U.S. lawsuits against China companies face hurdles

Mon Feb 14, 2011 11:22am EST

Related Topics

* Chinese companies accused of securities fraud in U.S.

* U.S. lawsuits run into barriers in China

* Plaintiffs accept relatively small settlements

By Carlyn Kolker

NEW YORK, Feb 14 (Reuters Legal) - As more Chinese companies trade on U.S. stock exchanges, investors are increasingly suing them for securities fraud in U.S. courts -- and slamming into a host of legal and bureaucratic barriers.

In theory, investors should be having an easier go of it. These Chinese entities, after all, agreed to abide by U.S. securities laws when they went public and gained access to U.S. financial markets. In practice, though, the companies have been able to hide behind a thicket of Chinese laws to avoid significant liability -- in large part because evidence in these matters often resides in China, where basic litigation tasks such as gathering evidence are exceedingly difficult. Depositions by private parties are not even allowed in China, and it is nearly impossible to subpoena third-party witnesses there.

The vast majority of all civil securities-fraud suits end in settlement; but with all the impediments to pursuing claims against Chinese companies, plaintiffs' lawyers often don't have much leverage, and as a result, cases either drag on or plaintiffs accept relatively small settlements.

To be sure, the hurdles in these cases aren't exclusive to China -- they frequently arise in civil litigation against companies based in non-Western countries with opaque legal systems. But China has emerged as a particularly tempting target. Twelve Chinese companies were sued in 2010, accounting for more than 40 percent of all shareholder suits filed against foreign companies listed on U.S. exchanges. That compares with 14 suits against Chinese companies in the prior three years combined, according to research by Stanford Law School and Cornerstone Research. The lawsuits allege that the companies misled shareholders by all sorts of underhanded means, from grossly inflating revenues reported in securities filings to reporting vastly different earnings to U.S. and Chinese regulatory authorities.

It's too soon to say how the newest spate of litigation will play out, of course, but if the earlier crop of lawsuits are any indication, shareholders could end up disappointed.

GIGANTIC LOOPHOLE

A 2007 lawsuit against LDK Solar Co. Ltd. LDK.N, a China-based solar-wafer manufacturer, is fairly typical of the genre. The suit, which settled last year for $16 million, accused the company of grossly overstating its financial performance in filings with the Securities and Exchange Commission. But when the plaintiffs attempted to subpoena documents from LDK's outside auditor, KPMG Huazhen, they hit a wall: Because KPMG Huazhen is based in China, it is not subject to U.S. discovery rules -- even though it is an affiliate of a major accounting firm based in the United States. So the plaintiffs could not obtain the sort of detailed financial information they needed to prove their claims that the company greatly overstated the value of its inventory. James Farrell, a partner at Latham & Watkins who represented LDK, declined comment.

At a hearing last June, U.S. District Judge William Alsup in San Francisco bemoaned this "gigantic loophole" and went so far as to ask the plaintiffs' lawyer, Herbert Milstein of Cohen Milstein Sellers & Toll, to bring the issue to the attention of the SEC. "SEC ought to say that if somebody is not going to make their work papers available they cannot trade on the national exchanges," Judge Alsup declared.

Milstein wrote the SEC in September, proposing that it consider a rule requiring companies that issue securities on U.S. exchanges to use auditors who are subject to U.S. jurisdiction. He said he hasn't heard back. SEC spokesman Kevin Callahan declined to comment. But the agency is well aware of the broader problem: The Wall Street Journal reported in December that the agency has launched a "wide-scale investigation" focused on possible accounting fraud by Chinese companies that have gone public in the United States.

THE CHALLENGE OF COLLECTING

When plaintiffs suing Chinese entities do prevail in court, this hardly means the battle is over. While Chinese law recognizes certain judgments awarded in the United States, legal, bureaucratic and cultural barriers have stymied efforts by U.S. parties to collect on judgments in China. "To date I am not aware of a single case where a United States judgment has been enforced in China," said Owen Nee, a Jones Day lawyer who has been practicing in China for more than 30 years.

In 2007, shareholders filed a securities-fraud lawsuit against e-commerce company China Expert Technology Inc. CXTI.PK, claiming it had forged 16 different Chinese government contracts, overstating the value of its revenue in public filings by $131 million. The company never responded to the complaint and was found to be in default in January 2008. Three years later, the plaintiffs still haven't even attempted to calculate damages and collect, according to the shareholders' lawyer, Phillip Kim of New York's Rosen Law Firm. Kim said any effort to collect at this point would be futile, since the company has moved its assets out of jurisdictions accessible to U.S. investors. The company still trades as a penny stock in the United States. Messages sent to a company e-mail address seeking comment bounced back, and phone calls were not answered.

With China Expert out of reach, in October 2009 Kim amended the complaint to add as defendants the company's auditors, PKF Hong Kong and BDO McCabe Lo Limited. Last week, U.S. District Judge Alvin Hellerstein of the Southern District of New York granted the defendants' motion to dismiss, finding that the plaintiffs had not adequately demonstrated how the auditing firms violated accounting rules. But he gave the plaintiffs six weeks to re-file.

Kim, whose six-lawyer firm typically files dozens of securities class actions every year, said that despite the hurdles, he believes there will eventually be a big payoff in developing this legal subspecialty -- especially as more Chinese companies move into the United States. "It's not like we were focused on Chinese companies in particular," Kim said. "This thing just blew up." (Reporting by Carlyn Kolker of Reuters Legal; Editing by Eric Effron and Amy Stevens) (This article first appeared on Westlaw News & Insight, westlawnews.com)

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