A large number of Chinese companies are facing parallel inquiries and proceedings stemming from allegations of US securities law and listing requirements violations. Often triggered by auditor concerns over the company's financials or public allegations of improper transactions, these companies have been subject to internal investigations initiated by the company's audit committee, SEC investigations, inquiries by the exchange on which the company is listed, and private litigation brought by aggrieved shareholders. Most Chinese companies wholly unexpect the onset, depth, and expense of these types of proceedings which place substantial demands on the company and its directors, officers, and employees. Managing and devoting resources to respond to these proceedings can significantly impact the company's financial resources, with costs easily reaching tens of millions of US dollars, as well as day-to-day operations and employee morale.
The costs of compliance and responding to US proceedings coupled with low share price and trading volumes have made US capital markets less attractive for many Chinese companies, causing some to reconsider their status as a US listed company. Various exit alternatives exist. A US listed company may delist and go private pursuant to a private equity buyout. Alternatively, the company may delist and trade as an OTCBB or Pink Sheets quoted company. The legal and practical costs of delisting can be significant and the decision to delist should only be made after careful consideration.
I. Audit Committee Investigations
Shortly after reports by outside auditors of concerns over the company's financials or public allegations of improper transactions, the company's audit committee may be compelled to or may in its own discretion initiate an internal investigation. The independent investigation team is comprised of US and PRC attorneys and accountants engaged by the audit committee through the US attorneys. This arrangement protects communication between the investigation team and the audit committee and the investigation team's work product (including its final investigation report and other documentation prepared by the team for the investigation) which falls within the attorney client privilege and the attorney work product doctrine. These privileges are especially important to protect information sought in parallel proceedings. The privileges belong to the company and may be waived if doing so is in the best interest of the company.
The scope of an internal investigation is determined by the audit committee and is far broader than an annual audit of the company's financials. The purpose is to determine the factual basis of the allegations or transactions at issue and confirm, to the extent possible, that the Company has not engaged in unlawful behavior or other similar practices. The investigation team will adopt corporate investigative procedures which include collection of electronic and hard copy evidence, forensic accounting procedures, and interviews with company employees, customers, banks, suppliers, and other relevant third parties. An internal investigation may last three to six months, and possibly up to a year, depending on the scope of the investigation and size of the company and will likely cost well over US$1 million.
Once a sufficient investigation has been performed, the investigation team will provide an oral or written report to the audit committee with its findings, keeping in mind that the report may be voluntarily disclosed to the SEC or listing exchange and may later be obtained for use in private civil litigation. Upon receipt of the report, the audit committee must determine what information relating to the team's findings must be disclosed in the company's SEC filings, remedial measures which should be taken, and internal controls which should be adopted to bring the company into compliance and prevent recurrence of any improper transactions uncovered.
II. SEC Investigations
If the SEC suspects a violation of US securities law has occurred or is about to occur, it may initiate a formal or informal investigation. The SEC has broad investigative powers over the listed entity and its directors, officers, and executives but has little reach over Chinese individuals, entities, and assets in China. Failure to comply with a formal SEC investigation, however, may result in both civil and criminal liability in the US, which may affect the company's assets within the US and its directors, officers, or executives with assets within or those who travel to the US.
A SEC investigation is a non-public fact finding inquiry to determine if a violation of US securities law has occurred or is about to occur. The SEC has the authority to obtain documents and information by issuing a subpoena to the US listed entity over which it has jurisdiction. Complete and accurate disclosure of all non-privileged information sought pursuant to the subpoena is mandatory. It is also a pre-condition to any favorable treatment. The audit committee may, however, elect to cooperate with the SEC and produce privileged information if will help the company resolve the issues and avoid or reduce fines and penalties. In such event, the company's counsel must carefully consider the form and nature of information disclosed and weigh the risk that information produced may be handed over to the US Department of Justice (DOJ) for use in a criminal investigation or may be obtained for use in private civil litigation.
Upon the completion of its investigation, the SEC will determine whether to bring an enforcement action. If an enforcement action is brought, civil penalties including disgorgement of profits, fines, and an order to restate inaccurate disclosures, adopt enhanced internal controls, or hire a corporate monitor may be imposed. The majority of enforcement actions are settled. Settlement of an enforcement action does not prevent the SEC, DOJ, or other government enforcement agencies from bringing a future civil or criminal action against the company or individuals.
III. Inquiries by the Listing Exchange
The US listed company may also be subject to proceedings initiated by the exchange on which it is listed. The scope of inquiries by listing authorities is typically narrower than an internal investigation or SEC investigation. If the company has failed to comply with its listing requirements, the exchange may suspend trading and request that it submit a plan outlining steps it intends to take to regain compliance. If the exchange does not accept the company's plan or the company fails to regain compliance with listing rules, the exchange may begin delisting proceedings. The company must continue to maintain its SEC filings during this time.
NASDAQ delisting hearings are non-public hearings before an independent panel requiring the company to demonstrate its ability to regain and sustain long-term compliance with listing rules and US securities laws. Members of the audit committee, company directors, officers, and executives, and even members of the investigation team may be asked to testify. Delisting hearings for NYSE listed companies, on the other hand, are public hearings which are conducted by FINRA, the NYSE's oversight and enforcement authority. Again, the company must carefully weigh the privileged information it elects to disclose as this information will likely become available to the SEC, other government agencies, and private litigants.
If the company is not delisted, it will be granted a narrow window to bring delinquent filings current. If the company is delisted, once it has cured issues raised by auditors, the SEC, and other government regulators and regains compliance with listing requirements, it may apply to relist. As discussed below, once a delisted company brings its SEC filings current, it may be eligible to trade as an OTCBB or Pink Sheets quoted company. Naturally, this will not provide the company with the same access to capital as national exchanges.
IV. Securities Class Actions
The announcement of delayed filings, an internal or SEC investigation, or allegations of improper transactions will often lead to a fall in stock price, which opens the door for private civil litigation. In a securities class action, plaintiff's attorneys may file a class action law suit against the company and its directors, officers, and executives on behalf of a group of shareholders who allege they suffered loss due to allegations of US securities laws violations or improper management. The threat of securities class action is real. In 2011, one in four securities class actions filed in the US have involved Chinese reverse merger companies1.
Jurisdiction over defendants depends on the defendant's contacts with the US. A US court has jurisdiction over the US listed company. It may also have jurisdiction over individual defendants who sign the company's SEC filings, live in or have assets in the US (e.g., a bank account), or travel to the US. Though it may be tempting for some to ignore, failure to respond to a claim in a US court may lead to the company's delisting or other government sanctions and may affect existing or future assets of the company or individual defendants located within the US.
Unlike PRC courts, US courts allow broad discovery of non-privileged company documents, information, and other evidence which may be admissible to support a party's claims. Though PRC law imposes restrictions on discovery sought by foreign litigants for use in US courts, a Chinese defendant or third party over which the court has jurisdiction may nonetheless be compelled to comply with discovery requests under US procedural law. Given the obstacles of obtaining evidence located within China, private civil litigants will likely seek evidence produced to the SEC, listing exchange, and even the audit committee.
Many securities class actions settle before going to trial, but settlement can still be costly. In 2010, the median settlement amount for a securities class action was US$11.3 million. Moreover, the legal costs for defending a claim can be substantial. If settlement is not reached, the company and individual defendants must defend the action in the US court, increasing the time and costs to defend. If a judgment is entered against the company or individual, though the award may be difficult to enforce in China, a US court may seize existing or future assets in the US, including bank accounts and accounts receivable, owned by the defendants to satisfy an adverse judgment.
V. Exit Alternatives for Chinese Companies
The threat of parallel proceedings, excessive costs of compliance with US securities laws and listing requirements, and lower trading volumes and stock prices have left many US listed Chinese companies considering alternatives to their US listings. A company looking to exit its US listing may elect to delist and go private or have its shares traded as an OTCBB or Pink Sheets quoted company.
Alternatives to an Exchange Listing. To go private, a company may sell its shares so that it becomes eligible to delist and deregister its securities. To achieve this goal, the company may accept a tender offer from another company or individual to buy the company's publicly held shares. The company may also merge with or sell its assets to another company or declare a reverse stock split to reduce the number of shareholders of record. Each of these transactions will trigger "going private" rules under US securities law, which impose extensive disclosure and reporting requirements and extensive internal company consideration before approval. In some circumstances, shareholders rights which affect the buyout may also be triggered.
Alternatively, a company may delist from a national exchange and move to the OTCBB. Under this option, the company's securities remain registered. While this may not provide the company with the same access to capital, it may afford the company continued access to capital while allowing it time to implement improved compliance measures. OTCBB quoted companies must still meet reporting and compliance requirements, though the costs of compliance are not as significant as those for exchange-listed companies. The company must bring current all delinquent SEC filings before it may be quoted on the OTCBB.
A final alternative is for the company to delist and degister its securities and trade on the Pink Sheets. Pink Sheet quoted companies are unregulated and generally not subject to listing requirements, though the company may still be subject to limited reporting requirements. Of course, the costs of compliance will be substantially lower than an exchange-listed or even an OTCBB quoted company, but the company's ability to raise capital by trading on the Pink Sheets will be considerably limited.
Overview of Process to Delist and Deregister. A company is eligible to delist and deregister its securities if they are held by less than 300 shareholders of record or, where the company has less than US$10 million in assets, less than 500 shareholders of record. In most instances, the company must first seek approval to delist from the national exchange on which it is listed and issue a press release notifying shareholders of its intent to delist. NASDAQ has simplified procedures for delisting but the procedures for delisting from the NYSE are more comprehensive.
Once the company has met the exchange requirements for delisting, it may then request approval to delist and/or deregister from the SEC. The delisting becomes effective 10 days after the application is filed and most of the company's filing requirements are suspended at this time. The SEC has 90 days to approve or deny the company's request to delisting and/or deregister. After deregistration, the company may still have limited reporting requirements under SEC or exchange rules, state law, or contractual obligations under registration rights agreements. Delisting is not a simple or rapid process so it does not offer immediate relief to companies seeking to avoid the costs of internal investigations or securities litigation.
VI. Final Considerations
A decision to delist should be carefully considered. For companies considering going private, a private equity buyout may be the company's most viable option, especially if its ability to raise capital in the US and secure bank loans in China has been restricted. Many private equity firms invest with the intent to relist in China or Hong Kong. Obtaining approval from listing authorities in China and Hong Kong, however, may be difficult. Moreover, the legal costs of going private can be substantial and dissenting shareholders may challenge the offeror's price in court which may also affect the buyout.
Ultimately, the company may elect to retain or regain its status as an exchange-listed company. The cost of listing in the US, even for reverse merger companies, is a substantial investment to gain access to US capital markets. Some companies may determine that the costs to adapt to US markets will be substantially outweighed by the benefits of access to capital to finance operations, projects, research, and development. The benefits of retaining its listed status may also be reaped at home, as the status of a US listed company may boost the company's public image in China which may be helpful when seeking domestic financing. Should the company elect to remain an exchange-listed company, the company and its directors, officers, and executives will continue to remain subject to the perils of failing to comply with US securities laws and listing requirements. Recently, it has become evident from comments by the SEC and the various exchanges that they have little tolerance for non-compliance and no sympathy for companies, whose sole defense is that the non-compliance is cultural. Arguing that this is how things are done in China has not been a strong defense to these US proceedings.
Footnotes
1 See NY Times, Chinese Stocks Plummet on News of Justice Department Inquiry, Sept. 29, 2011.
2 See Ellen M. Ryan and Laura E. Simmons, Securities Class Action Settlements, 2010 Review and Analysis at 2-3.
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