China: Forest Fire
14 October 2013 | By Yun Kriegler
17 March 2014
12 December 2013
17 December 2013
18 March 2014
30 June 2014
Two Chinese firms are being sued in a blazing forestry deal row but the country’s whole legal profession is about to feel the heat.
Storm clouds are gathering over two of China’s elite capital markets firms, Commerce & Finance (C&F) and Jingtian & Gongcheng, both based in Beijing.
On 31 May, 11 securities firms and financial institutions, including big names Credit Suisse Securities and Merrill Lynch, filed a claim against the two firms at the Ontario Superior Court of Justice alleging negligence and breach of duty. The damages sought could run to hundreds of millions of dollars – even billions.
This is one of the more recent claims filed in relation to the scandal-plagued Sino-Forest Corporation, a Chinese forestry company once traded on the Toronto Stock Exchange and worth $6bn (£3.7bn), but which collapsed following fraud allegations initiated by US short-selling firm Muddy Water in 2011.
The underwriters themselves are defendants of several class actions in Canada and in the US. The largest is a potential $9bn lawsuit filed by Canadian firms Siskinds and Koskie Minsky on behalf of burned investors in Sino-Forest against the company’s former auditors, consultants and underwriters.
In turn, the underwriters’ lawsuit against the Chinese law firms claims contribution and indemnity for any liability they may have in the class action or other litigation in relation to Sino-Forest and seeks damages from the firms to compensate the underwriters for any amounts they are ordered to pay in the litigation. It also pleads that the court treat this claim as a third-party claim within the class action. (See box for full list of parties, below.)
Root of the problem
The underwriters’ allegations arise from seven fundraising transactions between 2007 and 2010, including debt and equity offerings, that raised more than $2bn in all. In those issuances Jingtian acted as PRC legal counsel to the issuer Sino–Forest and C&F as PRC legal counsel to the underwriters.
This is significant because it is one of the first cases in which established Chinese law firms are being pursued by global clients in such a high-profile and big-ticket matter.
As the claim was filed in Canada and the trial has not started, the news is yet to spread widely in China, but it is known of among a group of local and international practitioners active in cross-border transactions. It is understood that the two Chinese defendants are yet to file their statements of defence.
“This is a wake-up call to all Chinese lawyers who handle cross-border transactions and particularly those who focus on capital markets,” says a Chinese capital markets lawyer who finds it hard to believe that two of the country’s most highly regarded law firms could have got themselves into such a situation. “We’re not going to judge if they made any errors or did anything wrong, but there are certainly lessons to be learned. For example, firms need to establish and vigorously enforce effective internal controls as well as risk management.
“Chinese firms are aware of the increasing professional risks as they become more involved in high-value and complex transactions. But it’s only when cases like this take place that people sit up, take notice and start thinking about it seriously.”
Any missteps by Chinese law firms in domestic capital markets deals do get punished by the increasingly strict regulators such as CSRC (The China Securities Regulatory Commission). But even the most severe financial punishment, which would be in the range of tens of thousands of US dollars, would be no way near the magnitude of the damages claimed in the Sino-Forest case. “There is more room for error when firms think they can get away lightly when things go wrong,” says an experienced capital markets lawyer in Hong Kong.
Capital markets lawyers in international firms are also surprised at the action.
“This case is extremely significant to the extent that it is the first time PRC firms are being sued in a capital markets deal. It’s already rare for global banks to sue their own counsel,” says a veteran US capital markets lawyer based in Hong Kong. “If it doesn’t happen again, then it won’t have much impact on the market and current practices, but if it happens more frequently it would have an impact on the pricing of PRC firms. They’d want to charge higher rates to bear the bulk of liability. It might drive PRC fees to the international level and would definitely make the wording and drafting of their PRC opinions more meticulous and conservative.”
Another international capital markets lawyer expects the investment banks and foreign stock exchanges to put more pressure on international counsel to review and check more stringently the legal opinions and due diligent reports issued by PRC counsel in cross-border transactions.
The fact that the two Chinese firms are among the most experienced and dominant outlets in cross-border capital-raising and M&A transactions makes this case particularly notable.
“If the firms being sued were unknown, smaller ones I wouldn’t have been so surprised,” says a partner at a national firm in China. “But this shows even the most experienced and respected firms may still run into trouble and it sends an alarming signal to the rest of the profession.”
Indeed, the firms in question are considered trailblazers in China’s capital markets. For example, Jingtian’s work on a number of ground-breaking multi-jurisdictional IPOs of large state-owned enterprises – such as its role as Chinese legal adviser to China Southern Airlines in its dual IPO on the Hong Kong and New York Stock Exchanges in July 1997 – set it apart from its domestic competitors. The IPO raised almost $700m (£440m) for the Chinese airline. Since then, the firm has advised on around 270 IPOs and listings on foreign stock exchanges.
C&F is also one of the most familiar Chinese names among the international investment banking circle and international law firms in Hong Kong. It has acted on more than 250 IPOs of Chinese companies on Hong Kong’s stock exchange and, in 42 per cent of these deals – or 107 – acted for the underwriters.
“These two firms are regarded as among the top five Chinese law firms in cross-border capital markets deals,” says a partner at a major US firm who regularly comes across the firms in deals, adding that the suit poses tricky reputational problems.
When Jingtian and C&F advised on Sino-Forest’s concurrent $349m secondary share offering and $460m convertible notes issuance in 2009 they were praised for their work in this highly complex transaction, which even won the ‘deal of the year’ accolade in a Hong Kong-based legal journal.
However, their advice on PRC law in relation to these deals and several other capital-raising deals are being attacked by the underwriters.
According to the statement of claim, the underwriters’ obligations under each of the underwriting agreements were expressly contingent on Jingtian’s opinions being favourable or satisfactory.
In each of the firm’s opinions on Chinese law, the filing states, Jingtian opined that Sino-Forest and/or its subsidiaries had certain contractual and land use rights with respect to forested lands in China, that the company’s documents were accurate in respect of Chinese law and that, after having conducted due diligence, Jingtian had no reason to believe the offering documents in question contained untrue statements of material fact, or omitted material facts.
Moreover, the underwriters claim that in all of Jingtian’s opinions on Chinese law it expressly or impliedly rendered an opinion that the
offering documents fairly summarised certain contracts and other material documents to which subsidiaries of Sino-Forest were parties, and never did Jingtian draw the attention of any of the underwriters to any misrepresentations or omissions of material facts in any of the company’s offering documents.
The claim alleges that Jingtian breached its duties to the underwriters and investors and was negligent or made negligent misrepresentation. The allegations include failure to conduct adequate due diligence and investigations into Sino-Forest’s business, contracts, offerings and offering documents and a failure to identify misrepresentations alleged in the class action statement of claim when it was in a special position to do so.
The underwriters made allegations against C&F on similar grounds.
“Had they known of the facts underlying the alleged misrepresentations, the underwriters would have refused further involvement in the offerings,” the claim reads.
The underwriters claim contribution and indemnity from C&F and Jingtian for any liability they may have in the class action or other litigation in relation to Sino-Forest, and require the firms to compensate the plaintiffs for any amounts they are ordered to pay in the class action and litigation.
“Any law firms, financial advisers and auditors involved in the capital raising of Sino-Forest have cause to worry, given the formal fraud allegations made by the Ontario Securities Commission against the company and its former executives,” said an international lawyer familiar with the matter. “Any professional firms involved in a public offering, when things have gone fundamentally wrong, will inevitably be drawn into legal proceedings. It’s a big mess to be caught up in, regardless of whether they are liable or not.”
Some Chinese lawyers are concerned about the potential reputational damage and long-term repercussions for the Chinese legal profession.
“If the underwriters succeed in this lawsuit it will set a legal precedent,” says one partner at a Chinese firm. “More banks and intermediates will take similar actions against Chinese firms when China-related capital markets deals go wrong, to protect themselves and avoid liability. The aftermath could be disastrous for the Chinese legal industry.”
For complicated cases like this it is expected to take a long time for legal proceedings to conclude. But some lawyers in China raise the question of the enforceability of a Canadian judgment in China, regardless of the final outcome.
“It’s difficult to enforce a foreign court judgment in China,” says one. “Even if the firms are found guilty it will be challenging to realise the damage awards. However, the reputational damage will be the most significant issue for these firms.”
However, some are less concerned about the business prospects of the two. “It’s a tricky situation,” says a Hong Kong-based US capital markets lawyer. “I can imagine the difficulty to get instructions from the banks that are suing them, but there are not that many Chinese firms of their calibre. Clients may still have to use them out of necessity.”
Most of the two firms’ peers share the view that it will be difficult to prove or find them guilty of negligence or liable in this case, but elite Chinese firms have vowed to use the incident as an opportunity to review and improve their own internal control and risk management.
“This will warn all the lawyers in China they are potentially exposed to huge professional liability risks and damages payable to financial loss sustained by a client by issuing PRC legal opinions,” says a managing partner at a national firm. “There has been no precedent, so some firms traditionally didn’t pay much attention to ensuring the quality of the legal opinion issued by their lawyers. As a result there have been cases in which a lawyer would sell legal opinions for a cheap price without undertaking substantial due diligence.
“In a sense, this lawsuit serves a good purpose to the whole Chinese legal profession.”
In several of the country’s leading firms, such as Fangda, King & Wood Mallesons, Jun He and Global Law Offices, there are already procedures to review and approve certain types of tough legal opinions. Generally, a review committee, consisting of three partners, will need to give the sign-off before a partner can issue PRC legal opinions that are deemed to be risky to the firm.
“On hearing about this story we called an internal meeting immediately and decided to seriously improve our internal control procedures,” says another managing partner at a Chinese firm. “We had some procedures and measures on paper but they weren’t vigorously followed. Now this will change. I believe other firms are doing the same.”
Chinese firms are increasingly undertaking large and complex cross-border transactions, and the need to have sufficient professional indemnity insurance (PII) is becoming urgent. The Sino-Forest affair is a case in point.
Earlier this year Big Four accountancy firm Ernst & Young, which was a defendant in the Sino-Forest class action, reached an agreement with the company’s shareholders to settle the allegations for $117m. This is the largest amount ever paid by an auditor in Canada to settle a class action suit and one of the largest in the world.
It is easy to assume that the damages to the underwriters would be at a similar level if not higher. Hypothetically, if C&F and Jingtian must pay for such damages in the worst-case scenario, they would be covered only for a maximum of RMB6m ($1m) each under the standard insurance policy.
In China, each city’s bar association is responsible for purchasing group PII for its member lawyers and firms. Law firms can purchase extra insurance but it is not compulsory. Several lawyers told The Lawyer they are willing to buy extra cover but insurance companies that offer such products are few and far between in China, and the international premium is too high relative to firms’ revenue.
“Awareness of the need to have sufficient insurance cover is very low among Chinese bar associations and firms. The Sino-Forest case will trigger the industry to think more seriously about this matter,” says a board member of the Shanghai Bar Association. “The legal industry should work closely with the insurance industry to come up with a new PII scheme that’s comparable to global markets.”
Another trend that will accelerate following the Sino-Forest case is the conversion from general partnership to special general partnership, a structure introduced in 2008 that is essentially similar to the LLP in the UK. Most of China’s largest
national firms such as Dacheng, Zhong Lun and Zhong Yin are operating in a special general partnership. Jingtian is the most recent one to have converted. The conversion completed in September, which will now offer some level of protection against negligence claims.
The Sino-Forest saga has had a far-reaching and profound impact on global capital markets and Chinese companies listed abroad. This impact is now spreading to the international and Chinese professional services industries. Although some initial pain is to be expected, the long-term effect will be to help improve the wellbeing of the Chinese legal profession, which is an increasingly important member of the global club.
The $9bn Sino-Forest class action in Canada
Ontario Superior Court of Justice
Date of action issued:
20 July 2011
The trustees of the Labourers’ Pension Fund of Central and Eastern Canada, the trustees of the international union of operating engineers local 793 pension plan for operating engineers in Ontario, Sjunde AP-Fonden, David Grant and Robert Wong
Counsel to plaintiffs:
Siskinds (lead partner Dimitri Lascaris) and Koskie Minsky (lead partner Kirk Baert)
Sino-Forest Corporation (Bennet Jones, Michael Eizenga), Ernst & Young (Lenczner Slaght, Peter Osborne), Allen Chan (Emily Cole, Miller Thomson), BDO, Judson Martin, Kai Kit Poon, David Horsley, William Ardell, James Bowland, James Hyde, Edmund Mak, Simon Murray, Peter Wang, Garry West, Poyry (Beijing) Consulting Company
Credit Suisse Securities (Canada), TD Securities, Dundee Securities, RBC Dominion Securities, Scotia Capital, CIBC World Markets, Merrill Lynch Canada, Canacoord Financial, Maison Placements Canada, Credit Suisse Securities (USA) and Merrill Lynch, Pierce, Fenner & Smith Incorporated (successor by merger to Banc of America Securities)
Counsel to the underwriters: Torys (lead partners John Fabello and Andrew Gary)
The underwriters’ claim:
Date of action issued:
31 May 2013
Defendants: Commerce & Finance and Jingtian & Gongcheng
Who are the two firms in question?
Commerce & Finance:
Established in Beijing in 1992, Commerce & Finance is a top-tier Chinese firm with a focus on corporate, foreign investment, M&A and capital markets transactions. The firm’s three founding partners were among the first 120 lawyers in China to attain the requisite qualification to work in securities law in 1993. It has a strong record and capability in advising on debt and equity capital markets deals. Since 1993 the firm has advised on more than 250 IPOs of Chinese companies on Hong Kong’s stock exchange, claiming the largest market share among Chinese legal advisers in this area.
Jingtian & Gongcheng
Jingtian & Gongcheng was established in 2000 via a merger between two Beijing firms. Its practice has always had a distinct capital markets focus since its establishment. In the firm’s earlier days, a number of ground-breaking multi-jurisdictional IPOs of large state-owned enterprises set it apart from domestic competitors, such as its role as the Chinese legal adviser to China Southern Airlines in its dual IPO on the Hong Kong and New York stock exchanges in 1997, which raised almost $700m. According to Thomson Reuters, the firm completed 19 M&A transactions in 2012 with a total value of $9.7bn.
Price war is no way to nurture the legal profession in China
Many capital markets specialists working in China claim the practice environment is challenging. Some have blamed the price war for IPO mandates as the reason for the deteriorating quality of legal opinions and thoroughness in due diligence processes. One international lawyer comments: “The price for international counsel is so low, it’s hard for any firms to make a profit if you send five associates to the data room for a week. It’s increasingly hard to balance doing a job and staying profitable.”
The price war is also said to be a result of an unsophisticated legal system.
“The rule of law is a new and still-developing concept in China,” says a veteran corporate lawyer in China who has worked extensively in China and the US. “The legality of many new projects, deal structures, financial arrangements and products relies on government approval. This has significantly reduced the creativity and innovative ability of lawyers.
“That’s why it’s hard for Chinese firms to develop differentiating services and projects, why China won’t have the equivalent of a Cravath Swaine & Moore and why PRC firms can’t charge premium prices and are more ‘replaceable’.”
According to lawyers on the ground, as an PRC legal counsel to issuer for a mid-cap overseas IPO the market rate ranges from $135,000 to $250,000. PRC counsel to the underwriters generally charge even less. However, the foreign counsel that drafts the prospectus will earn around $1m.
“Chinese firms do most of the groundwork and get paid the least of all the intermediates in capital markets deals,” says a capital markets lawyer in Shanghai. “And now, we’re exposed to all the liability too. This will force us to be more picky in taking on deals and clients.”
He says that in recent years he has had to turn down three client instructions due to pricing pressure and the quality of the projects and clients.
“Now, it’s a buyer’s market and deals are harder to come by,” he adds. “Many clients want to get deals done quickly. If a lawyer can’t issue the legal opinions required because of problems, clients will remove them and hire one who is willing to compromise on standards to get things done. The market needs a shake-up and the Sino-Forest case could provide the impetus for that change.”