Almost every D&O commentator and source of information on emerging trends has noted that over the past twelve (12) months there has been a remarkable growth in securities fraud litigation against U.S. companies that are subsidiaries or affiliates of companies incorporated in the People’s Republic of China (“PRC”).

Much of the current wave of litigation in the U.S. against PRC companies arises from initial public offerings (“IPO”) as a result of a so-called “reverse merger” wherein a privately-held operating company in the PRC is acquired by a public shell entity in the U.S., which is also under control of the owners of the PRC operating entity. The owners and executives of the private entity assume voting and operational control over the combined entity resulting from the reverse merger. This transaction enables the private entity in the PRC to skirt the registration requirements of the Securities Exchange Commission (“SEC”), which apply only to the public shell in the U.S. While PRC companies are not the primary users of the reverse merger mechanism, they do constitute about 25% of such transactions over the past three years. Plaintiffs in the U.S. litigation typically allege inadequate disclosure because the only publicly-audited company is the PRC shell and the U.S. auditors rely heavily on auditors of the operating company in the PRC or other sources without any independent analysis. As a result, the private operating component allegedly escapes any heightened scrutiny from U.S. auditors. Since these suits only began to emerge in significant numbers about a year ago, few, if any, have been disposed by settlement or dismissed by motion.

One recent case that has drawn both a securities fraud class action and a derivative suit in the U.S. is that involving Puda Coal, Inc. In addition to the fraud allegations in the class action, the derivative suit alleges blatant breaches of fiduciary duty by the Puda board and in particular its chairman, Ming Zhao, in that Mr. Zhao was permitted to sell off the operating unit in the PRC to a private equity firm without the knowledge of the U.S. shareholders. Without the operating entity, which was a coal processor, the U.S. shell was relatively worthless.

Before turning to the insurance coverage issues, it is important to note that, although PRC companies have been in the forefront of this wave of securities litigation arising from reverse merger transaction, this by no means suggests that all such companies doing business in the U.S. are part of a fraudulent scheme. Indeed, at this early stage of the litigation process, it remains to be developed in many of these cases whether what may appear on its surface to be an intentional and knowing fraud and scam on the investing public, may in fact be the somewhat less culpable genre of reckless behavior due to unfamiliarity with corporate governance structures and desirable transparency in the U.S. Also, one need look no further than the debacles of recent years in Enron, Worldcom and countless others to appreciate that we have our share of Ponzi schemers and other home-grown fraudsters.

Although insurance coverage issues will vary from claim to claim, just as they do in other securities class actions and derivative suits, there may be issues in these cases peculiar to the fact that in these actions you might have claims asserted against the directors and officers of both the U.S. and PRC companies. There could also be overlapping boards with individuals holding insured positions in both companies. Complicating things even further may be the fact that the operations in the PRC may be insured under a policy issued there, while the U.S. company is insured by policies issued in the domestic U.S. market. The coverages may overlap and wordings may clash, giving rise to ambiguities and ultimately disputes.

As stated above, this genre of claims is still in an embryonic stage. Time will tell how liability, causation and damages, as well as coverage, issues emerge and are resolved.