The last two years have witnessed a significant upswing in the number of securities class-action suits leveled against Chinese firms listed on US markets. Already in 2015, ten Chinese companies face securities class-action litigation in the US, accounting for half of all such suits brought against foreign-listed firms. Shareholders in these cases bring claims for lack of corporate governance and transparency issues in violation of US securities laws. In addition, the recent volatility of the China markets may only serve to underscore the foreign perception of corporate governance deficiencies in Chinese companies. Some commentators attribute the issues to differences between Western and Chinese business culture, while others argue that securities litigation is simply a cost of doing business in the US markets. However, steps can be taken to insulate companies from unnecessary risk. Such mitigation may not always forestall litigation, but it can provide a solid defense in the event of suit. The purpose of this article is to help Chinese listed companies understand class-action suits in the US and to suggest ways to minimize exposure.
Triggers of Class-action Lawsuits
Since the early 2000s, Chinese firms have increasingly listed on the US stock markets in search of capital. At a time when Chinese banks were unlikely to provide early stage funding to private companies, and when the listing criteria for China’s own domestic capital markets was considered overly steep, US markets provided a welcome alternative for many burgeoning PRC companies. In addition, listing on a major US market often afforded Chinese companies with a certain level of recognition and prestige, which then could be valuably leveraged to gain favor with clients, banks and government officials back in China.
However, in 2011, following the discovery of a series of financial irregularities, numerous US-listed Chinese companies were delisted from the US markets. The delistings provoked a surge of securities class-action lawsuits, and further shook investor confidence in the integrity of Chinese stocks. In that year, Chinese companies alone accounted for nearly 20% of all securities class-action lawsuits filed in the US. And while the stigma surrounding US-listed Chinese companies has slowly dissipated over the last few years, a heightened level of scrutiny continues to persist from both investors and regulators alike.
Given this context, US-listed Chinese companies should be extra vigilant in maintaining compliance with all relevant rules and regulations, as they have become a particular target of securities litigation. Triggers of shareholder suits are varied. A few more common triggers are discussed below. Usually, class actions follow these inquiries if there is shown to be wrongdoing and that such wrongdoing resulted in an injury to the shareholder, namely a drop in the share price. In the absence of proof of the merit of the allegations, the shareholder suit may not be ripe for filing. With that said, many plaintiffs’ law firms specializing in these suits will begin to prepare early and reach out to putative plaintiff shareholders to begin to organize the class that may one day proceed with the filing of the class action.
1. The US Stock Exchanges
If the NYSE, NYSE, AMEX, or NASDAQ suspects that either foul play or an irregularity exists, they will ask the company to correct or explain the issue. However, failing to do so, the exchange will typically halt, suspend, and eventually delist a company’s stock. Following the spate of delistings in 2011, the exchanges have adopted much more stringent rules and regulations regarding the initial listing process as well as disclosures. Action by the regulators may be reportable or publicly available and as such, may cause nervous shareholders to watch the stock value. If the stock value decreases in response to such inquiry, the shareholders may begin to believe a class-action suit could help them recoup their loss in share price.
2. The SEC
Following a government complaint in 2010 concerning the fraudulent business activities of US-listed foreign companies, the SEC established an internal task force specifically dedicated to investigate overseas companies. Since that time, the SEC has become much more proactive in the launching of both formal investigations and informal inquiries with respect to any accounting or auditing irregularities.
In addition, the SEC has begun to rely heavily on its ‘whistleblower’ program, which provides insiders, typically business competitors or disgruntled employees, with a monetary incentive to report any suspected securities violations. In fact, China has been one of the greatest sources of foreign-based tips for securities violations on US markets. Any discovered securities violation can be met with suspension of the company’s trading or revocation of its securities registration.
Action by the SEC is publicly available and often causes a drop in share price. Again, this can trigger shareholders’ consideration of a class-action suit to recoup their loss on the market.
3. Short-selling Investment Research Firms
Short-selling investment research firms, such as Muddy Waters or Citron, are notorious for outing companies for accounting irregularities. In regard to US-listed Chinese companies, the short-selling investment research firms typically search for and identify any discrepancies between the company’s US disclosure and its corporate annual filings maintained at the Chinese Administration of Industry and Commerce. If discovered, the research firm then publishes these irregularities and accuses the Chinese company of fraudulent accounting practices, which then causes a domino effect involving the sudden drop in share price and a subsequent SEC investigation.
4. Individual Shareholders
Finally, individual shareholders can discover irregularities and bring action against the company for the alleged impropriety. Common allegations brought by shareholders include inconsistencies between the US and Chinese disclosures, improper reporting in regard to receivables, revenues and bank balances, and executive or board of director negligence with respect to fiduciary duties.
In addition to the events that might trigger securities litigation, it is equally important to look to and address the root issues that create concerns in the first place. Given the current regulatory environment and general scrutiny of US-listed Chinese companies, PRC firms will be more likely to attract negative attention and subsequent lawsuits if the following conditions exist.
1. Weak Corporate Governance
Fraudulent activity often has been found to coincide with weak corporate governance. Without sufficient internal controls, the weakness leaves room for managers to manipulate accounting records and syphon funds, as well as engaging in acts of corruption. Red flags include frequent CFO or auditor changes, changes in the independent directors, and failure to file timely financial information or meet reporting deadlines.
2. Financial Irregularities
Financial irregularities can be a sign of fraudulent activities. One sign of irregularity may be discrepancies between the US and Chinese disclosures. AIC filings and other China regulatory filings can prove problematic, as the filing may be skewed to minimize tax, avoid excessive permitting and regulation, and a host of other reasons, unrelated to the true performance of the company. While marginal differences are to be expected because of the differences between US and PRC GAAP, a material difference, especially in regard to revenue, is likely to set off a red flag.
An additional means of detection can be found in discerning if a company has overstated revenue. From 2009 to 2013, over 30% of all class-action suits filed against US-listed Chinese companies were for overstating revenue. While not always easy to detect from the outside, a number of trends can signal overstated revenue, including whether there has been abnormal sales growth between years as compared with companies in the same industry, or if the accounts receivable have increased faster than sales growth. Again, the PRC company is caught between two regimes. In fact, the PRC company should be working to legally minimize tax liability and avoid undue regulatory intervention in China where legally possible, e.g. a PRC company may legitimately restate its business scope to avoid NDRC approval of its operations if in fact the operations should not be within NDRC scrutiny. However, to a third party shareholder, the US disclosure will appear overreaching and misleading if the company’s English promotional materials imply broader business activities.
3. Frequent Change in Auditors
Independent auditors can also serve as an important external barometer regarding the soundness of financial practices. While legitimate reasons for changing auditors may vary far and wide, the overly frequent changing of the independent auditor may signal the presence of unresolved financial irregularities. Similarly, if an auditor resigns because they cannot obtain satisfactory information from the company, this may cause a delay in the company’s submission of their quarterly or annual filings, which may in turn trigger a halt in trading or even a delisting.
In light of the recent escalation of securities class-action litigation, it is important that US-listed Chinese companies take extra steps to ensure their compliance with all applicable rules and regulations. Spearheading initiatives that bolster both the effectiveness of internal controls as well as the quality of financial reporting standards will help to discourage fraud and further foster the trust and confidence of the investment community and the regulatory authorities. The following preventative measures will help to promote the above initiatives and duly minimize the risk of a securities class-action lawsuit:
- establish a more robust system of corporate governance by integrating the management, directors, and financial staff, so as to promote the effectiveness of the company’s internal controls and company oversight;
- educate Chinese directors annually on their fiduciary duties and the US legal regime, and make clear that they will be subject to US law, even if they are residing in China;
- encourage positive auditing practices by maintaining a truly independent auditing committee, engaging a top tier auditing firm and facilitating open communication between auditors and management;
- refrain from making overly optimistic management forecasts, as this has been found to statistically draw more securities litigation from disappointed investors;
- promote transparency by communicating frequently with investors;
- communicate with shareholders about the business culture differences;
- incorporate robust safe harbor statements in your filings; and
- work closely with the company’s lawyers and be sure to disclose all pertinent matters, so that legal counsel can provide the best advice possible on how to avoid unnecessary liability.
In addition to preventative measures, the company should have at the ready a crisis management strategy for any contingency involving a securities lawsuit, including an immediate response in the media followed by a comprehensive internal investigation of the company’s finances. Such actions should help to mitigate damage done by allegations through the shoring up of investor confidence and duly prevent an unnecessary slide in share price. While implementing the above strategies may not eliminate the prospect of a securities class-action lawsuit, it should help to reduce likelihood of suit and further put the company in a stronger position to defend itself in the event that the company is sued.
The Good News
The shareholders’ burden of proof in securities class actions is still relatively high. Shareholders must prove that the acts alleged were not disclosed and that those acts specifically would have caused a drop in share price. It is not enough to allege injury from the loss in share price without some correlation to wrongdoing by the company. The recent dismissal of the PetroChina class action in New York is instructive. The PetroChina shareholder suit was dismissed for lack of a causal nexus. In dismissing the Plaintiffs’ suit, Judge Ramos concluded that the acts of Zhou Yongkang were not proven to be related to activities of the listed entity. Judge Ramos wrote in his analysis of the Plaintiffs’ Complaint: “However, it does not indicate when this event occurred, nor does it specify when Yongkang undertook any acts of corruption, what they consisted of, or whether they had any connection to PetroChina whatsoever.” He thereby concluded that there was no evidence of a causal nexus sufficient to sustain the suit. (In re PetroChina Co. Ltd. Securities Litigation, 13-cv-06180, U.S. District Court, Southern District of New York (Manhattan)). Class actions are common, costly and time consuming; but often, in the absence of solid evidence difficult to prove. Good preparation, a good defense, and good lawyering can help minimize risk and avoid liability.
Note：The author wishes to thank Ian Brown for his contribution to this article.
This article was originally written in English, and the Chinese version is a translation.