Shareholder Forensic Analysis Insights
The Rise of SEC Investigations and
Shareholder Lawsuits Involving Chinese
Companies Listed on U.S. Stock
Exchanges
Paul R. Bessette, Esq., Yusuf Bajwa, Esq., and R. Adam Swick, Esq.
Regulatory investigations and private securities actions against Chinese companies listed on
U.S. stock exchanges have significantly increased in the past 18 months amid allegations
that certain companies have accounting improprieties and ineffective internal controls.
Regulatory bodies seem especially concerned about the increased use of “reverse mergers.”
These transactions allow Chinese companies to go public without the traditional safeguards
that come with the IPO process. These concerns may not be bad if it flushes out the bad
companies. However, there are certainly some very good companies that are being hurt.
In any event, the increase of activity against Chinese companies has dramatically affected
the securities litigation landscape—affecting not only Chinese companies, but also their
accountants and investment bankers.
Introduction
China is growing and its companies need capital.
One way for a Chinese company to raise capital is
by listing on a U.S. stock exchange. While this is
not a completely new phenomenon, securities class
actions and regulatory investigations against Chinabased companies listed on U.S. stock exchanges have
increased dramatically in the past year and a half.
In fact, last year there were 12 securities class
actions against Chinese companies. This was the
highest amount of class actions against Chinese
companies observed in a single year. But in only
the first part of this year, at least 24 class actions
have been filed against Chinese companies, which
accounted for approximately 24 percent of all securities class actions so far in 2011.
This statistic is particularly alarming because
suits against all foreign issuers combined totaled
48 INSIGHTS • AUTUMN 2011
only 11.4 percent of all securities class actions filed
in 2010.
The increase in the number of China-based
issuers partly accounts for the upswing in cases.
However, the new surge is more attributable to
relatively new concerns by the Securities Exchange
Commission (SEC), Public Company Accounting
Oversight Board (PCAOB), and shareholders that
certain Chinese companies—particularly those
using the practice of a “reverse merger” to list on
a U.S. stock exchange—have accounting improprieties and/or ineffective internal controls.
This discussion explains the use of the reverse
merger by Chinese companies, regulatory efforts
to protect investors in this area, and the current landscape of private securities litigation
against Chinese companies listed on U.S. stock
exchanges.
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Reverse Mergers
In a reverse merger or reverse takeover, a private company gains control
of a “shell” company listed on a U.S.
stock exchange. The private company
then merges into the listed company,
and the combined entity can raise
new capital while remaining on the
stock exchange.
The shell company is referred to
as such because it is usually defunct,
and it does not have any operations,
assets, or liabilities—it’s merely listed.
The private company gets a quick and
inexpensive public listing, and the
listed company’s shareholders obtain
shares in a new and potentially successful company.
There are two very legitimate reasons to list by a reverse merger as
opposed to an initial public offering (IPO).
First, the process can be completed much faster
and much less expensively than an IPO. An IPO can
take over a year to complete compared to a reverse
merger, which can be accomplished in as little as a
week.
Second, while a reverse merger must be disclosed through an SEC Form 8-K, the process avoids
the time and cost involved with finding an underwriter and preparing and filing a registration statement and prospectus.
Many Chinese companies have begun using the
reverse merger to gain access to the U.S. capital
markets. In fact, the PCAOB found that 159 companies from the China region have conducted a reverse
merger to gain access to U.S. stock exchanges from
January 1, 2007, to March 31, 2010.1
Chinese and other international companies often
find that their companies have a higher stock price
in the Unites States than in their home countries.
These companies also get the other advantages of
going public in the United States, which include
increased visibility and credibility among investors
and customers.
While reverse mergers are becoming more popular, the combined entity can sometimes become
subject to manipulation and fraud. The advantages
of a reverse merger—speed, cost, and lack of thirdparty and regulatory oversight—are also what make
a reverse merger so dangerous. It allows a company
to go public that otherwise could not because of cost
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or the inability to satisfy underwriter, investor, or
regulatory inquiries.
As stated by SEC Commissioner Luis A. Aguilar,
a reverse merger, “gives the formerly private company the credibility and access to capital of being
registered as a public company, without any of the
vetting from underwriters and investors that companies undergo when they perform a traditional
IPO.”2 This is why the SEC Commissioner refers
to reverse mergers as “backdoor registration” as
compared to the traditional IPO, which he calls “the
gold standard.”3
Regulatory Concern Over
Chinese Company Reverse
Mergers
The increase in reverse mergers involving Chinese
companies has led to increased concern from
a number of regulatory agencies, primarily the
PCAOB, the New York Stock Exchange (NYSE),
the National Association of Securities Dealers
Automated Quotations (Nasdaq), and the SEC.
While these bodies coordinate their efforts, each
has individually contributed attention to Chinese
reverse merger companies.
The PCAOB
The PCAOB is a private-sector, nonprofit corporation created by Congress through the SarbanesOxley Act to oversee the auditors of public
INSIGHTS • AUTUMN 2011 49
companies. Its purpose is to “protect the interests
of investors and further the public interest in the
preparation of informative, fair, and independent
audit reports.”4
As part of its self-regulatory function, the
PCAOB has become increasingly concerned about
U.S. accounting firm involvement in Chinese
reverse mergers. On July 12, 2010, the PCAOB
issued Staff Audit Practice Alert No. 6 and followed
it up with Research Note Number 2011-P1 on
March 14, 2011.
The PCAOB noted that as of March 31, 2010:
n 159 Chinese companies accessed the U.S.
market through reverse mergers from
January 1, 2007, through March 31, 2010;
n the 159 Chinese companies that used a
reverse merger had a combined market
capitalization of $12.8 billion, less than half
of the $27.2 billion combined market capitalization of the 56 Chinese companies that
completed full IPOs during that time;
n 59 percent of the reverse merger Chinese
companies reported annual revenues less
than $50 million and 58 percent had total
assets below $50 million in their most
recent fiscal year;
n U.S. registered accounting firms audited
74 percent of the Chinese companies using
reverse mergers; and
n triennial accounting firms (firms that must
be inspected every three years) audit 94
percent of Chinese companies using a
reverse merger.5
Exhibit 1
Companies Recently Delisted by Nasdaq and NYSE
Nasdaq
The PCAOB stated that there is nothing inherently inappropriate about a U.S. accounting firm
issuing audit reports on financial statements filed by
issuers that have substantially all of their operations
outside of the United States.6 But in the reverse
merger context with Chinese companies, it appears
that some U.S. accounting firms “may not be conducting those audits in accordance with PCAOB
standards.”7 It appears that several “firms may be
issuing audit reports based on the work of another
firm, or by using the work of assistants engaged from
outside of the firm, without complying with relevant
PCAOB standards.”8
In fact, since February 2011, about 40 Chinese
companies have either acknowledged accounting
problems or had the SEC or U.S. stock exchanges
halt trading in their stocks because of accounting
problems.9
According to PCAOB Chairman James Doty,
the problem is compounded by the fact that “the
PCAOB continues to meet resistance to inspections
in China, based primarily on national sovereignty
grounds.”10
He went on to state that “[i]f Chinese companies
want to attract U.S. capital for the long term, and
if Chinese auditors want to garner the respect of
investors, they need the credibility that comes from
being part of a joint inspection process that includes
the U.S. and other similarly constituted regulatory
regimes.”11
And as it is now, the PCAOB’s inability to inspect
the work of registered firms from China is a gaping
hole in investor protection.12
The PCAOB has not been afraid to back up its
concerns with enforcement actions here in the
United States. In 2009, the PCAOB sanctioned a
U.S. accounting firm that
used a significant amount
of audit work from a
Hong Kong firm without
adequate coordination.13
NYSE
Fuqi International (FUKI.PK)
Duoyuan Printing (DYNP.PK)
China Agritech (CAGC)
China Century Dragon Media, Inc. (CDM)
China Media Express Holdings (CCME)
China Intelligent Lighting and Electronics, Inc. (CIL)
China Electric Motor (CELM)
NIVS Intellimedia Technology Group, Inc. (NIV)
Jiangbo Pharmaceuticals, Inc. (JGBO)
China Integrated Energy, Inc. (CBEH)
50 INSIGHTS • AUTUMN 2011
This year, the PCAOB
settled a disciplinary
action against an audit
firm and associated individuals for improper
audits of two Chinese
companies.14 The firm’s
registration was revoked,
and the individuals were
barred from being associated persons of a registered public accounting
firm.15
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NYSE and Nasdaq
The NYSE and Nasdaq are also taking steps to protect investors by delisting certain Chinese companies, as listed in Exhibit 1.
Nasdaq has gone a step further by filing with
the SEC a proposed rule change to adopt additional
listing requirements for a company that becomes
public through a reverse merger.16
Nasdaq proposes to:
n prohibit a company that is going public
through a reverse merger from applying
to list until six months after the combined
entity submits audited financial statements
to the SEC;
n require that the company maintain a $4 bid
price on at least 30 of the 60 trading days
immediately prior to submitting the application; and
Subsequently, the SEC issued an Investor
Bulletin specifically on reverse mergers, publicly
warning investors about the risks of reverse mergers
in the wake of accounting questions and investor
losses at some Chinese companies.23
These SEC investigations and inquiries of
Chinese companies for accounting violations and
lax auditing practices have begun to bear fruit. Since
March 2011, more than 24 Chinese companies have
filed public disclosures announcing auditor resignations and accounting problems.24
Many of these disclosures concern issues regarding cash and accounts receivables, and the auditors’
difficulties in confirming these amounts.25
Moreover, since April 2011, the SEC has suspended trading in multiple Chinese companies, including
Rino International, China Chagjiang Mining and
New Energy, and Heli Electronics.26
n not approve any reverse merger for list-
ing until the company has filed at least
two financial reports with the SEC if it is
a domestic issuer or one financial report
covering at least a six-month period if it is a
foreign private issuer.17
Nasdaq gave a number of reasons for the new
listing requirements, and it noted that there have
been widespread allegations of fraudulent behavior
by Chinese reverse merger companies, leading to
concerns that their financial statements cannot be
relied upon.18
Specifically, Nasdaq stated that it’s “aware of
situations where it appeared that promoters and
others intended to manipulate prices higher to satisfy Nasdaq’s initial listing bid price requirement.”19
Nasdaq believes that the new requirements will
allow FINRA20 more time to view trading patterns,
result in more bona fide shareholders, and assure
that the $4 bid price is legitimately satisfied.
The SEC
With the increased scrutiny over reverse mergers,
it comes as no surprise that the SEC has stepped
up its investigations into Chinese companies listed
on U.S. stock exchanges. In September 2010, the
House Financial Services Committee sent a letter
to the SEC questioning the lack of rigor in auditing
Chinese companies.21
The SEC responded by stating that it had created
an internal task force to investigate fraud in overseas companies with listings on U.S. stock exchanges with emphasis on companies engaging in reverse
mergers to achieve “backdoor SEC registration.”22
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INSIGHTS • AUTUMN 2011 51
Private Actions
With the rise of regulator awareness of Chinese
companies and reverse mergers, so too has the
awareness of the private plaintiff’s bar. There are
two main types of actions brought against Chinese
companies.
First, there is the class action for violations of
federal securities laws. Class actions have had the
most impact, by far, on Chinese companies listed on
U.S. stock exchanges.
As noted above, securities class actions against
Chinese companies have risen dramatically in
2011—accounting for approximately 24 percent
of all securities class actions—while last year suits
against all foreign issuers combined accounted
only for about 11 percent of securities class
actions.31
Second, there is the shareholder derivative suit,
which is brought on behalf of a corporation against
its officers and directors. A handful of these suits
have been filed, including against Duoyuan Printing
and Puda Coal.
On April 27, 2011, shareholders filed a suit
against Duoyuan Printing in the District of Wyoming
alleging that the directors and officers breached
their fiduciary duties by issuing false and misleading statements regarding the company’s financial
results.32
On May 12, 2011, shareholders filed a derivative
suit against Puda Coal Inc. The suit alleged that
directors breached their fiduciary duties by failing
to disclose that the company’s chairman inappropriately sold off its operating unit.33
Further, the SEC has also revoked the securities
registration of at least eight Chinese companies that
became U.S. issuers through reverse mergers for
failure to make required period filings that contain
information of critical importance to U.S. investors.27
The SEC’s investigation does not end with
Chinese companies. The Commission is also currently probing auditors of Chinese companies on the
heels of the PCAOB’s findings.28
If the SEC finds violations, then it could file civil
actions against the audit firms, as it did recently
against Moore Stephens Wurth Frazer & Torbet
LLP for improper professional conduct in connection with their audit work for China Energy Savings
Technology, Inc.29
The SEC censured the audit firm and required it
to disgorge all fees with prejudgment interest. It also
barred the engagement partner from appearing or
practicing before the SEC as an accountant.30
52 INSIGHTS • AUTUMN 2011
Private actions are triggered in a number of
ways. For example, SEC or PCAOB investigations
will usually spark private litigants’ interest. Another
trigger is when an auditor discovers fraud, forgery,
or other discrepancies. This usually results in the
auditor’s resignation or termination.
Another source for lawsuits is investigations
conducted by independent third parties and short
sellers. A good example of a short seller triggering
a lawsuit is the case Henning v. Orient Paper, Inc.
The research group Muddy Waters issued a
report on Orient Paper, Inc. Shortly thereafter, plaintiffs filed a lawsuit based almost entirely on the information contained in the Muddy
Waters report. This information indicated that
Orient Paper’s U.S. financial statements overstated
revenue by 2,700 percent and overstated the value
of assets by 200 percent, compared to filings in
China.34
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While private actions and investigations are
on the rise, not all Chinese companies listed on
U.S. stock exchanges—even those listed through a
reverse merger—should be automatically labeled
as fraudulent solely because an auditor resigns or a
short seller issues a negative report.
Short seller reports, especially, should be taken
with a grain of salt. A short seller, by definition, is
a trader that sells borrowed shares on speculation
that prices will drop and the stock can be replaced
at a much lower cost.
Thus, short sellers, while sometimes providing
valuable data and insight, sometimes purposefully try to lower a stock’s value. Muddy Waters
proclaims to “see[] through appearances to a
Chinese company’s true worth” based on a blanket statement that Chinese businesses on U.S.
stock exchanges are inflated to levels greater than
reality. 35
The Company believes its common stock
has been manipulated in collusion among
“naked” short sellers, which may include
U.S. and off-shore based hedge funds/
individuals that distribute false and fabricated information concerning the Company
via various websites and blogs, including through SeekingAlpha.com, a website
owned by Seeking Alpha Ltd., an Israeli
company.42
Deer labeled the accusations against it on
Seekingalpha.com as illegal and fictitious and vowed
to sue Seeking Alpha and pursue sanctions against
the plaintiffs’ firm who filed the lawsuit.43
The effect of short sellers on companies can
be devastating. In addition to Orient Paper,
Muddy Waters has reported negatively on China
MediaExpress Holdings Inc., Rino International
Corp., and Sino-Forest Corp.36
According to a Bloomberg article, the Muddy
Waters report on Sino-Forest alone wiped out $3.25
billion in market capitalization in only two days.37
While some Chinese companies have immediately settled after accusations of wrongdoing
by short sellers, others such as Sino-Forest are
fighting back. In a June 3, 2011, statement, Allen
Chan, Sino-Forest’s CEO, called the Muddy Waters
research “inaccurate and unfounded” as well as selfinterested.”38
Sino-Forest started an internal investigation
and opened up a data room overnight to investors
to show the authenticity of its operations as well
as offered tours of its Chinese tree plantations for
analysts.39
And recently, an analyst at Dundee Capital
Markets stated that the “Muddy Waters research [on
Sino-Forest] is a pile of crap” and was derived only
to make money on short positions.40
The analyst also sharply criticized the Muddy
Waters report on Orient Paper and stated that
Orient Paper hired Deloitte & Touche, and that they
are in the process of refuting every claim.41
Deer Consumer Products, Inc., also chose to
strike back at short sellers by issuing a press release
stating:
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INSIGHTS • AUTUMN 2011 53
“. . . the swift
rise of Chinese
companies has
sent shockwaves
through the U.S.
securities litigation landscape.”
Deer subsequently filed a
lawsuit in the Supreme Court
of the State of New York to
“defend itself and its shareholders against illegal short selling
and market manipulation.”44
In addition to short sellers
incorrectly placing the “fraud”
tag on some Chinese companies, fault for any actual misconduct may be more appropriately attributable to the Chinese
companies’ U.S. accountants or
investment bankers.
MaloneBailey, LLP, a mid-sized accounting firm
based in Houston, Texas, has been referred to in
the news quite often lately regarding its findings,
resignation, or termination as auditor of several
Chinese companies that have led to investigations
and private suits, including against China Electric
Motor, Inc., NIVS IntelliMedia Technology Group,
Inc., Chinese Intelligent Lighting & Electronics,
Inc., China Century Dragon Media, Inc., and Feigeda
Electronic Technology, Inc.45
According to at least one author, while
MaloneBailey’s involvement in so many troubled
Chinese companies may be purely coincidental,
it is also suspicious, because the same investment
bank, WestPark Capital Financial, worked for each
of the above-mentioned companies associated with
MaloneBailey.46
This at least raises the possibility that the players involved in taking Chinese companies public
through reverse mergers are at least partly to
blame.
Conclusion
While perhaps not completely warranted, the bottom line is that there is a huge increase in interest in Chinese companies listing on U.S. stock
exchanges.
Although foreign companies on U.S. stock
exchanges are not a new phenomenon, the swift
rise of Chinese companies has sent shockwaves
through the U.S. securities litigation landscape.
Not only are the Chinese companies’ practices
being questioned, but so too are the laws and
regulations regarding reverse mergers and how U.S.
accounting firms and investment banks deal with
Chinese companies coming to America.
54 INSIGHTS • AUTUMN 2011
Notes:
1. PCAOB Research Note # 2011-P1.
2. SEC Commissioner Luis A. Aguilar, Speech
at Council of Institutional Investors, Spring
Meeting, Washington, D.C., April. 4, 2011.
3.Id.
4.http://pcaobus.org/Pages/default.aspx.
5.PCAOB Activity Summary and Audit
Implications for Reverse Mergers involving
Companies from the China Region: January 1,
2007 through March 31, 2010, Research Note
# 2011-P1 (March 14, 2011) http://pcaobus.org/
Research/Documents/Chinese_Reverse_Merger_
Research_Note.pdf.
6. PCAOB Staff Audit Practice Alert No. 6, Auditor
Consideration Regarding Using the Work of
Other Auditors and Engaging Assistants from
Outside the Firm (July 12, 2010) http://pcaobus.
org/standards/qanda/2010-07-12_apa_6.pdf.
7. Id.
8. Id.
9.
Michael Rapoport, “SEC Probes China Auditors,”
Wall Street Journal, June 2, 2011, available
at
http://online.wsj.com/article/SB1000142
4052702304563104576361422372121248.
html?mod=googlenews_wsj.
10.PCAOB Chairman James Doty, Speech given
to Council of Institutional Investors, Spring
Meeting, Washington, D.C., April 4, 2011.
11. Id.
12. Id.
13.In the Matter of Clancy and Co., P.L.L.C.,
Jennifer C. Nipp, CPA, and Judith J. Clancey,
CPA, PCAOB Release No. 105-2009-01 (March
31, 2009).
14. In re Chisholm, Bierwolf, Nilson & Morrill, LLC,
Todd D. Chisholm, CPA and Troy F. Nilson,
CPA, Order Instituting Disciplinary Proceedings,
Making Findings, and Imposing Sanctions,
PCAOB Rel. 105-2011-003 (April 8, 2011).
15. Id.
16.http://Nasdaq.cchwallstreet.com/Nasdaq/pdf/
Nasdaq-filings/2011/SR-Nasdaq-2011-056.pdf.
17. Id.
18. Id.
19. Id.
20.FINRA stands for the Financial Industry
Regulatory Authority and is the largest independent regulator for all securities firms doing business in the United States.
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21.U.S. House of Representatives Subcommittee
Chairman for TARP Financial Services and
Bailout of Public and Private Programs, Patrick
T. McHenry, Letter to SEC Chairman Mary L.
Schapiro, April 11, 2011.
22. Luis A. Aguilar, Speech at Council of Institutional
Investors, April 4, 2011.
23. SEC Investor Bulletin: Reverse Mergers (June
2011), available at http://www.sec.gov/investor/
alerts/reversemergers.pdf.
24.SEC Chairman Mary L. Schapiro, Letter to
U.S. House of Representatives Subcommittee
Chairman for TARP Financial Services and
Bailout of Public and Private Programs, Patrick
T. McHenry, April 27, 2011.
25. Id. at 2
26. Id.
27. Id. at 3.
28. Michael Rapoport, “SEC Probes China Auditors,”
Wall Street Journal (June 2, 2011), available
at
http://online.wsj.com/article/SB1000142
4052702304563104576361422372121248.
html?mod=googlenews_wsj.
29.See In the Matter of Moore Stephens Wurth
Frazer & Torbet LLP, et al., (Dec. 2010), Rel.
No. 33-9166 (http://www.sec.gov/litigation/
admin/2010/33-9166.pdf).
30. Id.
31.Stanford Class Action Clearinghouse, http://
securities.stanford.edu/companies.html; 2010 a
Record Year for Securities Litigation an Advisen
Quarterly Report—2010 Review at 13.
32. Schmitz v. Diao, Case No. 11-cv-157-F (April 27,
2011).
33.Erhardt v. Zhao, Case No. 6476, Verified
Shareholder Derivative Complaint, Docket No. 1
(May 12, 2011).
34. Henning v. Orient Paper, Inc., Case No. 10-cv05887, Complaint (Aug. 6, 2010).
35.Http://www.muddywatersresearch.com/about;
“Herb Greenberg, Playing a ‘Regulatory Arbitrage’
on China,” (April 12, 2011), available at http://
www.cnbc.com/id/42556530.
36. Dune Lawrence and Nikolaj Gammeltoft, “Short
Seller Block Takes on Paulson, Greenberg in
China” (June 6, 2011), available at http://www.
businessweek.com/news/2011-06-06/shortseller-block-takes-on-paulson-greenberg-in-china-1-.html.
37. Id.
38 Id.
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39. Stuart Weinberg, “Sino-Forest Strikes Back at
Critic” (June 7, 2011), available at http://online.
wsj.com/article/SB100014240527023044323045
76369502044406210.html.
40 David Pett and John Shmuel, “Muddy Waters
Sino-Forest Research ‘Pile of Crap,’” Dundee,
Financial Post (June 7, 2011), available at
http://business.financialpost.com/2011/06/07/
muddy-waters-sino-forest-research-pile-of-crapdundee.
41. Id.
42.Deer Consumer Products, Inc., press release
(May 2, 2011), available at http://www.deerinc.
com/web/new20110502.asp; see “Are Short
Sellers Fabricating the Accounting Fraud
Allegations Involving U.S.-Listed Chinese
Firms?” The D&O Diary, available at http://
www.dandodiary.com/2011/05/articles/securities-litigation/are-short-sellers-fabricating-theaccounting-fraud-allegations-involving-uslistedchinese-firms.
43. Id.
44.Deer Consumer Products, Inc., press release
(May 28, 2011), available at http://www.reuters.
com/article/2011/03/28/idUS156310+28-Mar2011+PRN20110328.
45.See, e.g., Walter Pavlo, “Reverse Mergers—
Pushers May be the Problem,” Forbes
(April 15, 2011), available at http://
blogs.forbes.com/walterpavlo/2011/04/15/
reverse-mergers-pushers-may-be-theproblem.
46.See Id.
Paul R. Bessette, Esq., is a shareholder of
Greenberg Traurig LLP and is Co-Chair of its
Global Securities Litigation Group out of the firm’s
Texas, California and New York offices. Paul can
be reached at (212) 801-2130 or at bessettep@
gtlaw.com.
Yusuf Bajwa, Esq., is an associate in
Greenberg Traurig LLP’s Securities Litigation
Group in the firm’s Texas offices. He can be
reached at (512) 320-7239 or at bajway@gtlaw.
com.
R. Adam Swick, Esq., is also an associate in
Greenberg Traurig LLP’s Securities Litigation
Group in the firm’s Texas offices. He can be
reached at (512) 320-7233 or at swicka@gtlaw.
com.
INSIGHTS • AUTUMN 2011 55