Part II: The SEC and Chinese Issuers: Transparency and Accountability
This is the second segment of a five part series examining issues arising in SEC Enforcement Actions relating to issuers from the PRC whose shares are traded in the U.S.
Failure to file periodic reports
One group of cases brought by the SEC involving PRC issuers centers on allegaions that they failed to file the required periodic reports with the Commission. Companies who have registered their securities for trading with the SEC are required to file periodic reports with the SEC under Section 12 of the Exchange Act. Those include annual and quarterly reports. Failure to file those reports can result in the revocation of the company’s registration statement under Exchange Act Section 12(j). In that instance the company’s shares can no longer be traded on a U.S. exchange.
The SEC has revoked the registration statements of over a dozen Chinese issuers. At least 27 other revocation cases pending. In the Matter of Longtop Financial Technologies Ltd., Adm. Proc. File No. 3-14622 (Nov. 10, 2011) is an example of an action brought under Exchange Act Section 12(j) to revoke the registration statement of the company. Longtop is a Cayman Island company based in Shanghai whose ADRs have been traded in New York since its IPO in October 2007. On May 17, 2011 the Exchange halted trading and subsequently delisted the shares of the company. Longtop failed to file its annual report with the Commission for the fiscal year ended March 31, 2011. It also failed to provide investors with annual reports for 2008 – 2010. On December 14, 2011 a order was entered revoking the registration statement of the issuer by default.
Another China based company which went public through a reverse merger and had its registration statement revoked under Exchange Act Section 12(j) also spawned five other Commission enforcement actions. China Yingxia International, Inc. was a Florida corporation headquartered in Harbin, China. The company entered the U.S. capital markets through a reverse merger in May 2006. Its shares were quoted on OTC Link which was formerly the “pink sheets.”
From 2006 through 2009 the company purported to be in the health food business. On February 2, 2012 the Commission instituted an administrative proceeding against the company alleging violations of Section 12(j) since it had failed to file any periodic reports since late 2008. In an order dated March 7, 2012 each class of China Yingxia’s registered securities was revoked. In the Matter of China Yingxia International, Inc., Adm. Proc. File No. 34-66304 (February 2, 2012).
One of the actions related to China Yingxia named as defendants Peter Siris, and his companies, Guerrilla Capital Management, LLC and Hua Mei 21st Century, LLC. Mr. Siris and his entities served as advisers to China Yingxia as well as several other China based entities. SEC v. Siris, Civil Action No. 12-cv-5810 (S.D.N.Y. Filed July 30, 2012).
Mr. Siris is the author of several books on investing and manages two New York based funds which invest in U.S. listed Chinese companies. Guerrilla Capital is a management company and Hua Century is a sub-advisor to it. Mr. Siris invested $1.5 million in China Yingxia through the funds he manages. He was one of three consultants to the firm and, along with Hua Mei, helped raise money for it. In the reverse merger through which the company went public Hua Mei received both cash and shares in return for performing due diligence. Portions of the shares came directly or indirectly through a person controlled by the issuer, in a transaction structured to evade the registration provisions of the securities laws, according to the court documents. The shares were sold yielding $24,600 in illicit proceeds. The next year Mr. Siris acted as an unregistered broker in raising over $2 million for an $8.7 million PIPE transaction conducted by China Yingxia. In connection with that deal he was paid $107,500 in transaction based compensation.
As a consultant for the firm Mr. Siris reviewed filings made with the SEC, press releases and was involved in hiring decision. In February 2009, after learning of difficulties at the company from its CEO, including the fact that she had engaged in illegal fundraising in China and that the company had shut down, he sold a substantial number of company shares prior to the public disclose of these events. The next month, after reviewing a draft press release disclosing the matters he increased his selling activity. Overall Mr. Siris sold 1,143,600 shares of China Yingxia yielding profits of $172,000 while in possession of material non-public information. After a press release was issued on March 6, 2009 the share price plummeted and the directors and CFO resigned, effectively ending the operations of the company.
The complaint also alleges that Mr. Siris made misrepresentation to investors in his funds concerning China Yingxia and traded on inside information regarding ten other Chinese issuers. He is also alleged to have directed short sales on the shares of two other Chinese issuers in violation of restrictions prohibiting such sales prior to his funds’ participation in firm commitment public offerings for the companies. The complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Sections 10(b), 15(a) and Advisers Act Sections 206(4). Each defendant settled, consenting to the entry of permanent injunctions based on the sections cited in the complaint. In addition, the three defendants have agreed to pay disgorgement in the amount of $592,942.39 along with prejudgment interest. Mr. Siris will also pay a civil penalty of $464,011.93.
A related action was brought against Ren Hu, Alan Sheinwald and Alliance Advisors, LLC. SEC v. Sheinwald, Civil Action No. 12-CV-5810 (S.D.N.Y. Filed July 30, 2012). Mr. Hu became the CFO of China Yingxia in 2008 despite having expressed skepticism about the company. He was also the CFO of several other Chinese reverse merger company. He signed certifications required by the Sarbanes-Oxley Act of 2002 regarding the controls of the company. Mr. Hu claimed to have participated in the design of the disclosure and internal controls of China Yingxia when in fact it had virtually none. Mr. Sheinwald and his investor relations firm, Alliance Advisors, acted as unregistered securities brokers for China Yingxia in 20 07. The complaint alleges violations of Exchange Act Sections 10(b), 13(b)(2)(B) and 15(a). The case is in litigation.
See also In the Matter of Peter Dong Zhou, Adm. Proc. File No. 3-14964 (July 30, 2012)(settled administrative proceeding against a registered representative who helped China Yingxia engage in the unregistered distribution and sale of restricted securities, assisted with the retention of its CFO and insider traded when he learned the company was collapsing; the action settled with a consent to a cease and desist order based on violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b), the imposition of a bar from the securities business and from participating in a penny stock offering with a right to reapply after three years and an agreement to pay disgorgement of $20,900, prejudgment interest and a penalty of $50,000); In the Matter of Stephen Mazuchowski, Adm. Proc. File No. 3-14965 (July 30, 2012)(settled proceeding based on allegations that the Respondent acted as an unregistered broker for China Yingxia; the action settled with a consent to a cease and desist order based on Exchange Act Section 15(a), a bar from the securities business and from participating in a penny stock offering with a right to reapply after two years and an agreement to pay disgorgement of $126,800, prejudgment interest and a penalty of $25,000); In the Matter of James Fuld, Jr., Adm. Proc. File No. 3-14966 (July 30, 2012)(settled proceeding based on the alleged sale of securities of China Yingxia; based on the Respondent’s cooperation the case was resolved with the payment of disgorgement of $178,594.85 along with prejudgment interest).
Issues with auditors
The accessibility of work papers prepared by PRC based auditors registered with the PCAOB for Chinese issuers whose shares are traded in the U.S. markets is a critical issue. The Sarbanes Oxley Act of 2002 or SOX requires the independent audit firm for any issuer who has a class of securities registered with the SEC be registered with the Board. SOX Section 106(b) provides that any audit firm that registers with the PCAOB consents to produce its work papers on request by the SEC or the Board.
Despite the mandate of SOX, U.S. regulatory officials have not been able to access the accounting work papers related to PRC based issuers whose shares are traded in the U.S. capital markets. This is the critical issue on which the Commission’s action captioned In the Matter of Deloitte Touche Tohmatsu Certified Public Accountants Ltd., Adm. Proc. File No. 3-14872 (May 9, 2012) is based.
That proceeding names as a Respondent PRC based Deloitte Touche Tohmatsu Certified Public Accountants or D&T Shanghai. The action is based on Rule 102(e)(1)(iii) of the SEC’s Rules of Practice which permits the Commission to revoke the right to appear and practice before it as an accountant if that professional engages in a willful violations of the federal securities laws.
The Order for Proceedings or OIP alleges violations of SOX Section 106(b). According to the Order, since April 2010 the SEC staff has made extensive efforts to obtain the work papers related to “Client A.” The firm has declined, through its international parent, to produce the requested work papers based on its understanding that PRC law precludes production. The Order alleges that the failure to produce the requested work papers constitutes a violation of SOX Section 106(b). A hearing will be convened.
The same audit firm became the subject of a second Commission action which relates to Longtop Financial Technologies, Ltd. SEC v. Deloitte Touche Tohmatsu CPA, Ltd., File No. 1:11-MC-00512 (D.D.C. Filed Sept. 8, 2011). This is a subpoena enforcement action. The court papers allege that the audit firm is registered with the PCAOB and served as the outside auditors for Longtop. In a letter dated May 23, 2011 the firm resigned from the engagement after discovering numerous improprieties during a year end audit.
Subsequently, the SEC issued an investigative subpoena for documents to the audit firm. To date no documents have been produced. Initially, the Commission moved forward with the action, requesting that the court order the documents produced. In a July 18, 2012 filing however, the SEC asked that the Court stay the proceeding for six months. The request was made because of “ongoing negotiations with a foreign regulator that could impact the appropriate resolution of this case. If the Court grants this stay, the SEC would file a status report with the Court no later than January 18, 2013 to advise the Court of the general status of these negotiations and, if appropriate, to request that the briefing schedule be reset.”
The PCAOB has also engaged in discussions with their counterparts in the PRC. To date those discussions have not resulted in any agreement to give U.S. regulators access to audit work papers as required by SOX.
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