A U.S. investor won an unusual remedy in his fight against a Chinese company under an accounting cloud; Court Official Given Power to Seize Assets to Buy Back Burned Investor’s Shares

March 31, 2013, 8:44 p.m. ET

Novel Relief for China Woes

Court Official Given Power to Seize Assets to Buy Back Burned Investor’s Shares

By MICHAEL RAPOPORT

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A U.S. investor won an unusual remedy in his fight against a Chinese company under an accounting cloud: A judge gave a court-appointed official the power to seize company assets needed to buy back the investor’s shares for far more than their current price. The ruling in Delaware Chancery Court by Vice Chancellor J. Travis Laster also offers a glimmer of hope to other investors who suffered steep losses on Chinese companies that listed their shares in the U.S., but have plummeted in value in the past two years. Such investors were pounded by billions of dollars in losses as short sellers targeted U.S.-listed Chinese companies, auditing firms backed away from previous work on financial statements and regulators questioned the accounting and disclosure practices of some companies.

The Delaware ruling came after ZST Digital Networks Inc. ZSTN +11.20% a network-equipment supplier, flouted an earlier court order to give the shareholder access to “certain books and records” of the company. Peter E. Deutsch, who runs a wine importer, began buying ZST shares in 2011 and eventually accumulated 3.9 million shares. But ZST ran into questions over its accounting in 2012, ultimately prompting Mr. Deutsch to sue.

The judge granted a request by Mr. Deutsch for a “put option” that allows him to force ZST to buy back his shares for $8.21 apiece, or as much as $32.3 million. That per-share price is based on ZST’s book value in the last financial statements the company filed with the SEC. The shares recently traded for $1.39 a share.

“We are gratified by the court’s decision,” said David Graff, Mr. Deutsch’s lawyer. Mr. Graff added that the ruling will “deter” foreign-based companies such as ZST from trying to exploit U.S. capital markets for their own ends.

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Other lawyers said the March 28 ruling appointing a receiver to take “all actions [he] deems appropriate” will be hard to enforce.

Chinese authorities and audit firms have refused to allow the Securities and Exchange Commission to see audit documents of Chinese companies under investigation in the U.S. Chinese officials also won’t let U.S. inspectors into China to evaluate the performance of firms that audit Chinese companies traded in the U.S.

The order “certainly is a very creative approach,” said Jacob S. Frenkel, a former SEC lawyer who now leads the securities-enforcement practice at Shulman Rogers Gandal Pordy & Ecker in Potomac, Md. “This likely is a strategy that provides paper satisfaction but no substantive satisfaction or relief for U.S. investors.”

ZST couldn’t be reached for comment. Judge Laster said the company didn’t respond to a contempt motion by Mr. Deutsch in January. ZST has said the “substantial portion” of its assets and operations are located in China.

Short sellers, who bet that a company’s shares will decline in value, criticized ZST’s business as far back as 2010. Last year, outside auditor BDO resigned because it said ZST refused to follow the procedure the auditor wanted to use to confirm bank balances.

When it quit and withdrew its blessing for previous financial statements filed by ZST, BDO said restrictions on the auditing firm “could indicate a probability” that the financial statements were flawed.

ZST said it believed the reasons for BDO’s resignation were “not warranted.” But the lack of audited financial statements prompted the company to remove its shares from the Nasdaq Stock Market NDAQ -0.25% . ZST also dropped its SEC registration, meaning the company no longer has to disclose its financial statements.

Mr. Deutsch sought access to ZST’s books and records in an effort to confirm the company’s value. ZST said it would allow him to inspect the documents only in China. Mr. Deutsch sued for access in Delaware, where ZST is incorporated. In December, the Delaware Chancery Court ruled in his favor.

In holding the company in contempt for ignoring that ruling, Judge Laster wrote that Mr. Deutsch’s requests for a “put option” and receiver to go after ZST’s assets were “exceptional.” Still, he added, the shareholder provided “persuasive justifications” and ZST didn’t even appear before the court to address the request.

In court filings, Mr. Deutsch claimed ZST and other Chinese companies have “gone dark,” or withdrawn from U.S. exchanges and stopped filing financial statements with the SEC, in order to depress their stock prices and help the companies go private at a much lower cost.

In December, The Wall Street Journal reported that an increasing number of U.S.-listed companies from China had announced going-private deals.

Mr. Graff said the trend was “a disturbing and insidious impropriety.” The Delaware ruling “sets an important precedent” for other investors who have suffered losses in Chinese companies, he said. Mr. Graff said he is “confident the receiver will carry out his charge to fruition.”

The court-appointed receiver, Robert W. Seiden, is president of Confidential Security & Investigations, a forensic-investigation company in New York.

Mr. Seiden couldn’t be reached for comment.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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