by T. GormanPosted on Posted in SECActions

Companies based in China have long sought to list their shares for trading on U.S. markets. The reason is clear – the US. markets are deep, liquid and the envy of the world. Nevertheless, there has been a long-standing tension regarding those listings. A key element of that tension emanates from the Sarbanes-Oxley Act of 2002 or SOX requirement that all audit work on issuers whose shares are traded on U.S. exchange is subject to inspection by the PCAOB. China has refused to permit the inspections despite repeated negotiations with the Board, enforcement actions by the Commission and the recent passage of the Holding Foreign Companies Accountable Act or HFCA Act which largely reiterates the SOX mandate.

PRC officials have recently taken steps to effectively preclude or at least discourage their firms from listing on U.S. and other foreign exchanges. Nevertheless, issuers based in the PRC continue to seek and obtain listings for their shares in the U.S. Key to that trend is the use of a VIE, a Variable Interest Entity. Those vehicles – a form of SPE – have been around for some time.

In the model being used by China based issuers, a company is created in an off-shore jurisdiction such as the Cayman Islands. Foreign investors are the shareholders. The new Cayman shell company then enters into a series of contractual arrangements with its PRC creator that give it effective control. To complete the transaction the Cayman shell company issues shares that are listed for trading on a U.S. exchange. Yet the China based company is still owned by its PRC based shareholders and subject to local law which voids any arrangement to circumvent its law. The financial statements of the PRC based entity and the Cayman shell can be consolidated.

SEC Chair Gary Gensler recently expressed concern regarding these entities stating that “I worry that average investors may not realize that they hold stock in a shell company rather than a China-based operating company.” Accordingly, he directed the staff “to ensure that these issuers prominently and clearly disclose . . .” a series of facts. Those disclosures will tell investors that they are “not buying shares of a China-based operating company but instead are buying shares of a shell company . . .” that has contracts with a China based issuer. Additional disclosures the Chair directed the staff to implement will inform investors that each of the issuers involved – China and the off-shore entity – and all investors will be subject to actions by the government of China and will include detailed metrics to facilitate an understanding of the consolidated financial statements.

Mr. Gensler also directed the staff to ensure that two additional disclosures are made by all China-based operating companies. Those will require disclosure: 1) if the China-based operating company received or was denied permission from the Chinese authorities granted to seek a U.S. listing or if those authorities could retract permission; and 2) that the HFCA Act which requires that the PCAOB be permitted to inspect the issuer’s public accounting firm files. The staff was also directed to do periodic, targeted reviews of these firms.

Whether the additional disclosures ordered by Chair Gensler will significantly impact the registration in the U.S. of China based shell companies is difficult to discern. More importantly, regardless of what disclosures are made about these firms, the investment is high risk. The equity ownership of the firms involved is held by China based shareholders. The assets of the company are subject to the direction of PRC authorities.

To be sure, the shareholders of the VIE Shell will have contractual rights. But the enforceability of those contracts is at best questionable. Similarly, making the entities subject to the HFCA Act in theory affords protections for investors since PCAOB inspectors should be able to examine the audit work papers. At the same time there is no reason to believe that PRC officials will permit those inspectors to review any work papers except those relating to the off-shore shell which has no assets. The repeated refusal of PRC officials to permit inspections under SOX for the last two decades all but ensures this result.

In the end, any investor purchasing shares of a VIE Shell tied to a China based issuer may well be securing rights that are little more than a piece of paper, not an interest in a China based issuer but only in a shell. Under these circumstances the real question is whether disclosure is enough? Stated differently, does it offer any real protection at all?

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by T. GormanPosted on Posted in SECActions

Robinhood is now valued at about $32 billion after raising approximately $2 billion in an IPO during which it initially offered shares at $38 but which closed at day end under $35. The firm had set aside over 30% of the shares to be sold for retail investors. The amount was later reduced to about 20%. There was criticism of the offering on various message boards. Many commentators declared the offering a failure. Regardless, the firm represents a huge potential change for the financial industry, broadening it significantly by attracting a new class of investors with its no commission approach. It remains to be seen if that approach will be successful.

Be careful, be safe this week

SEC

Statement: Chair Gensler issued a Statement on Investor Protection Related to Recent Developments in China on July 30, 2021(here). In his statement Mr. Gensler cautions investors regarding changes in structure to China based entities. Some of those entities are now using Variable Interest Entities or VIEs in view of the PRC’s latest effort to preclude the listing of China based issuers on foreign exchanges. VIEs are essentially shell firms formed off-shore that have contractual relationships with a China based issuer. The financial statements of the two firms can be consolidated. Chair Gensler directed the staff to increase certain disclosures to ensure that investors are fully informed about the entities prior to purchasing shares (here).

Securities Class Actions

Cornerstone Research published its semi-annual analysis of trends in securities class actions filings on July 29, 2021 (here). The Report provides a detailed analysis of trends in this key are for issuers and compliance departments. Despite the pandemic, which may have impacted filings, several key points emerge from the report. Plaintiffs filed 112 securities class actions in the first half of 2021. Most of the actions were what Cornerstone calls “core” cases, that is, not M&A related. Overall, 100 of the 112 cases initiated were core; only 12 were M&A related. Total filings for the first half of the year were 25% lower than in the second half of 2020. They were also lower than in the first half of that year. For example, in the first half of 2020 186 actions were initiated. During the second half of the period 150 cases were filed. Similarly, the number of filings for each half of 2019 also exceeded the number for the first half of this year. In the first half of 2019 207 cases were filed while in the second half of that year 120 cases were brought. Indeed, the trend in case filings was largely flat from the first half of 2017 through the second half of 2019. Since that time the number of filings has continued to drop.

Other sub-trends emerge from the filings during the first half of 2021. For example, during the first half of 2021 there were 14 filings related to SPACs. Of those filings 8 cases alleged that investors had been defrauded prior to the merger. During the period cryptocurrency filings were on pace to match the elevated level of 2020. In contrast, filings involving cannabis were below the peak of 2019 when 13 actions were filed. Finally, while only 2 cybersecurity cases were filed in the first of 2021, 3 actions were filed in July 2021 tied to the Cyberspace Administration of China.

SEC Enforcement – Filed and Settled Actions

Last week the Commission filed 4 civil injunctive actions and 27 administrative proceedings, exclusive of tag-along and other similar proceedings.

Offering fraud: SEC v. Milton, Civil Action No. 1:21-cv-6445 (S.D.N.Y. Filed July 29, 2021) is an action which names as a defendant Trevor Milton, the founder, largest shareholder and CEO of Nikola Corporation, a public company. Beginning in 2015 Defendant Milton raised funds through several private offer for the company which was supposed to be a low emission truck makers. Using social media he built himself into something of a media star. Focusing on Robinhood investors, beginning in late 2019 he raised funds for the firm by making representation about the firm’s products and the progress made toward its goals. The claims were false. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending.

Short tender rule: SEC v. Lupo Securities LLC, Civil Action No. 1:21-cv-04027 (N.D. Ill. Filed July 29, 2021) is an action against the registered broker-dealer. The complaint alleges short tendering – that is, tending more than its net share holdings into a partial tender offer – exceeding the limit and thereby depriving other shareholders from fulling tending their shares. Here the claim centers on the July 2016 partial tender offer by Lockheed Martin Corp. Defendant tendered 1 million shares which exceeded its net number of shares. The complaint alleges violations of Exchange Act Section 14e-4. The case is pending. See Lit. Rel. No. 25152 (July 29, 2021).

Manipulation: SEC v. Taub, Civil Action No. 16-cv-09130 (D.N.J.) is a previously filed action which named as defendants Joseph Taub, Shaun Greenwald, CPA and others. The action centered on a market manipulation scheme in which accounts at several brokerage firms were used to manipulate the prices of over 2,500 stocks. Mr. Greenwald was previously charged in a parallel criminal action in which he pleaded guilty to one count of conspiracy to commit securities fraud and one count of conspiracy to commit tax fraud based on his role in concealing the trading. Defendant was sentenced to serve three years of probation and a period of home confinement. He was also directed to pay restitution of $394,424 to the IRS. In this case he consented to the entry of permanent injunctions based on Securities Act Section 17(a) and Exchange Act Sections 9(a)(2) and 10(b). In a related administrative proceeding Defendant was barred from the securities business and from participating in any penny stock offering. See Lit. Rel. No. 25150 (July 28, 2021).

Offering fraud: SEC v. Mine Shaft Brewing LLC, Civil Action No. 2;21-cv-00457 (D. Utah Filed July 27, 2021) is an action which names as defendants: the firm; Timothy Nemeckay, a recidivist who has been barred by the Commission from the securities business, sanctioned by the state of Utah and who is the sole owner of Mine Shaft; John Lofgan; and Charlie Whittington. Defendants solicited investors to purchase shares of Mine Shaft. Those investors were told the funds would be used to develop the company. In fact, portions of the funds were used to make Ponzi like payments to others while other portions of the investor funds were diverted to the personal use of Defendants. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b), 15(a) and 15(b)(6)(ik).

Unregistered broker: SEC v. Rupp, Civil Action No. 1:21-cv-643 (W.S. Mich. Filed July 28, 2021) is an action which names as a defendant, Joshua L. Rupp, formerly a construction worker with a building license. Over a period of about 18 months, beginning in January 2018, he solicited investors to invest in a pool with funds from other investors which was to be invested for the benefit of all. Investors were told that Mr. Rupp was associated with a registered broker and furnished with account statements. Over 20 investors entrusted Defendant with about $2.2 million. In fact, Defendant was not licensed and the pool suffered significant investment losses. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a). The case is pending. A parallel criminal actions was brought against Mr. Nemekay. The Utah Department of Commerce-Division of Securities filed an action against the Defendants. The Commission’s case is pending. See Lit. Rel. No. 25149 (July 28, 2021).

Form CRS: In the Matter of James Altschuler, Adm. Proc. File No. 3-20411 ((July 26, 2021) is one of 27 actions based on Form CRS. The Form provides clients of investment advisers and broker-dealers with relationship summaries. The Commission charged 21 investment advisers and 6 broker-dealers with failing to properly delivery the firm. Each firm was charged in an administrative proceeding based on alleged violations of the Form. Each firm consented to the entry of a cease-and-desist order based on either Advisers Act Sections 204 and Rules 204-1 and 204-5 or Exchange Act Section 17(a)(1) and Rule 17a-14 and a censure and paid a penalty ranging from about $10,000 to under $100,000.

Singapore

Proposal: The Monetary Authority of Singapore published on July 28, 2021 a proposal in conjunction with BIS Innovation Hub for enhancing global real-time payments network connectivity (here). The proposal will allow countries to link real-time national payment systems. The blueprint includes technical standards, operational guidelines and common functionalities. It is designed to build on the successful connection of Singapore and Thailand’s national payment networks.