This excerpt from a recent PLUS Journal article titled “Reversal of Fortune: Exposure to Insurers from U.S. Securities Class Actions Against Chinese Companies” (published in the February 2012 issue), authors Edward (Ned) J Kirk and Anthony Sassi from Clyde & Co. look at the exposures for Chinese companies listed on U.S. exchanges. From the article:

What’s Gone Wrong?

Chinese companies have been involved in reverse mergers in the U.S. for over a decade. So why is it only now that problems with these companies are emerging and they are being named in so many U.S. regulatory investigations and class actions?

Short sellers have had a major impact. Short selling is the practice of borrowing securities from a third party with the intention of paying them back at a later date. The short seller makes a profit if the securities fall in value between the date borrowed and repaid. In the last couple of years, a number of short sellers have targeted Chinese companies as an easy way to make money. The highest profile short seller targeting Chinese companies is Carlson Block who runs Muddy Waters LLC, a company whose name is based on the Chinese old proverb, “muddy waters make it easy to catch fish.” In other words, opacity creates opportunities to make money. Muddy Waters and a number of other short selling companies claim to carry out independent research into Chinese companies listed in the U.S. and produce reports making various allegations about the legitimacy of the business in question and its financial position. This trend started in June 2010 when Muddy Waters issued a report on Orient Paper alleging it had overstated revenue and misappropriated funds. Further reports have since been produced by Muddy Waters, and others, and more are expected.

Whenever a short seller report is published, the value of the stock of the company in question tends to plummet. Sino Forest is perhaps the best example-its stock dropped by 70 percent in 2 days following Muddy Waters’ report. Short sellers tend to take a short position in the company’s shares shortly before releasing their report and invariably make a lot of money as a result of the subsequent drop in the stock.

Litigation

A surge in U.S. securities class actions against Chinese companies has followed in the wake of the short seller allegations. In 2011, investors filed 39 securities class action lawsuits against Chinese companies, accounting for almost 20 percent of all securities class action filings. These class actions tend to follow the same pattern, relying heavily on the short sellers’ report to allege fraudulent misrepresentations and inadequate disclosures regarding discrepancies in financials reported by the company to U.S. and Chinese authorities, improper transactions between related parties and the company’s operations and business prospects.

Implications for Insurers

Up until a few years ago, writing D&O insurance of Chinese companies seemed somewhat of a benign risk. With no class actions in China or Hong Kong, exposure was limited. The U.S., where many of these companies have sought capital in recent years, is a totally different environment.

Exposure

Very few U.S. securities class actions go to trial; around 35-40 percent are dismissed and the majority of the rest are settled. It was initially thought (and hoped by D&O insurers) that, due to the lack of substance in the complaints against Chinese companies (which often merely repeat allegations made in a short sellers’ report), most of these claims would be dismissed at an early stage. However, based on the limited number of rulings to date on motions to dismiss involving these types of complaints, this may be unlikely in the majority of cases.

In a case brought against Orient Paper Inc. ( Henning v. Orient Paper, 2011), the U.S. District Court for the Central District of California refused to dismiss the plaintiffs’ securities fraud claims. Significantly, the court’s July 2011 decision found that the plaintiffs could rely upon a short seller’s report to support their allegations of securities fraud, and that allegations of related party transactions supported a finding of scienter under the Exchange Act.

In a case against China Education Alliance, where the plaintiff also relied heavily on a short seller’s report, the court reached a similar conclusion in an October 2011 decision.Relying on the Orient Paper decision, a different federal judge in the Central District of California found that the facts that the individual authors of the report were not named and that those individuals were self-interested were not grounds for dismissal of plaintiffs’ claims.  Further, the court found that, viewed “holistically” rather than individually, plaintiffs’ allegations (based on an online short seller report) adequately alleged scienter.

The Orient Paper and China Education decisions demonstrate that investors’ class action lawsuits can survive early strike-out applications by the defendant company or its former advisers. As many of the securities class actions against Chinese companies are based on similar allegations, investors may be able to obtain early settlements from defendants seeking to avoid the publicity risk, cost of discovery and a full length trial (which, if the defendants lose, could set an unhelpful precedent for them).

Two other cases, however, demonstrate that in certain circumstances, complaints can be dismissed at an early stage. In a securities class action brought against China North East Petroleum in the U.S. District Court for the Southern District of New York, the court found in an October 2011 decision that the alleged misrepresentations could not have caused a loss because the stock price rose after disclosure of the alleged fraud and plaintiffs had the opportunity to sell their shares at a profit. This ruling would be distinguishable from cases against many other Chinese companies where share prices dropped upon disclosure and did not rebound.

Most recently, a third judge in the Central District of California granted a motion to dismiss a securities class action against China Century Dragon Media. As the plaintiffs’ claims under the Securities Act sounded in fraud, the plaintiffs were required to meet the heightened pleading standards applicable to securities fraud. The court found that allegations that the revenue and profit numbers reported to the SEC in the prospectus for the company’s U.S. IPO were significantly greater than those it reported to the SAIC in China were insufficient. The differences between the numbers provided to the SEC and SAIC merely raised the possibility that the SEC figures were false, but did not “suffice to make that claim plausible.” Notably, this decision was without prejudice and plaintiffs will have another opportunity to plead fraud with sufficient particularity in an amended complaint.

PLUS members can read this full article on the PLUS website.