[Flashback] Rare Victory for U.S. Investor in Chinese Reverse Merger Company


Posted by Eugene SAY Gui Hua, Year 4 undergrad at the School of Business, Singapore Management University

Jan 23, 2013

Rare Victory for U.S. Investor in Chinese Reverse Merger Company

Investors have lost billions over the last couple of years from investing in U.S.-listed Chinese companies that saw their share prices fall to mere pennies after short sellers accused them of fraud or auditors said their financial disclosures couldn’t be trusted.This month a U.S. private equity investor has finally won a decision saying it was it was entitled to a refund on its investment in a fraudulent Chinese firm.

On Jan. 15, Starr International, an investment vehicle run by Maurice “Hank” Greenberg, the former chairman of AIG, filed to a Delaware court the findings of an arbitration committee in Hong Kong that had convened to determine whether Starr had been fraudulently induced to invest in Fujian-based media company China MediaExpress Inc.

According to the filing, the committee of three judges found in Starr’s favor, and instructed China MediaExpress’s chairman and two main shareholders to pay Starr $77 million in damages and other relief. Lawyers say that Beijing has a good track record of recognizing the findings of international arbitration tribunals (including Hong Kong tribunals) that involve Chinese firms.

According to the document, dated Dec. 19, 2012, Starr had invested $53.5 million in China MediaExpress.

China MediaExpress – like many of the small Chinese firms that listed in the U.S. between 2007 and 2010 – looked like a good bet at the time of Starr’s investment. The company, which sells advertising on television screens installed in buses that travel between Chinese cities, had posted runaway revenue growth that was significantly faster than its peers’.

But in early Feb. 2011, three short-sellers issued negative reports on the company online, accusing it of greatly exaggerating the scope of its business, allegations China MediaExpress denied at the time. Soon after, Deloitte Touche Tohmatsu resigned as China MediaExpress’s auditor saying the company’s financial reports could no longer be relied upon, and the Nasdaq delisted the company. Meanwhile, the company’s audit committee said that it had hired external consultants to carry out an independent investigation into the various accusations against the company.

In March 2011, Starr launched legal proceedings again China MediaExpress in Delaware, and an arbitration process in Hong Kong. But for almost two years there has been no light shed on exactly what went down at the company – until now.

The Jan. 15 filing has some interesting details. According to the document, Starr invested in China MediaExpress after Dorothy Dong, a managing partner at Starr’s Asia unit, spoke with an unnamed partner at Deloitte who “spoke highly of [China MediaExpress’s] business” and set up an introduction with the company’s chief financial officer, Jacky Lam. Ms. Dong was “so confident…in the viability of [China MediaExpress’s business] that she invested her own money.”

Ms. Dong, who joined the board of the Chinese company after Starr’s investment, resigned from the role on March 16, 2011 — a day before Starr filed for arbitration in Hong Kong and two days before it launched the suit in Delaware.

Still, the arbitration committee failed to shed any light on how exactly China MediaExpress was a fraud. The judges were clearly under no doubt that the Chinese firm – and specifically its chairman, Cheng Zheng – was dodgy. Mr. Cheng didn’t present to the committee the results from the independent investigation or call anyone involved in the investigation as witnesses, and claimed not to even know its status.

It is “impossible to believe that such an investigation even existed, or that, if it commenced, is still ongoing,” the arbitration committee said, according to Starr’s filing. “Given the implausibility of much of [Mr. Cheng’s] evidence and, perhaps more importantly, what he did not say or explain, we cannot accept any of his evidence.”

Moreover, the committee was incredulous of Mr. Cheng’s assertion that the short sellers had destroyed his business.

“To put it bluntly, this claim…that short sellers destroyed his business is nonsense,” the filing said. “It is a fabrication evidently designed to hide the fact that [China MediaExpress] never had the business it represented to the world that it had, or that, if it did, it has been ravished by dishonest conduct.”
Calls to China MediaExpress Wednesday went unanswered.

Given the lack of evidence provided by Mr. Cheng, the tribunal was left to “infer” that the company would have incriminated itself had it presented witnesses and documents, and so can only “speculate” about the nature of the fraud.

Here lies the problem facing dozens of other investors: Unlike Starr, which had recourse to arbitration written into to its investment contract, most investors are left to rely on the court system in the U.S.

According to Cornerstone Research, which tracks class actions suits in the U.S., there were more than 45 class action motions launched against Chinese reverse merger companies listed in the U.S. between the begging of 2010 and mid-2012 (pdf). Reverse mergers allow a company to obtain a stock market listing by taking over the shell of listed company that no longer has any operations. The process is a lot less transparent that a traditional initial public offering, and most of the Chinese companies that have run into trouble used this method to list. China MediaExpress obtained a listing in the U.S. via reverse merger in late 2009.

The problem for these investors is providing evidence that the company they invested in did, in fact, lie to them. But with all the relevant documents about most of these companies physically located in China and written in Chinese, and with U.S. courts unable to compel Chinese companies to hand over necessary documents, it’s no easy feat collecting the necessary proof. Many of these companies have completely shut down communication with investors and are not even engaged in the legal process launched against them.

In a late-September speech, Lewis Ferguson, a board member of the Public Company Accounting Oversight Board, the U.S.’s audit-industry regulator, said that 126 Chinese companies have either been delisted from U.S. exchanges, or “gone dark” — meaning that they are no longer filing current reports with the Securities & Exchange Commission — since the troubles started in late 2010.

At least in the short term, it looks as though Starr’s victory, though significant, will remain an outlier.


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