United States: Reversals Of Fortune: Putting The Brakes On Section 10(b) And Section 11 Claims Against Auditors Of China-Based Companies

A federal court's recent dismissal of Securities Exchange Act claims against the auditor of a Chinese company prompted us to examine the state of recent U.S. civil securities litigation against accounting firms that audited China-based companies that were listed on US exchanges.

On January 23, 2015, U.S. District Judge Alison J. Nathan of the Southern District of New York granted Ernst & Young Hua Ming's ("EYHM," represented by Orrick) motion to dismiss Section 10(b) and Rule 10b-5 claims brought in a purported shareholder class action concerning EYHM's former audit client, SinoTech Energy Limited ("Sino Tech"). The alleged fraud concerned the intentional overstatement of SinoTech's assets and revenues which was accomplished through the use of shell companies. The court rejected plaintiffs' claims against EYHM, finding that plaintiffs failed to plead scienter with the particularity and corroborating detail required for alleging securities fraud against auditors.

In particular, plaintiffs failed to make the requisite showing of strong circumstantial evidence of conscious misbehavior or recklessness. The court agreed with EYHM that the GAAP and GAAS violations alleged by plaintiffs were insufficient to meet the standard of recklessness, which requires "a state of mind approximating actual intent, and not merely a heightened form of negligence." In fact, the pleadings as a whole "generated the compelling inference that EYHM was one of the principal targets of the fraud, rather than its perpetrator." Accordingly, the Court dismissed the complaint in its entirety and terminated the case.

The dismissal of this case against EYHM comes on the tail of a wave of litigation concerning China-based companies listed on U.S. exchanges following IPOs or reverse mergers. The number of Rule 12(b)(6) motions in connection with China-based securities complaints has been in decline as the volume of Chinese reverse mergers listings has decreased. Indeed, as Cornerstone Research reported last week, only three complaints against so-called "Chinese reverse merger" companies were filed in all of 2014, down from a peak of 42 in 2011.

EYHM's success in federal court is by no means a sign of the times that an auditor of a China-based company has any advantage over an auditor defendant in any other federal securities fraud action. Comparable cases that have recently made their way through the courts show that auditors have had a strong track record in obtaining Rule 12(b)(6) dismissals on essentially the same arguments that would prevail in any other auditor liability suits, as well as in addressing particular China-related issues. For example, courts have held that discrepancies between a company's audited financial statements and its filings with Chinese regulators are insufficient, without more, to provide a basis for auditor liability. See, e.g., Scott v. ZST Digital Networks, Inc., No. CV 11-0351 GAF, 2012 U.S. Dist. LEXIS 19392 (C.D. Cal. Feb. 14, 2012) (granting motion to dismiss Section 10(b) and Rule 10b-5 claims brought against auditors where plaintiff did not allege that auditors knew SAIC filings were inconsistent with the corporation's financial statements). Furthermore, courts in the Chinese audit cases continue to recognize the distinction between global umbrella organizations and local accounting firms. See Hoi Ming Michael Ho v. Duoyuan Global Water, Inc., 887 F. Supp.2d 547 (S.D.N.Y. 2012) (granting motion to dismiss Section 10(b) and Section 11 claims against global auditing firm's umbrella entity where only the local member firm had "made" statements).

Although courts have found many China-based companies and their managers liable under Section 10(b), they have most often denied auditor motions to dismiss where auditors failed to detect that the audited companies were mere shells or had ceased operations. See, e.g., In re Long Wei Petroleum Inv. Holding Secs. Litig., No. 13 Civ. 214 (MGC), 2014 U.S. Dist. LEXIS 9689 (S.D.N.Y. Jan. 27, 2014) (court denied auditors' motion to dismiss where news reports revealed that corporation had ceased operations except granting motion with respect to controlling liability under Section 20(a)); 2014 U.S. Dist. LEXIS 117522 (S.D.N.Y. Aug. 22, 2014) (denying motion to reconsider); Brown v. China Integrated Energy, Inc., No. CV 11-02559, 2012 U.S. Dist. LEXIS 47019 (C.D. Cal. Apr. 2, 2012) (denying motion to dismiss Section 11 claim against auditor where company allegedly lacked the facilities and supply of used cooking oil necessary to run a biodiesel facility at full capacity, and where company's SEC financials did not match up with its SAIC financials). Where auditors, like EYHM, have been sued by investors, they have often successfully demonstrated that they were more likely the targets of such egregious frauds than participants in them.

Thus, while these cases share a common geographic and regulatory context, there is no indication that courts treat motions to dismiss in cases concerning Chinese companies differently from other types of securities complaints. Accordingly, auditors accused of securities fraud in such cases should expect a level playing field in federal court. Meritorious arguments, superior facts and lawyering, as well as the difference in quality between Big 4 auditors such as EYHM and firms with little to no experience auditing publicly traded companies and no China presence, are all important factors influencing whether an auditor will be successful in defending against claims of securities fraud. These, and other factors, are key rather than than the nature of the transaction or nationality of the company.

Finally, the stringent requirements of the PSLRA, and case law interpreting those requirements, create other necessary barriers to protect auditors from claims lacking a basis in law or fact.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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