The last two years have witnessed a significant upswing in the number of securities class action lawsuits leveled against Chinese firms listed on US markets. While the total number of securities class actions filed in the US over the past three years remains below the historical average,[1] foreign companies listed in the US have bucked this trend and appear to be increasingly targeted by unhappy investors. Class actions against foreign companies now make up approximately a quarter of all securities class actions filed in the US. In particular, of the 20 securities class actions filed against foreign-headquartered companies in the first half of 2015, half were against Chinese companies.[2]

Why the increase?

Chinese companies have listed on US stock exchanges in increasing numbers over the last ten years, taking advantage of more readily available capital, less stringent listing criteria, and the greater recognition and prestige that comes with listing on some of the largest stock exchanges in the world. This prestige can be a valuable asset to Chinese companies to leverage back home with domestic clients, banks and government officials.

The growing number of Chinese firms choosing to list on US exchanges does not however solely account for their increasing share of class actions. We take a look at some of the other factors driving this growth, including the additional financial disclosure requirements Chinese companies face and an increasing level of scrutiny and general oversight.

Stricter scrutiny

In 2011, following the discovery of a series of financial irregularities, numerous Chinese companies were delisted from the US markets. These delistings provoked a surge of securities class action lawsuits against those companies, and further shook investor confidence in the integrity of Chinese stocks. Following this, a heightened level of scrutiny continues to persist among both investors and regulators alike in relation to US-listed Chinese companies.

One example of this is the actions taken by the SEC, which in 2010 established an internal taskforce specifically dedicated to investigate US-listed foreign companies, following a government complaint concerning fraudulent business activities. Since that time, the SEC has become much more proactive in launching both formal investigations and informal inquiries with respect to any accounting or auditing irregularities. In addition, the SEC has begun to rely heavily on its ‘whistleblower’ program, which provides insiders, typically business competitors or disgruntled employees, with a monetary incentive to report any suspected securities violations. China has been one of the greatest sources of foreign-based tips for securities violations in US markets. [3]

Actions taken by the SEC are publicly disclosed and not looked upon favourably by markets, often leading to a drop in share price. Consequently, the risk of a shareholder class action suit may increase as shareholders seek to recoup their market losses.

US stock exchanges also continue to play a crucial role in overseeing company behaviour, often asking a company to correct or explain an issue if it suspects either foul play or an irregularity. If the company fails to do so, the exchange may halt, suspend or even delist a company’s stock. Inquiries made by exchanges may be reportable or otherwise publicly available, thereby negatively affecting the share price and putting the company at risk of a class action.

Additional disclosure requirements

Because Chinese-headquartered companies listed in the US are required to lodge corporate financial reports both domestically in China and in the US according to US securities law, inconsistencies can often arise between the two. In some cases, these discrepancies may be minor and merely represent differences in accepted accounting procedures in each country. However they may also be a sign of fraudulent activities. The problem in part is that domestic filings may be drafted with an eye toward tax minimization, while off-shore filings may be drafted to make investors feel good about the company. Any material difference relating to revenue, for example, is likely to be a red flag. The additional disclosure requirements that Chinese companies are subject to in the US may therefore result in investors discovering inadequate or misleading disclosures that would have otherwise gone unnoticed.

This risk has been compounded in recent years by the emergence and growth of short-selling investment research firms, such as Muddy Waters and Citron, which are notorious for trawling through companies’ filings and outing companies for accounting irregularities. If discrepancies are discovered, they are quickly published, often leading to an SEC investigation and a subsequent drop in share price (as well as substantial profits for the short sellers, of course).

Identifying companies at risk of class action lawsuits

The following conditions are typically associated with a higher risk of corporate wrongdoing, and may be helpful in identifying Chinese companies that are at a higher risk of a class action lawsuit in the US:

  • Weak corporate governance: Without sufficient internal controls, managers may have room to manipulate accounting records, siphon funds and engage in other acts of corruption. Red flags may include frequent CFO or auditor changes, changes in the independent directors, and failure to file timely financial information or meet reporting deadlines.
  • Overstating revenue: From 2009 to 2013, a significant percentage of all class-action suits filed against US-listed Chinese companies were for overstating revenue. Many Chinese companies seek to legitimately restate the scope of their businesses in order to avoid the need for government approval of their operations. However, to a third party shareholder, this may appear misleading if the company’s English promotional materials imply broader business activities than those stated in the Chinese filings. Trends that may signal overstated revenue include abnormal sales growth between years (compared with companies in the same industry) or a faster increase in accounts receivable than sales growth.
  • Frequent change in auditors or late filings: While legitimate reasons for changing auditors may exist, the frequent changing of a company’s independent auditor may signal the presence of unresolved financial irregularities. Similarly, if an auditor resigns because they cannot obtain satisfactory information from the company, this may cause a delay in the submission of require quarterly or annual filings, triggering a halt in trading or even a delisting.

Tips for minimising the risk of class action lawsuits

To minimise the risk of a class action lawsuit, all companies should ensure compliance with all applicable rules, regulations and reporting standards. In particular, the establishment of effective internal controls is essential to discourage fraud and build trust among investors and regulators. Our top tips:

  1. establish a robust system of corporate governance by integrating management, directors and financial staff, to promote the effectiveness of the company’s internal controls and oversight;
  2. educate Chinese directors annually on their fiduciary duties and the US legal regime, and make clear that they will be subject to US law, even if they are residing in China;
  3. encourage positive auditing practices: maintain a truly independent audit committee, engage a top tier auditing firm and facilitate open communication between auditors and management;
  4. refrain from making overly optimistic management forecasts that may disappoint investors;
  5. communicate frequently and transparently with investors, including in relation to differences between Chinese and US business cultures;
  6. incorporate robust safe harbor statements in your filings and keep the company’s lawyers informed of all pertinent matters; and
  7. establish a crisis management strategy, including a comprehensive internal investigation of the company’s finances, and a plan for responding quickly to media enquiries.

While implementing the above strategies may not eliminate the prospect of a securities class action lawsuit, it should help to reduce the likelihood of a suit and put the company in a stronger position to defend itself in the event that the company is sued.