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By JONATHAN BERR, who has written for national media outlets for more than 15 years

Chinese companies that take a shortcut to get listed on U.S. stock exchanges are magnets for legal trouble, which is making it more difficult for them to buy directors' and officers' insurance.

Most of the companies accused of fraud had liabilities averaging $5 million in connection with the fraud, even though the companies were covered by directors' and officers' (D&O) insurance. Not surprisingly, getting coverage for these companies is becoming more costly.

"What we are seeing now is that the market has virtually dried up ... Prices could double (from previous levels) and you can see tougher terms and conditions, and an increase in deductibles," said James M. Cowan, chairman of Asia Global Client Services at Marsh Inc.

The potential claims arising from Chinese companies executing reverse mergers actually is worse from a risk vantage point than the claims they faced in recent years because of liability suits arising from defective products, such as Chinese drywall, since insurance carriers are declining to cover risks associated with reverse mergers affecting Chinese companies.

"With product liability, there were multiple insurers," Cowan said, now far fewer carriers are willing to underwrite directors' and officers' policies for these companies.

Reverse mergers allow companies to go public faster and cheaper than a traditional initial public offering. Instead of selling shares through Wall Street banks, companies going through with reverse mergers offer shares to the public by having a private company merge with a public shell company.

After the merger, the public shell company holds the assets and liabilities of the operating company. Shareholders, formerly shareholders of the private company, control the now-public shell company. Though not illegal, the process often is a red flag for investors.

More than 150 Chinese companies have been listed on U.S. stock exchanges through mergers or "backdoor" IPOs since 2007, according to the Public Company Public Oversight Board. This group of 150 companies or more are responsible for 29 percent of all reverse mergers and one-quarter of all securities lawsuits from 2007 to 2010.

Many firms fail after the reverse merger process because they are not strong enough financially, according to the Securities and Exchange Commission, and many of these companies have subsequently disclosed accounting problems.

"The company now has access to the capital markets without having to file registration statements or undergo the typical regulatory review," said Scott O'Sullivan of Aon's Risk Solutions' Financial Services Group in an email to Risk & Insurance^®. "The limited initial regulatory oversight would normally be a concern to most savvy investors. However, China's extraordinary and continued economic growth has attracted billions of dollars to these foreign companies from investors looking for attractive returns."

Anthony Bolton, the influential manager of the Fidelity China Special Situations investment trust, described his investments in these companies as a "huge disappointment," according to the Financial Times.

The SEC has reportedly taken action against dozens of Chinese companies since 2010. On April 1, the agency suspended trading in China Changjiang Mining & New Energy Co. after "questions had arisen regarding the accuracy and completeness of information contained in (its) public filings," the agency said in a fact sheet. The lawsuits show no sign of slowing.

"Whether the fraud allegations have substance or are the product of profit-motivated short-sellers," O'Sullivan writes, "the existence of these accusations is continuing to drive securities class-action litigation against Chinese reverse-merger companies."

December 5, 2011

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