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Equities: Litigation boom as China stock scandals roll on

CEOs can be forced to testify; Accused companies face difficulties in counter-suing

China stock scandals

Chinese companies listed in North America are at risk of overlapping government investigations and civil lawsuits, as the number of overseas-listed China stocks facing fraud allegations grows, according to lawyers working on such cases.

"Executives that think they can avoid discovery because they are in China can be startled to find that in some circumstances they can be compelled to testify in the US"

Steve Perlstein, Kobre & Kim

Steve Perlstein, partner at Kobre & Kim


"Last year, 12 Chinese companies were hit with class-action lawsuits," says Steve Perlstein, partner at Kobre & Kim, "and the trend has continued this year with around 25 new lawsuits filed already." As the number of investors that have lost money on China stocks accused of fraud grows, they are starting to seek legal measures to recoup those losses. Executives at the Chinese companies, meanwhile, are starting to discover the extent to which listing in North America places them at the mercy of a complex system of rules covering disclosure, accounting and legal obligations.

"What some companies don’t initially understand," says Perlstein, "is that discovery obtained by plaintiffs in a civil litigation may then come into play in parallel regulatory investigations. Furthermore, executives that think they can avoid discovery because they are in China can be startled to find that in some circumstances they can be compelled to testify in the US. Even if they cannot, refusing to do so or invoking their rights not to testify could put them at odds with their own company and harm it in the civil litigation."

As the short-selling industry whose negative research reports trigger these stock plunges finds more targets, many Chinese companies that insist they are legitimate are finding that their hunters are not so easy to counter-attack. The US legal system is better equipped to cope with instances of corporate fraud than potentially malicious short sellers, say industry insiders.

Moreover, even if it can be proved that a short seller is manipulating the market through false research, the damage has already been done to the accused company, as scared investors abandon it during the lengthy investigation process.

Hottest case

All eyes are thus on the hottest current case. Toronto-listed Sino Forest, accused by Hong Kong-based short seller Muddy Waters of large-scale fraud, said in a June 6 release that it was "considering its legal remedies" against Muddy Waters. Euromoney understands that no formal proceedings have been launched as yet.

Sino Forest, like many of the other companies accused of fraud, has hired an external auditor – in this case PwC – in an attempt to demonstrate external validation of its business model and accounting. The company estimates that it will take two to three months for this investigation to be completed, a timeline that Muddy Waters research director Carson Block describes as "aggressive".

The question in the minds of many observers of this and other cases is: what comes next should Sino Forest – or indeed any firm suffering such attacks – be wholly or partially vindicated by external audit. Nobody is quite sure how such a company would go about suing the short sellers, who are typically small, asset-light firms often publishing from different jurisdictions from those in which the companies operate. That means that any company wishing to counter-attack the short sellers will have to get creative.

Perlstein says companies that have suffered from the attentions of short sellers are indeed starting to take the initiative. "As for companies whose stocks have plunged because of short-seller research," he says, "the traditional application of US laws has made it difficult for private companies to hold those short sellers responsible for harming shareholders. Recently, however, a number of companies have advanced innovative legal theories to take action and correct the public record."

Follow the latest developments on twitter at #ChinaStockScandals

see also:

Chinese stock scandal: US-listed go private

Editor's letter: China stock scammers driven by lack of alternatives

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