21 December 2011
On November 30, 2011, Judge John A. Kronstadt of the US District Court for the Central District of California dismissed a putative class action brought by shareholders of China Century Dragon Media based on the inconsistencies between revenue and profit figures reported to the US Securities and Exchange Commission (SEC) and the Chinese State Administration for Industry and Commerce (SAIC). Katz v. China Century Dragon Media, Inc., et al., No. 2:11-cv-02769-JAK-SS (C.D. Cal. Nov. 30, 2011).
Specifically, the district court held that the claims brought under Sections 11 and 12(a) of the Securities Act of 1933 were required to be pleaded with particularity, but that the complaint failed to do so. This decision is of particular interest because it is the first dismissal granted in a wave of new securities litigation based on the discrepancies between a company’s SEC and SAIC filings.
These cases typically involve plaintiff-investors that purchase the securities of a Chinese corporation through an IPO on an American exchange. The Chinese corporation is usually a holding company that does the majority of its business in China through wholly owned subsidiaries, which account for most, if not all, of the company’s revenues and profits.
Most commonly, an admitted short-seller issues a report that the subsidiaries’ filings with the SAIC contain revenues and profits substantially lower than those reported to the SEC. As a result, the stock prices drop and trading is usually suspended. Investors then file class action complaints alleging that the SEC filings and other reports to investors were false, basing their allegations on the differences between the figures reported to the SEC and the SAIC.
In Katz, trading in China Dragon’s stock was halted a month after its IPO, followed shortly by its auditor resigning and issuing a resignation letter indicating that the accounting records had been falsified. Plaintiffs, purchasers of China Dragon stock in the IPO, brought Section 11 and 12(a) claims against the company and the IPO underwriters and a Section 15 “control person” claim against individual officers and directors.
The plaintiffs alleged that the registration statement filed with the SEC reported $45 million and $75 million in revenue from fiscal years 2008 and 2009, respectively, while the main subsidiary in China reported only $15 million and $9.5 million to the SAIC for the same years. Because the SAIC severely penalizes companies for submitting false filings, plaintiffs argued, the revenue and profit figures reported to the SEC must be false and the SAIC filings must be accurate. The company, underwriters, and one of the individual defendants moved to dismiss the action.
The district court first held that the particularity requirements of Rule 9(b) of the Federal Rule of Civil Procedures applied to these Section 11 and 12(a) claims because they “sound in fraud.” Although plaintiffs met this pleading burden with respect to other elements, they failed to sufficiently plead that the profit and revenue figures filed with the SEC were false. The heightened standard of pleading required the plaintiffs to indicate “inconsistent contemporaneous statements or information (such as internal reports) which were made by or available to the defendants.” The difference between the SEC and the SAIC numbers, the court stated, was “‘merely consistent with’ the SEC numbers’ being false, and [did] not suffice to make that claim plausible.”
The court advised plaintiffs that they could have met this standard by averring that Chinese and American accounting standards are substantially similar and that the reported numbers should be the same, or even by claiming that the numbers were created using the same underlying financial data. By failing to meet this level of specificity, the falsity element was not sufficiently pled.
For this reason, the district court granted the motion to dismiss the claims under Sections 11, 12(a), and 15 claims of the Securities Act, with leave to amend.
This decision is the first dismissal of a securities class action basing its allegations of false statements on the differences between Chinese and US regulatory reporting. For the first time, a court has rejected the theory that SEC filings are false simply because numbers reported to the SAIC are different and because Chinese authorities are much stricter than those in the United States. The district court’s holding that the identification of Chinese regulatory filings that are merely different than those in the US is an insufficient basis to state a claim under the securities laws could potentially be a bellwether.
In sum, the Katz decision creates useful precedent that the mere differences between SEC and SAIC filings is insufficient to plead falsity under the securities laws. As district courts continue to wrestle with the challenges presented by securities suits against Chinese companies that must comply with extremely different standards in China, litigants can expect further developments in this area of law.
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