Thursday, February 23, 2012

SEC Charges China-Based Executives with Securities Fraud and Internal Control Violations Involving Company Created by Reverse Merger

In an enforcement action, the SEC charged two China-based executives with defrauding investors into believing they were investing in a Chinese coal business when in fact they were investing in an empty shell company created through a reverse merger. Among other things, the SEC alleged that the company’s former CEO falsely certified in financial statements filed with the SEC that he had disclosed to the company’s auditors and audit committee all significant deficiencies and material weaknesses in the design or operation of the company’s internal controls and. any fraud, whether or not material, that involved management or other employees who had a significant role in the company’s internal controls. According to the SEC’s complaint, the company entered the U.S. capital markets through a reverse merger, with the company’s common stock listed and traded on the NYSE Amex from September 2009 to August 2011. (SEC v. Ming Zhao and Liping Zhu, SD NY, Feb 22, 2012, Civ. No. 12-CV-1316, Litigation Release No. 22264)

The SEC alleged that the company’s board chair schemed with the former CEO to steal and sell the company’s sole revenue-producing asset, a coal mining company. The chair secretly transferred the company’s controlling interest in the mining company to himself and then sold a substantial portion to a fund controlled by what is reported to be China’s largest state-owned financial firm. The scheme enabled the executive rather than the company’s shareholders to profit from a lucrative business opportunity and left the company a shell company with no ongoing business operations. The SEC also alleged that the two senior executives failed to disclose these transactions in periodic reports to the SEC, and continued to raise funds from U.S. investors by conducting two public offerings.

The SEC charged the board chair and the former CEO with violations of the antifraud provisions, as well as violating the proxy solicitation rules and various corporate reporting, recordkeeping and internal controls provisions of the Exchange Act. The SEC’s complaint seeks a final judgment ordering the senior officers to disgorge their ill-gotten gains plus prejudgment interest, imposing financial penalties, barring them from acting as officers or directors of a public company, and permanently enjoining them from committing future violations of these provisions.

The SEC also said that the company’s outside auditor during the time of the events sent the company a letter resigning from the engagement and stating that further reliance should no longer be placed on its previously issued audit reports for the company’s fiscal years ended December 31, 2009 and 2010. In its resignation letter, the audit firm stated that the company had made representations to it that were materially inconsistent with the share transfers made by the board chairman.

The SEC’s Cross Border Working Group, which has representatives from each of the SEC’s major divisions and offices and focuses on U.S. companies with substantial foreign operations, has assisted the New York Regional Office enforcement staff in the investigation. Over the past year, the SEC has moved to protect U.S. investors in U.S. companies with substantial foreign operations through trading suspensions of at least 20 U.S. issuers based abroad; stop orders against two U.S. issuers based abroad to prevent further stock sales under materially misleading and deficient offering documents; and filing a subpoena enforcement action against a foreign-based audit firm to obtain documents.

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