Chinese corporations continue to look to public markets in the United States as a capital source. With increased listings comes an increase in shareholder litigation. An examination of the types of shareholder lawsuits that target these companies, and subsequent settlements are important considerations for claims professionals and underwriters as they evaluate some of the unique risks that these issuers listed in the United States face. Additionally, as the rules and regulations surrounding all issuers are constantly evolving, underwriters may wish to consider Securities and Exchange Commission (“SEC”) guidance issued regarding disclosure considerations for these issuers that list on U.S. Exchanges.
The Reverse Merger Years
A number of foreign corporations, including corporations operating in China, used reverse mergers to list on United States Exchanges during the early 2000s. In these transactions, a private company acquires enough shares of an American publicly traded firm and essentially the private company becomes the publicly traded company (“Reverse Merger Companies”).
From January 2007 through March 2010, approximately a quarter of the companies that used reverse merger transactions to publicly trade were based in China. Following the wave of listings came increased scrutiny on many of these Reverse Merger Companies from short sellers. The short sellers published reports that detailed serious financial and operational irregularities regarding several Reverse Merger Companies. These reports and the related sharp price drops for the securities of this category of Reverse Merger Companies spurred a wave of shareholder litigation.
According to Cornerstone, the aforementioned cases largely involved smaller companies and thus, lower shareholder losses than the shareholder losses in lawsuits filed against comparatively larger companies. The reverse merger cases largely disappeared as fewer private companies used reverse mergers to enter U.S. Markets. As larger China-based Issuers started to go through the IPO process and list on American Markets, the public assumed that these companies would not suffer from similar issues that the Reverse Merger Companies faced.
Corporate Fraud Securities Litigation Against Issuers
Despite an overall decrease in shareholder litigation in the first half of 2021, filings against China-based Issuers have continued unhindered. In the first half of 2021, there were 9 filings against these companies out of 15 filings against non-US issuers. If the trend continues, 2021’s filings against companies are on pace to exceed 2020’s filings by almost 40%.
A recent category of actions brought against these companies share notable similarities with the Reverse Merger Companies cases. The alleged frauds are being revealed by short seller reporting that purports to have uncovered fraud at the company tied to operational and financial irregularities. The SOS Limited (“SOS”) case is a recent example of a case in this category.
SOS is a cryptocurrency mining company incorporated in the Cayman Islands but based in China. On February 26, 2021, two short sellers released reports on SOS, claiming that SOS was an intricate “pump and dump” scheme that used fake addresses and doctored photos of cryptocurrency mining rigs to create an illusion of success. A securities class action complaint followed shortly thereafter. This case is still in its early stages.
A case with similar allegations of corporate fraud, In re Luckin Coffee Inc., Securities Litigation, was filed in 2020. The Luckin plaintiffs alleged that Luckin Coffee’s stores were operating at substantial losses, the Company’s financial health was in jeopardy, and Luckin Coffee’s store sales data was allegedly fabricated over multiple quarters which caused Luckin Coffee’s ADSs to trade at artificially inflated prices throughout the relevant time period. The first disclosure of the truth was attributed to a report issued by investor research firm Muddy Waters in January 2020. The price of Luckin ADSs fell as much as 26% after the report’s publication and fell a total of 80% in the month of April following the announcement of an internal investigation. The internal investigation revealed that the company’s Chief Operating Officer and his direct reports had been fabricating sales. Luckin Coffee has announced that it has entered into a binding term sheet with the lead plaintiffs in the pending securities class action. Pursuant to the term sheet, shareholders will receive a $187.5 million settlement which could be reduced on a pro-rata basis based on opt-out notices received. The settlement is subject to obtaining approvals from the Cayman Court where Luckin Coffee’s liquidation is pending and the approval by the U.S. court where the class action is pending. The final report on opt-out notices was due on or before October 8, 2021.
Shareholder litigation against larger companies look to be setting precedents as these lawsuits are achieving much bigger settlement sums, as compared to the earlier reverse merger cases.
Cybersecurity Shareholder Litigation
Regulators in China recently increased their enforcement of existing cybersecurity laws through the Cybersecurity Review Office, an office established under the Cyber Administration of China. In the first year of its existence, the Cybersecurity Review Office did not commence any regulatory proceedings; however, in its second year the Office has initiated several cybersecurity reviews against mobile application developers and Chinese Issuers that list in the United States.
The first company subjected to this review was Didi Chuxing (“Didi”) which was announced two days after Didi’s $4 billion IPO in New York. In response to the commencement of a review, Didi shareholders filed a securities class action against the company in the United States. Didi is not the only company to be subjected to the cybersecurity review and a subsequent securities class action lawsuit. Full Truck Alliance, and Kanzhun Limited, have encountered the same fate.
On December 3, 2021, Didi announced that its board of directors authorized the delisting of Didi’s American Depositary Shares (“ADSs”) from the New York Stock Exchange. The board of directors also authorized Didi to pursue a listing of its class A ordinary shares on the Main Board of the Hong Kong Stock Exchange.
This category of cases is still in its infancy. As they make their way through the courts and early procedural challenges, there may be opportunities to learn how judges view the strength of these allegations and what factors can strengthen or weaken a case.
Conclusions for Underwriters
While underwriters have been issuing D&O policies in China for years, it is important to note that the risks of underwriting these policies, as with many things, are constantly evolving. Seemingly, a new category of securities class action against China-based Issuers has appeared over the last eighteen months and it may be challenging for underwriters and claims professionals to properly evaluate the new risks.
One thing to consider is the pace of recent SEC actions. Specifically, in November 2020, the SEC’s Division of Corporate Finance issued CF Disclosures Guidance: Topic No. 10. , which identified disclosure considerations for China-based issuers that list on U.S. exchanges.
The SEC’s guidance followed a series of legislative and executive actions that are aimed at curbing listings by issuers if their auditors had not been inspected by the Public Company Accounting Oversight Board (“PCAOB”), or if the auditor did not demonstrate that it was capable to audit a publicly traded company.
In addition to the above-mentioned trends, there are also emerging industry specific issues that underwriters operating in China may wish to consider. For example, the significant debt load and potential spread of the Evergrande crisis may be so great that the fallout from any failure could hurt many other aspects of China’s economy, including Chinese corporations that trade on American exchanges and potentially US and European financial institutions. Among other things, such failures could result in securities class actions alleging that certain corporations had undisclosed balance sheet exposure to Evergrande or were effected by Evergrande in a way that was not adequately disclosed to shareholders.
For analysis of some of the other industries that have seen a rise in shareholder litigation please see this article on the cannabis and SPAC industries please see: https://kennedyslaw.com/thought-leadership/article/cannabis-and-spacs-the-potential-convergence-of-growing-industries-and-opportunities-for-do-underwriters-to-assess-risk/
For further analysis on companies that maintain cryptocurrency on their corporate balance sheet and some of the D&O and E&O considerations please see: https://kennedyslaw.com/thought-leadership/article/cryptocurrency-on-corporate-balance-sheets-do-and-eo-underwriting-and-claims-considerations/
For further analysis on China’s Personal Information Protection Law please see: https://kennedyslaw.com/thought-leadership/article/prc-enacts-the-personal-information-protection-law-a-10-point-cheat-sheet/