The Rise (and Fall?) of Chinese Reverse Merger Litigation, Contributed by Pamela L. Signorello, Troutman Sanders LLP
Over the past year and a half, anyone paying attention to the ever-changing landscape of securities litigation has witnessed a dramatic rise in the number of cases involving “Chinese reverse merger” companies. Quite understandably, what appear to have caught the attention of the plaintiffs’ bar are the often dramatic discrepancies in the financial figures presented in the reverse merger companies’ U.S. and China-based filings. Unfortunately for such companies and their directors and officers (and insurers), even the more recent influx of information into the market offering a seemingly “innocent” (non-fraud-based) explanation for the discrepancies has done little to quell the litigation fervor. Indeed, plaintiffs likely are only emboldened by the first decision recently issued on a motion to dismiss such litigation, in which the court credited at the pleading stage allegations derived almost exclusively from an admitted short seller concerning such discrepancies. Meanwhile, triggering those insurance coverage defenses typically applicable to cases involving fraudulent financials―most notably, rescission and fraud exclusions―may require more than the existence of these disparate financial statements alone. Ultimately, the practical considerations involved in litigating these claims may go the farthest in shaping reasonable (and early) settlements.
Effecting a Reverse Merger
In a “reverse merger,” a private company seeking access to the U.S. capital markets merges with an existing public “shell company.” Although the public shell company survives the merger, typically the private operating company’s management takes over the Board of Directors and management of the public shell company. A reverse merger often is perceived as being a quicker and cheaper method of “going public” than an initial public offering (IPO); the legal and accounting fees associated with a reverse merger tend to be lower than for an IPO, and there are no registration requirements under the Securities Act of 1933, as there would be for an IPO. A company engaging in a reverse merger transaction effectively “goes public” much like in an IPO, but with less of the expense and little of the scrutiny.1
Comparing Apples to Dragon Fruit
Of course, once a reverse merger company’s securities are listed and traded on a U.S. exchange, the listed company must comply with the exchange’s rules and the federal securities laws. For previously private and foreign-based companies unaccustomed to the rigors of such requirements, achieving such compliance can be a formidable challenge. Among other things, these fledgling public companies must act quickly to identify adequate outside auditing resources and to establish and maintain effective internal controls over financial reporting. Those reverse merger entities that fail to achieve compliance may have their trading suspended by the U.S. Securities and Exchange Commission (SEC), as numerous such companies have experienced in recent months, or have their securities registration altogether revoked.2
The trouble for some of these companies does not end with expensive regulatory investigations and enforcement actions. Nearly forty U.S.-listed Chinese companies have come under fire in the context of private securities class action (and attendant) litigation over the past year. Prominent among the allegations in such litigation is the assertion that the reverse merger entity filed discrepant financial statements with the SEC and China’s State Administration for Industry and Commerce (SAIC). At first blush, such discrepancies―which invariably involve SEC filings that, in comparison to the SAIC filings, present a much inflated version of the company’s financial soundness―have the makings of a veritable field day for U.S. securities and derivative plaintiffs (and a minefield for the company and its accountants). Often urged on by scathing reports issued by short sellers seeking to profit from an anticipated Chinese economic boom-turned-bust scenario, plaintiffs have taken wide-eyed notice of these discrepancies. Except that plaintiffs employ a less accommodating word for such discrepancies: fraud.
What has yet to play out fully in this new wave of litigation, though, is one much anticipated defense to these claims. In recent months, investment analyst and other reports have offered “innocent” explanations for the discrepancies, arguably dampening the initial appeal of this otherwise alluring feature of the litigation. According to these reports, the discrepancies, in and of themselves, do not render false the SEC filings under attack. Rather, a contextual review of a company’s SEC and SAIC filings is required in order to appreciate that the divergence of U.S. and China-based filings does not, without more, establish error, misstatement or fraud in a company’s U.S. GAAP financials. Specifically, it is explained, the SAIC and its local arms (referred to as “AIC”) are the Chinese government agencies responsible for business registration and supervision of corporations.3 Effectively functioning as the Chinese equivalent of an Office of the Secretary of State at the state level in the United States,4 the AIC’s main purpose is to receive and coordinate public filings of articles of incorporation, amendments, ownership, etc.5 Because the AIC is primarily concerned with corporate registration issues rather than operating data, it does not audit or verify the financial statements submitted with companies’ annual filings.6
In light of the primary role and function of the AIC, which differ dramatically from those of the SEC, many Chinese companies submit inaccurate (typically understated) financial information to the AIC. This purposeful (and apparently widespread) practice of underreporting profit in AIC filings avoids disclosing a company’s operating metrics to its customers, suppliers and competitors.7 (In apparent recognition of the weakness of the financial statements submitted with the AIC filings, China recently raised the standards of its AIC filing requirements.)8 The discrepancies in the SEC and AIC filings are further explained with reference to the different accounting standards applied in the two jurisdictions. The financials submitted to the AIC are based on Chinese accounting methods and standards, which can differ widely from the U.S. GAAP standards for financial reporting on which SEC filings must be based.9 Additionally, while SEC filings include consolidated worldwide data, AIC filings only reflect business activities of the company within China, and no consolidated financial statements exist for a holding company in China.10
Playing Out In Court
Under this contextual approach, a company’s China-based filings should have little, if any, relevance to the credibility of its SEC filings. Nonetheless, at least for now, variances in these filings have piqued the interest of securities and derivative plaintiffs alike and continue to be exploited in inflammatory short seller reports. (Notably, however, while securities lawsuits involving U.S.-listed Chinese companies comprised nearly 21 percent of securities lawsuits filed in the first nine months of this year, the third quarter saw such lawsuits comprising only 12 percent of new lawsuits filed. This reduction in the rate by which such lawsuits were filed in the third quarter of 2011 may indicate that the tide already has begun to turn on these matters.)
While it remains to be seen how these cases will fare for plaintiffs beyond the pleading stage, at least the first reported decision on a motion to dismiss securities litigation involving a U.S.-listed Chinese entity has proven plaintiffs’ initial litigation investment potentially worthwhile. On July 20, 2011, the U.S. District Court for the Central District of California denied defendants’ motion to dismiss in Henning v. Orient Paper, Inc., et al.11 In that decision, the court deemed it inappropriate to resolve at the pleadings stage the truth of a short seller’s report, which featured prominently in the complaint and challenged the accuracy of the company’s reported revenues based primarily on a comparison of its SEC and SAIC filings. The court rejected defendants’ argument that the company’s independent investigation determined no evidentiary basis to question its reported revenues and customers, noting that the “investigation was conducted by [the company’s] own audit committee, with no public or signed statement by any of the outside firms [it] hired to assist it in its efforts.”12 The court also determined that loss causation was adequately pled. In this connection, the court rejected defendants’ argument that the complaint failed to plead loss causation where the alleged stock price drop was “not caused by any action of any defendant but instead by the publication of unsubstantiated rumors by Muddy Waters.”13 The court found sufficient for purposes of pleading loss causation plaintiffs’ allegation that their losses stemmed from the revelation of the alleged fraud in the short seller’s report. Specifically, the court noted the $4.22 stock price drop that followed issuance of the June 28, 2010 Muddy Waters report “bringing to light various alleged frauds” at the company.14
More recently, on October 6, 2011, the U.S. District Court for the Southern District of New York granted defendants’ motion to dismiss in In re China North East Petroleum Holdings Ltd. Securities Litigation.15 However, that case was dismissed on loss causation grounds based on the atypical stock price movements following the disclosures at issue. Specifically, the court in China North determined that the plaintiff had not suffered any economic loss where it held stock whose post-disclosure price had risen above the purchase price, after having initially fallen following the alleged corrective disclosures. According to the court, “[a] plaintiff who forgoes a chance to sell at a profit following a corrective disclosure cannot logically ascribe a later loss to devaluation caused by the disclosure.”16 In light of the unique circumstances of the China North matter, the decision arguably offers little, if any, insight into the “trend” these motions ultimately may take.
If the Orient Paper decision is any indication, plaintiffs in some of these cases will get past the motion to dismiss stage―and, therefore, quite possibly to a seat at the settlement table―based on allegations largely rooted in short seller reports highlighting discrepancies between SEC and SAIC filings. While the novelty of these cases makes it too soon to tell whether the companies’ insurers (assuming the companies even have directors and officers (D&O) coverage) will enjoy similar “success” invoking coverage defenses in the context of the same discrepant financials, the likelihood is that it will take more. After all, the majority of modern day fraud exclusions require a final adjudication of fraud (often in the underlying action itself), which may be unlikely to occur based on the disparate financials alone (and particularly by the settlement stage). Insurers seeking to deny coverage under an arguably less stringent “in fact” fraud exclusion also may be hesitant to do so based solely on such disparate financials. Additionally, even those jurisdictions that do not impose an intent requirement on a rescission claim require at least the establishment of a material misrepresentation―an element not necessarily satisfied with reference to these discrepant financials alone.
Of course, where most of these reverse merger cases involve companies with no history of compliance with U.S. securities laws and accounting rules, as well as management with no experience operating a public company, it is not hard to envision a landscape ripe for coverage exploration. Whereas discrepant financials alone may not suffice to trigger coverage defenses, certain of these fledgling public companies inexperienced with U.S. GAAP compliance and adherence to U.S. securities laws may indeed have run afoul of important expectations and legal requirements. As the SEC recently observed:
some of the foreign companies that access the U.S. markets through the reverse merger process have been using small U.S. auditing firms, some of which may not have the resources to meet its auditing obligations when all or substantially all of the private company’s operations are in another country. As a result, such auditing firms might not identify circumstances where these companies [may] not be complying with the relevant accounting standards.17
Additionally, it is at least foreseeable that certain D&O insurers may have relied on the accuracy of an insured’s China-based financial filings in underwriting coverage, arguably opening up rescission as a potential defense to coverage. As Tao Li, Chairman and CEO of China Green Agriculture, Inc. recently commented publicly: “We knew we were giving the correct numbers to the SEC. . . . Now, we also recognize that as a public company, to the extent that U.S. investors may consider SAIC filings, those filings must also be compatible to . . . those we provide to the SEC.”18
In light of the massive defense cost exposure potentially associated with the regulatory investigations and proceedings of, and securities and derivative litigation against, reverse merger entities, D&O insurers undoubtedly will be highly motivated to investigate the potential applicability of coverage defenses to these matters.
Despite class plaintiffs’ apparently wide appetite for these claims as of late, it remains to be seen how they ultimately will fare once the first wave hits the settlement table. Although many such cases presumably will have survived a motion to dismiss by that stage, plaintiffs are likely to be faced with some real challenges to consider at settlement. For one thing, many may encounter a severely underinsured (or altogether uninsured) company. The inconvenient reality that any judgment ultimately achieved in the U.S. litigation would be unenforceable in China may serve to further temper plaintiffs’ settlement expectations, particularly in cases involving defendants with little or no U.S.-based assets.19 (Of course, there is the additional matter of plaintiffs’ ability to effect service on a company’s Chinese-based directors and officers in the first place. Plaintiffs in the Duoyuan Printing, Inc. securities lawsuit have been unable to effect service of process on several of the directors and officers named as defendants in that case.)20 For example, in Perry v. Duoyuan Printing, Inc., the court refused to allow service of process through Duoyuan’s U.S.-registered agent because the plaintiffs had not yet first attempted service through the Hague Convention. Additionally, the geographic distances and language differences invariably involved in these cases could cause litigation expenses to significantly erode any available insurance―not to mention plaintiffs’ own litigation coffers―the longer the litigation takes to get to settlement. These economic realities, together with the potentially shaky factual underpinnings of these Chinese reverse merger lawsuits may help to explain the recent slowdown of these filings. At minimum, the unique features to this latest breed of securities action undoubtedly will factor into the strategic considerations and decisions made by the parties at each stage of the litigation.
Pamela L. Signorello has experience in insurance coverage matters arising nationwide. She represents insurers in matters implicating directors and officers liability insurance and other forms of professional liability coverage, including cases involving Chinese reverse merger companies, subprime lending, auction rate securities, options backdating, ERISA stock drop suits, employment discrimination and criminal and regulatory investigations.
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