In the 1974 movie Chinatown
, private investigator Jake Gittes famously did "as little as possible" while he was a beat cop in Chinatown, because he never knew what was really going on.
Investors in U.S.-listed Chinese companies - especially those structured as reverse mergers - face a similar problem. Stock analyst Lucas McGee, for instance, began his February 2011 post this way: "Based on our research, we think that China Agritech does not have a currently functioning business generating anything close to $100 million in revenue. We're very confident that the company is a scam."
McGee, principal in LM Research, apparently had done his homework. "Our factory visits revealed that Agritech's manufacturing facilities are currently all idle and only one out of its four factories produced anything at all in 2010." At the end of his report, McGee disclosed that he had shorted the stock.
The report was an investor's nightmare - and it could have been a securities lawyer's dream. China Agritech is a reverse merger, created through the purchase and reuse of a dormant shell company that is listed on the NASDAQ exchange. The technique permits easy entry to U.S. capital markets without undergoing the regulatory scrutiny of an initial public offering. It also facilitates all manner of accounting irregularities by unscrupulous company officials.
PriceWaterhouseCoopers reports that of the 159 Chinese reverse mergers created from 2007 through the first quarter of 2010, nearly one-fourth have been sued in securities class actions. In April, the Financial Fraud Law Report related that U.S. exchanges had delisted or suspended 30 Chinese companies.
Back in early 2011 Laurence Rosen, principal of the Rosen Law Firm of New York and Los Angeles, filed suit against China Agritech, basing allegations of federal securities fraud on Lucas McGee's financial report. (Dean v. China Agritech, Inc.
, CV 11-01331 (C.D. Cal. filed February 2, 2011).)
The barriers to financial recovery in such suits, however, are daunting. Plaintiffs must first meet the heightened pleading standard for securities class actions, including alleging sufficient facts to show falsity, scienter, and loss causation. If the investors survive a motion to dismiss, they must locate company officials, attempt service of process through the Hague Convention, establish personal jurisdiction, certify a class, and conduct discovery - which is virtually impossible in mainland China. And should the plaintiffs eventually prevail, they must somehow enforce the judgment.
Last year the Rosen firm had a breakthrough when one of its Chinese reverse merger (CRM) cases survived a motion to dismiss - a first. (Henning v. Orient Paper, Inc.
, 2012 WL 2909322 (C.D. Cal.).) The Central District federal court rejected the defendants' argument that the complaint had failed to plead loss causation because it relied on a short seller's report. This spring a different Central District judge denied a motion to dismiss in a separate Rosen CRM case. (Snellink v. Gulf Resources, Inc.
, 2012 WL 1693979 (C.D. Cal.).)
Rosen's Dean v. China Agritech
, however, stumbled on class certification. In May, U.S. District Judge R. Gary Klausner ruled that the plaintiffs had failed to satisfy the "common question" requirements of F.R.C.P. rule 23(b)(3), which addresses groupwide reliance. To use the fraud-on-the-market presumption, Klausner wrote, class members needed to show that China Agritech's shares traded in an efficient market. The judge found that the plaintiffs had failed to demonstrate the most important factor: a cause-and-effect relationship between China Agritech's financial reports and the change in its share price. (Dean v. China Agritech, Inc.
, 2012 WL 1835708.)
"The ruling changed the case dramatically," says China Agritech defense counsel Seth Aronson, a partner at the Los Angeles office of O'Melveny & Myers. "A potential class of thousands of members was reduced to four individuals."
A Debevoise & Plimpton client alert on the case concluded, "[I]f a company's securities are thinly traded and the company is not the subject of press coverage, investors may have different levels of knowledge about the company, and their reliance on particular statements cannot be presumed."
Indeed, because so little company reporting is available, plaintiffs in CRM cases often rely on the analysis of short-sellers, including LM Research, Seeking Alpha, and Muddy Waters Research. Muddy Waters posts on its website, "The Chinese have an old proverb: 'Muddy waters make it easy to catch fish.' In other words, opacity creates opportunities to make money." But opacity can also create problems in court.
"The reliability of negative information from short sellers is inherently suspect," says Michael MacPhail, a partner in the Denver office of Faegre Baker Daniels who has defended reverse merger companies. "Their motives can be presumed to be self-interested."
Or worse. Several of the Rosen complaints, for instance, relied on analysis by "Alfred Little," a blogger's online pseudonym. In at least two of those cases, the defendants responded by countersuing Little, Seeking Alpha, and several John Does for fraud and defamation. The complaints allege that Alfred Little either doesn't exist or was part of an organized scheme to manipulate the stock prices. (Deer Consumer Products, Inc. v. Little
, No. 650823/2011 (N.Y. Sup. Ct. filed Mar. 28, 2011); Sino Clean Energy, Inc. v. Little
, No. 651248/2011 (N.Y. Sup. Ct. filed May 9, 2011).)
In Orient Paper
and Gulf Resources
, the Rosen firm now faces the challenge of conducting discovery in China - a country that permits no such thing under state secrecy laws. Theoretically, depositions may be taken in Hong Kong under the Chinese policy of "two systems, one country," says David N. Feldman, a partner in the New York office of Richardson & Patel and author of Reverse Mergers and Other Alternatives to a Traditional IPO
(Bloomberg Press, 2006). But compliance wouldn't be easy. "The first challenge is service of process and personal jurisdiction," Feldman says. "You have to get defendents to sit down for a deposition
Collecting a judgment, however, may be impossible. To date, no foreign judgment has ever been enforced by a Chinese court. "We will continue to see some complaints filed," concludes O'Melveny's Aronson. "But the great wave of reverse merger cases is over."
Still, plaintiffs lawyers invariably see options. "China Agritech
was very fact-specific," notes Kevin M. LaCroix, an insurance lawyer in Beachwood, Ohio, who blogs at The D & O Diary
. "Plaintiffs lawyers could proceed as a mass action. They could pursue U.S.-based directors, or the investment bankers who structure reverse mergers. They live to get past the motion to dismiss-and then they take the shortest path to the settlement table."
Like Jake Gittes's pursuit of elusive truth in Chinatown
, Laurence Rosen continues to chase reverse merger cases in New York and California. Asked about his next move in China Agritech
, Rosen responds by email from his New York office, "We are not deterred."