Case Studies

     

Case Study

Claims against Accounting Firms Dismissed in Chinese Reverse Merger-related Case

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Background
Wilson Elser was retained to represent two accounting firms named as defendants in a securities class action brought by investors who purchased stock of the accounting firms’ former audit client. The plaintiffs alleged that the accounting firms had violated Section 10(b) of the Securities Exchange Act in that the auditor defendants had violated Section 10(b) of the Securities Exchange Act in that the auditor defendants had allegedly ignored or recklessly disregarded numerous red flags and had failed to conduct their audits in accordance with Public Company Accounting Oversight Board (PCAOB) standards. 

In the past few years, numerous class actions have been brought relating to Chinese entities that went public in the United States by virtue of a reverse merger transaction, a common method for foreign entities to avoid the rigors of an initial public offering. As the first of these lawsuits was not filed until recently, the law in these actions is evolving, and Wilson Elser attorneys have been faced with addressing the developing, unsettled law.ad allegedly ignored or recklessly disregarded numerous red flags and had failed to conduct their audits in accordance with Public Company Accounting Oversight Board (PCAOB) standards.

In addition to representing the two accounting firms in this class action, Wilson Elser’s Accountants practice is representing seven other accounting firms being sued in similar cases.

Strategy
Wilson Elser filed a pre-answer motion to dismiss the complaint arguing, among other things, that the plaintiffs had failed to allege “scienter,” intent or knowledge of wrongdoing, the requisite intent in a Section 10(b) claim, against the accounting firms. Although the plaintiffs had cited several red flags that allegedly should have alerted the accounting firms to a purported fraud, the motion addressed each purported “red flag” and argued that, as a whole, the plaintiffs had failed to sufficiently allege auditor scienter.

Result
In a 40-page decision, the judge addressed each of the purported “red flags,” affirmatively agreed with arguments and dismissed the action against the accounting firms. The decision is significant as this is one of the first decisions addressing auditor scienter in the Chinese reverse merger context and will provide important precedent in future cases.

Notably, the judge addressed one issue prevalent across all Chinese reverse merger actions. These actions are typically based upon discrepancies between the entity’s SEC filings in the U.S. and financial filings in China. The judge found that the discrepancies could not constitute a red flag for the relevant audits because there was no allegation that the accounting firms actually reviewed, or were required to review, the Chinese filings.

As a result of the Wilson Elser’s efforts, a complex securities fraud claim was dismissed against the firm’s clients, who will now avoid years of discovery and potential exposure in the tens of millions of dollars.

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