Financial Regulatory Forum

Disclosure system no guarantee of protection for China-focused investors

By Guest Contributor
March 26, 2012
By Helen H. Chan (Hong Kong)

HONG KONG/NEW YORK, March 26 (Business Law Currents) – China’s bourse regulators and the nation’s IPO watchdog, the China Securities Regulatory Commission, have been busy brainstorming improvements to legislation governing the disclosure requirements of listed companies in the PRC.

Aiming to bring increased transparency and other investor protection merits often associated with a disclosure-based securities regulatory framework, the CSRC is contemplating models from Hong Kong, the United States and other jurisdictions where listed companies are required to publicly disclose corporate and financial statements in a timely manner.

Recent fraud allegations involving U.S.-listed Chinese companies have highlighted shortcomings in a disclosure based system, particularly where securities regulators primarily rely on companies and their professional advisors to truthfully and accurately disclose information in filings. Although many of the accused companies appeared to comply with disclosure obligations, subsequent investigations produced allegations of material misstatements, omissions and even forgery of regulatory filings.

China MediaExpress (CCME), a provider of televised advertisements on buses in the PRC, is one such example. Prior to becoming embroiled in an accounting scandal last year, the China-based company boasted of an extensive local market presence in its disclosure filings to the SEC. According to its 2009 annual report, CCME’s advertising networks accounted for 81 percent of “all inter-city express buses installed with hard disk drive players” and 55 percent of “all inter-city express buses installed with any type of television display” in China.

In January 2011, short seller firm Citron Research issued a report accusing China MediaExpress of grossly overstating its profits and other elements of its operations. Citron Research argued that if CCME’s financial statements were true its return on investment would be “a complete outlier in the Chinese advertising market.” Pointing to the absence of CCME in a 2010 market study on China’s top 10 outdoor LCD screen businesses, Citron Research also questioned the accuracy of CCME’s claims about its extensive local market presence.

CCME’s shares lost 89 percent of their value over the course of 2011 as investors became skittish about the truthfulness of the company’s U.S. disclosure filings. Major stakeholders such as Starr International Co have also sued the company for fraudulently misleading investors. For more information, please see Securities enforcement: U.S.-listed Chinese companies duck and dodge legal enforcement.

By way of background, CCME gained its U.S. listing through a reverse merger with a Delaware blank check company. Disclosure documents were routinely submitted to the SEC, including qualitative and quantitative analysis of its business operations, without much objection from regulators.

CCME’s independent auditor resigned in April 2011. The company was delisted one month later and currently trades on the OTC market.

CCME’s banishment from the NASDAQ has done little to compensate the company’s shareholders, who may have to wait for years for an outcome through securities litigation in the United States. In the end, shareholders may be left with nothing due to difficulties in enforcing U.S. judgments on China-based businesses. For more information, please seeU.S.-listed Chinese companies: enforcement fails to go the distance.

In a similar scenario, U.S. securities regulators and angry shareholders of Duoyuan Global Water Inc have had little success in verifying the accuracy of the company’s disclosure filings after short seller Muddy Waters LLC accused the company of forging elements of its financial statements in 2011. Duoyuan announced in 2010 that it had formed a special investigation committee to look into issues related to the company’s internal controls on financial reporting and other business practices.

Duoyuan has declined to be more specific on the investigation although there have been several erratic announcements, such as the abrupt resignation of Skadden, Arps, Slate, Meagher & Flom LLP as legal counsel to Duoyuan’s audit committee and special investigation committee in April 2011. Duoyuan subsequently retained Baker & McKenzie and accounting firm PricewaterhouseCoopers to continue the internal investigation.

Duoyuan also submitted multiple late filing notices to the SEC last year, claiming that it could not provide investors with more details because the investigation was still ongoing and as a result it was “premature to report any conclusions.”

The company’s silence sent investors into a panic and roiled its share price; it was subsequently delisted from the NYSE for failing to file its 20-F on “a timely basis” for the year ended December 31, 2010.

While Duoyuan has appealed the delisting decision multiple times, most recently in February 2012, the company still has yet to file the required annual report. To date, it remains unclear whether the internal investigation has been completed.

Glancy Binkow & Goldberg LLP, have filed a class-action lawsuit against the company on behalf of a group of Duoyuan shareholders. According to an amended complaint submitted last June, Duoyuan has continually evaded commenting on the accuracy of its disclosure documents. Additionally, the company is alleged to have gone dark altogether, “indefinitely” delaying the release of financial information such as quarterly disclosure reports for 2011.

As with the shareholders of CCME, Duoyuan’s investors are unlikely to get answers from the company any time soon. Regulators of the disclosure-based system in the U.S. have been largely unable to protect the shareholders, meaning that some of CCME and Duoyuan’s investors have suffered financial losses due to their reliance on potentially false regulatory filings.

Disclosure alone, without regulatory authority to verify the authenticity of documents and hold listed companies responsible for violations of disclosure rules, may therefore be insufficient to protect investors.

As the guardians of China’s capital markets move towards a disclosure-based system in securities regulation, they may well be looking to such enforcement gaps and considering efficient alternatives to protect investors when companies are accused of lying in disclosure documents.

(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at http://currents.westlawbusiness.com. )

 

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