Door Opens for Discovery on Auditors of China-based U.S.-Listed Companies in U.S. Securities Lawsuits

November 22, 2011


On November 7, 2011, federal district court Judge Alvin K. Hellerstein rendered two rulings in Munoz v. China Expert Technology, Inc., Case 1:07-cv-10531-AKH, which is one of the U.S. securities cases against China-based U.S.-listed companies. These rulings are likely to have significant implications for other cases over accounting problems in China-based companies. China Expert Technology’s three outside auditors, PKF Hong Kong, PKF New York and BDO McCabe Lo, are named as defendants in the lawsuit. Shareholders of the company have accused the auditors of failing to detect an alleged $132 million fraud carried out by the company. In one of the rulings on the motion to dismiss filed by one of the auditor defendants, PKF New York, the judge rejected the accounting firm’s motion to dismiss. In the other ruling on a discovery issue, the judge denied requests by the auditor defendants, PKF Hong Kong and BDO’s Hong Kong unit, to limit discovery in China.

PKF New York’s motion to dismiss cited the U.S. Supreme Court’s decision in Janus Capital Group Inc. v. First Deriv. Traders, 564 U.S._, 131 S.Ct. 2296 (2011), which limited the exposure of advisers who assisted but were not the “maker” of an untrue statement in securities class actions. In Janus, the court held that “the maker of a statement is the entity with authority over the content of the statement and whether and how to communicate it.” Id., at 2303 In the order denying defendant PKF New York’s motion to dismiss, the judge concluded that the allegations against the auditor “create genuine issues of fact as to whether PKF New York explicitly or implicitly controlled sufficiently - and thus ‘made’” the statements in the audit opinions in question. The judge held that discovery is required to determine such issue. The judge’s order did not rule on the merits of the case, but instead allowed shareholders’ claims to proceed to the next phase.

Regarding how the discovery should proceed, PKF Hong Kong and BDO’s Hong Kong unit argued that Chinese laws limit discovery because Chinese laws criminalize the disclosure of information that relates to Chinese national security and other potentially sensitive interests. But in his order allowing discovery to proceed, the judge applied the balancing test as employed in Richmark Corp. v. Timber Falling Consultants, 959 F.2d 1468 (9th Cir. 1992), and concluded that in China Expert Technology “the national interest of the United States is observably strong; China’s is speculative.” The judge noted that China’s state secrecy laws are “viewed with some skepticism in U.S. courts” because “these laws have broad sweep and can preclude disclosure of a host of nebulously defined categories of information.” The judge cited the U.S. Supreme Court’s ruling in Societe Nationale stating that “[i]t is well settled that [foreign ‘blocking’] statutes do not deprive an American court of the power to order a party subject to its jurisdiction to produce evidence even though the act of production may violate that statute.” Societe Nationale Industrielle Aerospatiale v. United States Dist. Ct., S.D. Iowa, 482 U.S. 522, 544 n.29. (1987) The judge noted that “any deference to state secrets laws should be decided by examining the facts in each individual case.” In the current case, the judge pointed out that the fact that China Expert Technology is obligated to file disclosure statements with the SEC puts into question any claim that may arise under China’s state secrecy laws. The judge does acknowledge, however, that China Expert Technology contracted with local Chinese governments and thus there may be documents subject to assertions of state and archival secrecy under Chinese law. The judge noted that he would consider specific issues that may require balancing interests between preserving the policies of China’s laws on state secrets and U.S. federal policy in relation to issuer’s and accountants’ obligations.

More than 30 securities class actions have been filed against China-based U.S.-listed companies since 2010. Most of these proposed class actions are still in the early procedural stages. The China Expert Technology lawsuit, filed in 2007, is at a slightly more advanced stage. Although only the findings of a single court, the rulings in the case mentioned above may open the door for shareholders to pursue auditors of these China-based companies; many of these cases involve such auditors’ overseas units or branches, and they are less protected by Chinese law as well as Chinese territory restrictions generally imposed on third parties seeking to effect service of process or obtain discovery from companies located in China.

Also, it is interesting to note that China state secrecy laws have been claimed by accounting firms as a basis to resist discovery requests in U.S. securities lawsuits. Another example is the argument made by Deloitte & Touche in connection with the Longtop Financial Technologies case. In September, the U.S. Securities and Exchange Commission sued the Shanghai arm of Deloitte & Touche to enforce a subpoena seeking documents in China in connection with Longtop Financial Technologies. One of the reasons Deloitte’s counsel asserted in refusing to comply with the subpoena was the risk of sanctions under China’s state secrecy law. The scope and definition of state secrets under Chinese law are known to be broad and vague, and yet enforcement of these laws seems to have been intensified by Chinese authorities. It is interesting to watch how these issues will play out in the context of U.S. securities litigation.