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Mounting litigation filed against Chinese reverse merger firms could contribute to a harder directors and officers liability insurance market, some observers say.
Because of the litigation, Chinese reverse merger firms, which also are undergoing increasing regulatory scrutiny, are experiencing multiple rate increases, higher retentions and more stringent terms and conditions at renewal, and even possible rescission of existing coverage, observers say.
A reverse merger is an acquisition of a private operating company by a publicly held shell firm. This allows Chinese companies to access the capital markets while avoiding the scrutiny, expense and time of registering an initial public offering.
Between January 2007 and March 2010, 159 companies from the China region accessed U.S. capital markets through a reverse merger deal, according to a March report by the Washington-based Public Company Accounting Oversight Board.
Lawsuits against these reverse merger firms account for a growing portion of securities litigation. Of 94 federal securities fraud class actions filed during this year's first half, 24 lawsuits were against Chinese reverse merger companies, about 25% of the total filed, according to a July report by San Francisco-based Cornerstone Research Inc. There were nine such suits a year earlier.
Charges against these companies include accusations of self-dealing, accounting irregularities and misleading financial statements, according to observers.
The alleged accounting deficiencies and corporate governance problems make “for a really easy case” from the plaintiffs bar's perspective, said Carl Bach, London-based head of NavPro Europe, a division of Navigators Underwriting Agency Ltd..
While most of these lawsuits are in the early stages, a federal judge in Los Angeles in July refused the defendant's motion to dismiss Mark Henning vs. Orient Paper Inc., a lawsuit in which the company was accused of failing to disclose material related-party transactions between it and its main supplier, among other charges.
However, there also has been speculation that short sellers are criticizing the companies as part of a cynical strategy to profit by driving down their stock prices.
John Bruce, a partner with Kennedys Law L.L.P. in London, who represents D&O insurers in this litigation, said one-quarter of his firm's cases involve targeted companies that are sham firms, while the remainder may be the targets of short sellers.
“It doesn't look good when...half the board of directors resigns and are replaced with a whole new board” or when auditors abruptly resign, both of which have happened with Chinese reverse merger firms, said Anjali C. Das, a partner with Wilson Elser Moskowitz Edelman & Dicker L.L.P. in Chicago. However, she said, “It's obviously a very case-specific, fact-specific inquiry until the investigations are completed.”
Will Fahey, New York-based head of D&O for large companies for Zurich North America, said, “I would argue that these cases may prove to have more teeth even than your typical securities claim because of the many facts involved when you have restatements and auditors resigning.” These are “typically stronger, more concrete facts indicating fraud than you would normally see” in class action securities suits, he said.
In light of investigations by regulators, there may be political pressure on judges to “not dismiss these kinds of allegations outright,” Ms. Das said.
In June, the U.S. Securities and Exchange Commission warned investors to “proceed with caution” with regard to investing in Chinese reverse mergers because many companies “either fail or struggle to remain viable following a reverse merger.” It also has suspended trading in several reverse merger entities.
This month, the SEC announced it and PCAOB are working with the Chinese Ministry of Finance on audit oversight of public companies.
In addition, the New York and NASDAQ stock exchanges have proposed standards that would tighten rules under which these companies could be listed, observers say.
“Some of those suits are going to hit, and probably hit for significant dollars, and some of them won't,” said Alexis J. Rogoski, a principal with law firm Boundas, Skarzynski, Walsh & Black L.L.C. in New York, who has represented D&O insurers in these cases. Despite what short sellers are saying, there are legitimate firms that have not “misrepresented themselves to the public,” he said.
Kevin LaCroix, executive vp at OakBridge Insurance Services L.L.C. in Beachwood, Ohio, said even if the litigation survives motions to dismiss, plaintiff attorneys face many hurdles in pursuing these cases, including “trying to do discovery at that distance, where many of the key documents are in Mandarin or some other language.”
This means there will be a “tremendous escalation right from the beginning in legal costs” under D&O policies, said Michael Chester, a New York-based principal with the Boundas law firm.
Most of the reverse merger firms had D&O coverage, experts say. Coverage bound before the spate of litigation averaged about $5 million, with relatively low retentions of about $150,000 to $250,000. The business is spread widely among D&O insurers, observers say. Because of these relatively low limits, this means if losses do impact the D&O market overall, it will be on the basis of frequency rather than severity, observers say.
With only one court decision so far, observers are unsure to how much the litigation ultimately will cost the industry, which will depend at least in part on its success. But primary D&O insurers are “starting to feel the pain,” said Tripp Sheehan, U.S. D&O practice leader for Marsh Inc. in Boston.
Some observers believe the litigation will be at least one factor leading to a harder D&O market. “This will contribute to that momentum,” said Peter Taffae, a D&O liability insurance expert at Los Angeles-based wholesale brokerage ExecutivePerils Inc.
Others disagree, noting these companies represent only a small proportion of the total market. Maria Treglia, senior vp at Woodbury, N.Y.-based Program Brokerage Corp., likened the situation to 2008, when D&O rates for financial institutions hardened but the rest of the market remained soft, and the sector was “just completely carved out” from the rest.
Meanwhile, Chinese reverse merger companies seeking renewals are having difficulties, observers say. Brendan Dolan, Irvine, Calif.-based senior vp and southern California regional practice leader for Willis North America, said companies that had been able to get $5 million or $10 million of primary coverage are now getting quotes for only $1 million to $2 million of coverage. They also are being charged premiums of $50,000 to $100,000, where before they may have been able to get $10 million in coverage for $125,000, he said.
Observers say insurers are including “no prior acts” exclusions in polices, which excludes acts that occurred prior to the policy's inception, and financial restatement and fraud exclusions. “And that's if you can get the insurance at all,” said Mr. Sheehan.
However, Anthony Zinicola, New York-based vp of international for Hartford Financial Products, said it would consider writing the business, depending on the individual submission's merits.
Mr. Fahey said the D&O sector will be more widely open to these submissions at some point “because Chinese companies are not going to go away. But at the moment, it's very much wait and see until they get their governance and accounting houses in order.”
These companies are maturing to have better corporate governance procedures, said Joseph Monteleone, a New York-based partner with the Tressler L.L.P. law firm, “but that's not going to happen overnight.”