China-based agricultural company Agria Corporation announced (here)
that it had settled the securities class action lawsuit that had been filed
against the company, in exchange for a payment by the company's D&O
insurers of $3.75 million. While $3.75 million is a respectable sum, it does
raise the question whether, if that amount is representative of the settlement
range for these kinds of suits, these cases will wind up being worth it
for the plaintiffs' lawyers, given the practical, logistical and legal barriers
these cases entail.
Of course, the plaintiffs' lawyers intend to engage in a
for-profit enterprise, so they clearly must think these cases will prove worth
pursuing. We shall see. From what I have seen of the D&O limits that many
of these companies carry, it could all turn out otherwise.
The Role of the Auditors: In
a June 13, 2011 post on the New York Times Dealbook blog, Wayne State
University Law Professor Peter
Henning wrote an interesting column entitled "The Importance of Being
in which he examines the critical role the auditors have played in raising
questions about many of these companies. A problem that can arise when the
auditors raise questions or even resign is that the companies involved may
delay reporting these auditor actions. As Henning details in his column, these
delays have in some cases been substantial.
But while the auditors have served a key role identifying
many of the companies that have accounting concerns, some auditors have also
found themselves targeted for alleged complicity in the misstatements. As
detailed in a June 9, 2011 Reuters article entitled "Auditors Face Suits
Over U.S.-Listed Chinese Blowups" (here), recent
securities lawsuits involving Chinese companies have in some instances also
included the companies' auditors as defendants. Among the recent cases cited in
the article are those involving Puda Coal and China Integrated Energy.
Other case mentioned in which the auditors have been sued include those
involving China MediaExpress and Orient Paper.
In addition, the recent lawsuit
filed in Ontario involving Sino-Forest also named the company's auditor as a
defendant. In a June 9, 2011 New York Times article entitled "Troubled
Audit Opinions" (here),
Floyd Norris examined the role of Sino-Forest's auditor, the Toronto office of
Ernst & Young, in the accounting questions surrounding the company. On the
one hand, the audit firm issued a clean audit opinion. On the other hand,
serious questions have been raised in the media about Sino-Forest (see below).
Which, for Norris, raises question not just about the audit, but raises
questions about what investors realistically can expect from an audit, the
purpose of which is not necessarily to detect fraud.
As the questions swirl about the veracity of the Chinese
companies financial statements, fundamental questions about the reliability of
the financial statements are inevitable. Which in turn will lead to questions
about the auditors' role in the process, and to questions whether the auditors
were complicit in the financial misstatements.
Securities Analysts or Short-sellers?:
Many of the accounting concerns involving Chinese companies have come to light
through on-line postings by supposed securities analysts. But as I noted in an
earlier post (here),
some Chinese companies have gone
on the offensive, charging that the supposed analysis is really just an
attack job by financially motivated short-sellers seeking to undercut the
companies' share prices.
The most recent company to raise this assertion is
Sino-Forest, which has attacked Muddy
Waters Research, the financial analyst responsible for the first
report questioning the company's financial statements. The June 9 Floyd
Norris column I referenced in the preceding section specifically discussed the
role of Muddy Waters Research in the controversy surrounding Sino Forest.
Similarly, a June 9, 2011 Wall Street Journal article entitled
"'Backdoor' China Plays Under Fire" (here)
described the questions surrounding China Media Express, the questions about
which also first arose following the publication by Muddy Waters of a
report on the Internet raising concerns about the company's financial statements.
On June 9, 2011 the New York Times DealBook blog
ran an article entitled "Muddy Waters Research Is a Thorn to Some Chinese
describing Muddy Waters Research's founder, Carson C. Block, who is "delivering
a controversial message to investors enamored with Chinese companies: buyer
beware." The article cites critics of these kinds of firms, whom the critics
allege, are "rumor-mongering" because they hope to profit by shorting the
stocks of the companies they are attacking.
And the SEC Gets Into the Act: As
I noted in an earlier post (here)
, the SEC seems to have found itself once again in a reactive mode, this time
on the question of whether or not it is adequately protecting investors with
respect to the potential dangers of reverse merger companies. With the
onslaught of media coverage , the SEC is stepping forward, trying to assert
itself into the dialog and to establish that it is on patrol and looking for
For starters, on June 9, 2011, the SEC released an
Investor Bulletin (refer here)
cautioning investors about companies that entered the U.S. markets through a
"reverse merger" with a U.S. listed shell company. Among other things, the SEC
cautioned in its
press release regarding the Bulletin, that "investors should be especially
careful when considering investing in the stock of reverse merger
companies." The Bulletin also details enforcement actions the agency has
taken just since March 2011 against six companies that obtained their U.S.
listing through a reverse merger. These companies had either failed to maintain
current financial statements or questions had arisen about the accuracy or
completeness of the company's financial statements.
In addition, on June 13, 2011, the SEC announced (here) that it had
instituted proceedings to determine whether stop orders should be issued
suspending the effectiveness of registration statements filed by two companies
- China Intelligent Lighting and Electronics Inc. (CIL) and China Century
Dragon Media Inc. (CDM). The purpose of a stop order is to prevent a company or
its selling shareholders from selling their privately-held shares to the public
under a registration statement that is materially misleading or deficient. The
agency said that it initiated these proceedings after the companies'
independent auditor resigned and withdrew its audit opinions on the financial
statements included in the companies' registration statements.
A Final Comment: I
started this news roundup by saying that one problem with the torrent of
information is that it is getting hard to keep up. Another problem is that the
coverage is getting overheated. There are over 500 U.S.-listed Chinese
companies and the questions that have been raised so far have involved only a
small number of these companies. The problem is that the concerns are now being
generalized to all of the Chinese companies.
This very large group of companies is unfairly being
swept with the same broad brush. That is not only unfortunate from an
investment perspective, but also from a D&O insurance perspective. This has
turned into the classic contagion event, where every company in the entire
category is been treated as if it were plague-infested.
The media may now have switched to an "all China, all the
time" mode on this topic, but that does not mean that this story relates
to all U.S.-listed Chinese companies. A discerning underwriter that understands
the difference could profit from these circumstances.
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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