Shareholders suing Alibaba face high bar to prove fraud

February 4, 2015

It has been a week since China’s State Administration for Industry and Commerce published a report accusing the e-commerce company Alibaba of selling counterfeits, infringing trademarks and other dubious business practices. The Chinese regulator has since retracted the report, but in the meantime Alibaba announced disappointing earnings for the third quarter of 2014. The company’s U.S.-traded American Depositary Shares, which launched in a record-setting initial public offering in September, fell sharply after both troubling disclosures. In all, Alibaba lost $11 billion in market capitalization last week.

Is it any surprise then that two big plaintiffs’ firms – Robbins Geller Rudman & Dowd and Pomerantz – have already filed securities class action complaints against the company? Robbins Geller was first off the mark with a Jan. 30 suit in federal court in Manhattan. Pomerantz filed in the same court on Tuesday. Both cases were brought in the name of individual shareholders, but these are early days. You can be sure that plaintiffs’ lawyers are talking to the pension and healthcare funds they represent about jumping into the litigation. (One complication may be that, as I’ve reported, Alibaba’s IPO includes a fee-shifting provision that requires unsuccessful shareholder plaintiffs to bear the company’s cost of defending their suits.)

Here’s the interesting thing about the complaints already filed: They assert claims under the fraud provisions of the Securities Exchange Act of 1934, not under the investor protections against misleading registration statements in the Securities Act of 1933. That might sound like a mere technicality, but it’s not. Fraud carries a higher pleading standard than the strict liability provisions in the 1933 Act. In order even to obtain discovery from Alibaba, shareholders bringing claims under the 1934 Act will have to provide good evidence that corporate officials intended to deceive investors.

Alibaba just had an IPO and the new complaints specifically allege that its registration statement was misleading because (among other supposed deficiencies) it failed to disclose that before the IPO, Chinese regulators had already met with corporate officials to advise them of concerns about Alibaba’s business practices. Moreover, securities litigation based on IPO registration statements is booming while 1934 Act fraud class actions are stagnant.

So why didn’t Robbins Geller and Pomerantz sue under the 1933 Act? There’s a simple answer: share prices. Alibaba’s IPO price was $68, but shares quickly shot up by more than $20, en route to a high of $119 in November. Even after last week’s bad news about the regulatory report and earnings shortfalls, shares traded at about $90. Stockholders who bought Alibaba shares in the IPO, in other words, made money even if they sold when the share price dropped to $89 last week.

But that’s not true for shareholders who bought on or after Oct. 21, when the average price was $90, and sold as the stock fell after last week’s disclosures. Investors who traded in that window of time can claim they lost money as a result of Alibaba’s supposed misstatements. That’s why the complaints are formulated as fraud claims, with the class period beginning on Oct. 21, and not as IPO misstatement claims on behalf of Alibaba’s initial investors.

I don’t want to overstate the additional burden shareholders face because of the way the Alibaba complaints are pleaded. Courts often require plaintiffs to meet fraud standards for 1933 Act allegations that “sound in fraud.” And as the Wall Street Journal reported Wednesday, there may be tougher obstacles than the fraud standard for investors to overcome in the case against Alibaba, including the company’s unusual corporate structure and the potential difficulty of enforcing a judgment against a foreign-incorporated company whose operations are based outside of the United States.

I reached out to securities lawyers at Simpson Thacher & Bartlett, which advised Alibaba on the IPO, and Sullivan & Cromwell, which was counsel to Alibaba’s underwriters. They’re both in Hong Kong, and neither got back to me. Alibaba has said publicly that it was not aware of the allegations in its regulator’s since-retracted report until the report was published.

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