Lister Lo Lui & Choy CHINESE REVERSE MERGERS Insurance & Auditor Angles Mary-Pat Cormier Partner Edwards Angell Palmer & Dodge Boston, MA Gregory D. Pendleton Associate Edwards Angell Palmer & Dodge Boston, MA Kenneth Choy Partner Lister Lo Lui & Choy Hong Kong
2 Chinese Reverse Mergers (CRM) What is a Reverse Merger? U.S. public shell company acquires a foreign private company Operating and voting control of surviving public company ceded to foreign owners Result: the foreign private company becomes publicly-listed on a U.S. stock exchange Why a Reverse Merger? Quick access to raising capital in the public market Avoidance of strict IPO regulations Most popular with small and medium sized Chinese companies
Litigation Against Foreign Issuers Proportion of Federal Filings that Involve Foreign Issuers 35% 30% % of US Listings Represented by Foreign Issuers % of US Filings Against Foreign Issuers 33.8% 25% 20% 15% 12.1% 12.4% 12.7% 13.4% 15.2% 14.7% 14.5% 14.8% 15.7% 15.7% 15.8% 16.2% 10% 5% 0% 8.3% 7.4% 9.8% 5.0% 10.5% 11.0% 9.0% 4.5% 5.9% 7.8% 9.3% 10.8% 14.3% 12.8% 10.0% 15.2% 11.7% 11.1% 11.3% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: NERA Economic Consulting
Federal Filings Against Chinese Issuers 61.4% of 2011 filings against foreign-domiciled issuers target Chinese companies 30 27 25 20 15 10 8 10 5 2 2 2 2 3 1 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: NERA Economic Consulting
Key Issues in CRM Securities Litigation 5 1. Accounting Irregularities Starr Investments Cayman II, Inc., v. China MediaExpress Holdings, Inc. 2. Related-Party Transactions Henning, et al. v. Orient Paper, Inc., et al. 3. Short-Sellers
Regulatory Interest 6 1. SEC Investor Bulletins 2. Suspension of Trading 3. NASDAQ Proposed Rule Changes
Directors & Officers Insurance 7 1. Policy Limits 1. Modest market cap usually means modest policy limits 2. Defense Costs 1. Compounded by distance, language barriers 3. Coverage Defenses 1. Personal profit and fraud exclusions 2. Coverage for attendant investigations by regulators 3. Misrepresentations in application
Circular 10 and The Use of VIE August 2006: Ministry of Commerce issued Circular 10 covering acquisition of PRC entities by foreign investors Requires approval for foreign acquisition of PRC companies Circular 10 aimed at foreign investors acquiring domestic Chinese companies round-trip investment reverse takeovers
Circular 10 and The Use of VIE (cont.) VIE is a structure intended to get around Circular 10 restrictions Prior to Circular 10, VIE used in industries where foreign participation is prohibited Examples: online businesses, telecom, publishing With Circular 10, VIE used for listing of PRC companies overseas Note: new rule implemented September 1, 2011: outlaws use of VIE for such acquisitions
What is VIE? Offshore Listed Company Wholly Foreign Owned Enterprise ( WFOE ) suite of contracts PRC Operating Company offshore onshore
How VIE Works 11 1. No ownership interest in VIE 2. Rights based entirely on contractual arrangement 3. Shifts benefits and liabilities from VIE to WFOE 4. Creates auditing problems for auditors
12 Auditors Become Targets CRM defendants tend to ignore complaints and default Key Issues CRM defendants have little or no assets in US No applicable treaty between US and PRC for mutual recognition of judgments Result: Chinese courts do not recognize or enforce US default judgments
Auditors Become Targets (cont) 13 Plaintiffs need reliable source of compensation Outside accounting firms suitable targets Key Issues Accounting firms are licensed and in regulated industry Accounting firms generally carry E & O insurance Accounting firms generally do not evade service
Munoz v. China Expert Technology, Inc. One of first CRM cases filed in November 2007 Initially filed against company, its directors and management Company did not respond and Certificate of Default obtained Individual defendants dismissed without prejudice All accounting firms appeared, including those overseas, and successfully moved to dismiss complaint, amended complaint and 3 rd amended complaint 4 th amended complaint finally survived motion to dismiss
Typical Claims Against Auditors 6 cases where auditors are sued, of which 3 involved CRM In two cases, defendants motions to dismiss were denied Only one, China Expert Technology, involved auditors filing of motion to dismiss The Orient Paper case, the auditor had been disbarred by the PCAOB, did not appear in the case. The motion to dismiss was filed by the other defendants and the motion was denied. Claims based on: Accountant s position as independent auditor of CRM company who issued unqualified audit opinion Access to vital information Aware that information disseminated to investing public are materially false and misleading Failed to withdraw audit opinion
Typical Claims Against Auditors (cont) 16 1. Obtained credit reports and SAIC filings 2. Conducted site visits AUDITOR SHOULD HAVE: 3. Independently verified information instead of relying on CRM s provision of information 4. Exercised professional common sense 5. Considered compliance with general Chinese law
Allegations that Survive Motion to Dismiss Auditor failed to: Exercise professional skepticism Obtain audit evidence supporting management s assertions from independent third parties Make reasonable investigation or possessed reasonable grounds for the belief of financial statement Detect fraud or material misstatements Review internal controls Conduct audit in Generally Accepted Auditing Procedures as represented Certifying financial statements as accurate even though false and misleading Conduct the audits as represented in SEC filings Withdraw audit opinion
Coverage Defenses Fraud and intentional acts by auditors Negligence
Contact Us Mary-Pat Cormier, Partner Edwards Angell Palmer & Dodge Boston, MA 617.951.2225 MCormier@eapdlaw.com Gregory D. Pendleton, Associate Edwards Angell Palmer & Dodge Boston, MA 617.239.0764 GPendleton@eapdlaw.com Kenneth Choy, Partner Lister Lo Lui & Choy Hong Kong (associated office) +852 2116 3748 KChoy@eapdlisterllc.hk