Recent business or financial news has been filled with reports of insider-trading cases that the Securities and Exchange Commission has been or is pursuing. Many of those cases involve large amounts of money, well-known persons or companies, and interesting factual questions. But they do not necessarily raise questions about the theory of insider-trading liability. In mid-July, the SEC settled an insider-trading case against an individual, engaged solely in personal trading activities, in which the disgorged profits were less than $90,000, and the facts of the case point to the limits of the “misappropriation” theory of insider-trading liability.
A recent Texas Court of Appeals decision in Ritchie v. Rupe, 339 S.W.3d 275 (Tex.Civ.App. – Dallas 2011, pet. filed), raises uncertainty for boards of directors and management of privately held Texas corporations that are dealing with shareholders desiring to sell shares. The case concerned a minority shareholder of a closely held Texas corporation who desired to sell shares she held as trustee of a family trust. The shares had been held for a number of years and were not subject to a shareholders’ agreement that restricted sales. The board of directors and management of the corporation cooperated in certain respects with the minority shareholder’s efforts to sell, but refused to meet with prospective purchasers of the shares.
Last month we noted a trend concerning fraud and accounting irregularities at NYSE- and Nasdaq-listed Chinese companies. The trend is not being ignored: on July 11 and 12, representatives from the SEC and the Public Company Accounting Oversight Board (“PCAOB”) met with representatives from the China Securities Regulatory Commission and China’s Finance Ministry. The SEC and the PCAOB (which oversees audit firms) are seeking cross-border oversight that would allow U.S. examiners to inspect audit firms in China, which Chinese officials have claimed violates China’s existing laws relating to state secrets. But whether China can afford to resist such access cannot be ignored: according to Bloomberg, “Chinese companies listed in the U.S. have had $4.1 billion wiped off their market value this year amid a wave of auditor resignations and fraud allegations by short-sellers . . . .”
The SEC recently initiated stop order proceedings against China Intelligent Lighting and Electronics Inc. and China Century Dragon Media Inc. on suspicion of accounting fraud. As reported by The New York Times, both companies failed to disclose that their independent auditors resigned after asking questions about the accuracy of the companies’ financial statements.
A number of Chinese companies have come under fire for accounting fraud stemming from corporate governance issues according to Forbes: “[i]n the past six months alone, more than 25 [NYSE and Nasdaq]-listed Chinese companies have disclosed accounting discrepancies or seen their auditors resign.” In light of these discrepancies and departures, the need for increased transparency, strong risk management and broad financial oversight is greater than ever. In particular, Chinese companies have been criticized for their relatively low number of independent directors (33% of the directors of Chinese-listed companies compared to 75% of the directors of U.S.-listed companies) and the lack of relevant industry experience these independent directors offer.
In one recent case involving Chinese financial software company Longtop Financial Technologies Limited, auditor Deloitte Touche Tohmatsu handed Longtop a resignation letter, included as an exhibit to a Form 6-K filed by Longtop, that asserted financial statement fraud, bank corruption and threats against the auditors. The New York Times explained the breakup as an investigation by Deloitte, after six years of clean audit opinions, into Longtop’s cash balances. Longtop blocked Deloitte from following up with bank headquarters regarding cash balances (that bank branches had already confirmed) by telling the bank that Deloitte was not the company’s auditor and threatening to hold Deloitte staff captive unless Deloitte allowed Longtop to retain Deloitte’s audit files. As described in the resignation letter, Longtop’s chairman Jia Xiao Gong, explained to a Deloitte partner why Deloitte could not find the cash: “there were [sic] fake revenue in the past so there were [sic] fake cash recorded on the books.” That is a disturbing clarification.
OUR TAKE: Sound accounting practices and the independence and experience of directors are of paramount importance to sound corporate governance. Foreign companies, which bring with them different regulatory, governance and financial backgrounds and standards, may pose unique risks for U.S. investors. Investors should pay close attention to corporate governance and accounting issues generally, but especially with respect to less familiar foreign companies. Reports identifying trends with respect to corporate governance deficiencies and/or accounting fraud especially raise investment red flags.
According to some reports, there are over 200 Chinese companies currently listed on U.S. securities exchanges, and the number will continue to grow. At the same time, the number of securities class action lawsuits filed against Chinese issuers listed in the United States has also increased. While this increase is hardly surprising, a closer look at the trends affecting Chinese issuers reveals some unique factors that are fueling complaints against Chinese issuers.
According to a report by Cornerstone Research in January 2011 (PDF), 12 securities class action complaints were instituted in 2010 against Chinese companies listed on U.S. stock exchanges. This represents a whopping 42.9% of all class action filings against foreign issuers listed in the United States.
The disproportionately high number of class action complaints against Chinese issuers appears to be prompted by two factors. First, Chinese companies listed both in the United States and China are subject to financial reporting requirements that vary significantly. These differences often result in the same company reporting different earnings in China versus the United States and, in some cases, higher earnings in the United States than in China. While these differences could more clearly be explained through appropriate footnote disclosure in their public filings, many Chinese issuers appear to be reticent to provide the additional disclosure. While these differences are in most cases the result of differing reporting standards, they provide a natural attraction to plaintiffs’ attorneys. The other factor that may explain this trend is the fact that many Chinese issuers are coming to market not through the traditional IPO, but rather through reverse mergers with already listed U.S. shell companies. While this provides a significantly quicker and less expensive way to list in the United States, the lack of disclosure associated with this process in some cases leads to regulatory investigations and allegations from shareholders that material information was withheld prior to listing.
OUR TAKE: Securities litigation against Chinese issuers is a natural byproduct of increasing numbers of Chinese companies choosing to list in the United States As a result, Chinese issuers and their advisors must be cognizant of the important differences in disclosure regimes in the United States and China and fashion their public disclosure accordingly.