By Mak Yuen Teen and Wesley Loo
Kangmei Pharmaceutical Co. (“Kangmei”), a Fortune China 500 company in 2018[1], was a large Chinese medicine producer based in Guangdong province[2]. Its primary business revolved around the production and wholesale of pharmaceutical and biological products[3].
It was one of China’s biggest publicly traded drug makers and has been described as a “stock market darling” prior to the revelations about its fraudulent activities[4].
The Fraud
On 29 April 2019, Kangmei restated its 2017 financial statements, revealing an understatement of CNY 641.07 million (USD 100.68 million) in the company’s receivables, CNY 19.55 billion (USD 3.07 billion) in stock and CNY 631.60 million (USD 99.19 million) in projects under construction[5]. There was also an overstatement of CNY 29.94 billion (USD 4.7 billion) of its cash holdings[6]. Kangmei cited “procurement payment, project payment and accounting error” as reasons for the restatement of its 2017 financial statement[7].
However, investigations by the China Securities Regulatory Commission (“CSRC”) found that Kangmei had intentionally and systematically engaged in financial fraud over a considerable period of time[8]. Between 2016 and 2018, Kangmei overstated its cash holdings by CNY 88.6 billion (USD13.6 billion)[9], revenue by CNY 29.1 billion (USD 4.1 billion) and operating profit by CNY 4.1 billion (USD 640 million)[10]. Kangmei’s auditor of 19 years[11], GP Certified Public Accountants (“GP”), had also falsified records of its audit field visits and included bank documents forged by Kangmei in its 2016 audit[12]. In addition, Kangmei failed to disclose that the company had been using accounts under related parties to trade its own shares, an act of market manipulation[13], based on regulations on connected transactions[14].
Timeline of Events
On 16 October 2018, allegations of Kangmei’s fraud first emerged on social media[15]. The CSRC then launched an investigation into the social media allegations on 2 December 2018[16].
On 17 May 2019, the CSRC accused Kangmei of falsifying its reports, claiming to have uncovered “major falsehood” in its 2016 to 2018 Financial Reports[17] which Kangmei attributed to an “accounting error” in their restatement issued on 29 April 2019[18]. According to the CSRC, Kangmei had used false bank documents to increase bank deposits, false business credentials to increase income and related party transactions to purchase company shares and manipulate stock prices[19]. That same month, Kangmei admitted to spending CNY 8.88 billion (USD 1.38 billion) in share buybacks and the CSRC started investigating Kangmei’s auditor GP[20].
In May 2020[21], the CSRC fined Kangmei the maximum penalty of CNY 600,000 (USD 92,200) for falsifying its financial reports[22]. Kangmei’s former chairman Ma Xingtian (“Ma”) was taken into police custody over his alleged role in the fraud in July 2020.
On 3 September 2020, it was announced that the control over Kangmei by Kangmei Industry Investment Holdings will be transferred over to Jieyang Yilin Pharmaceutical Investment, a Guangdong Government-controlled firm set up just one month prior to the announcement, to “help the firm get out of its difficulties”[23].
In February 2021, the CSRC ordered Kangmei’s auditor to pay CNY 57 million (USD 8.8 million) for its involvement in the fraud.
Kangmei’s creditors applied to a Guangdong court to put Kangmei into bankruptcy reorganisation in April 2021[24]. In November 2021, the Guangdong court approved the bankruptcy reorganisation plan which involves a CNY 6.5 billion (USD 1.02 billion) injection of funds by five investors including state-owned Guangzhou Pharmaceutical Holdings[25]. Ma was also sentenced to 12 years in prison in the same month[26].
Landmark Ruling
In December 2020, eleven shareholders started legal action against Kangmei through an ordinary representative lawsuit[27]. However, the China Securities Investor Service Center (“CSISC”), a government-affiliated body, took over the case in April 2021 and turned it into China’s first class-action lawsuit against Kangmei and some of its former executives, as the case fits CSRC’s criteria for a class-action lawsuit[28]. The criterion includes that an administrative penalty must have been issued, the case must have had a negative impact on society and the defendant has the financial means to pay compensation[29].
After a public hearing in July 2021[30], a Guangzhou court ordered Kangmei to pay CNY 2.46 billion (USD 385.26 million) to 55,326 investors on 12 November 2021[31]. The court ruled that the actual controllers of Kangmei, some executives and the auditor of Kangmei should compensate investors for their losses, while also specifying the proportion of liability to be borne by each defendant[32].
The defendants who bear 100% joint and several liability include the actual controllers, Ma and Xu Dongjin, as well as Qiu Xiwei (Director, Deputy General Manager and Secretary of the Board of Directors), Zhuang Yiqing (CFO), Wen Shaosheng (Employee Supervisor and Deputy General Manager), Ma Huanzhou (Supervisor and Independent Director) and Yang Wenwei (GP Partner and Signatory Accountant)[33]. The defendants who bear 20% joint and several liability amounting to CNY 492 million (USD 77.26 million) in the event of any shortfall[34] are directors Ma Hanyao, Lin Dahao, Li Shi, Luo Jiaqian and Lin Guo Xiong as well as Li Jianhua (Supervisor), Han Zhongwei (Deputy General Manager) and Wang Min (Deputy General Manager)[35]. The directors who bear 10% joint and several liability amounting to approximately CNY 246 million (USD 38.63 million) in the event of any shortfall[36] are independent directors Jiang Zhenping, Li Dingan and Zhang Hong[37]. Two other independent directors, Guo Chong Hui and Zhang Ping, are to bear 5% joint and several liability amounting to approximately CNY 123 million (USD 19.32 million) in the event of any shortfall[38],[39].
The court ascertained that the losses to investors amounted to approximately CNY 2.46 billion (US$385.26 million) based on estimates from China Securities Investor Protection Fund Co. Ltd (“SIPF”)[40]. Under China’s Law, the losses should be calculated using the estimated reduction in share price multiplied by the quantity of the securities sold or retained in the period[41]. In estimating the losses, SIPF utilised the moving weighted average method to ascertain each investor’s precise average purchase price[42]. The court also adopted the relevant market index to evaluate the percentage of losses caused by systematic risk on an investor-by-investor basis[43].
In determining who was eligible for the compensation, the court held that all investors who bought shares from 20 April 2017, the date when Kangmei released its 2016 annual report[44], to 16 October 2018 were eligible to be part of the lawsuit and to be awarded compensation. The cut-off date was the date when the allegations of Kangmei’s fraudulent activities first surfaced on social media[45].
According to the CSRC, the case was a “milestone”[46] of great significance in the reform and development of China’s capital market and the safeguarding of the rights and interests of investors[47]. CSRC further stated that the costly penalty against the executives not only holds the “top evils” responsible but would also act as a deterrence for future corporate wrong-doers[48].
Repercussions
According to the 2020 financial report of the company, the five independent directors were paid monthly amounts of around CNY 10,000 (USD 1,570)[49]. Four of the five independent directors are university professors. With each of them being held liable for between 5% to 10% of the compensation amount (equivalent to CNY 123 million to CNY 246 million), the penalty is hundreds of times their annual remuneration[50].
Following the ruling, independent directors of at least 20 companies listed on the Shanghai and Shenzhen stock exchanges resigned, possibly “spooked” by the fines levied on the five independent directors of Kangmei[51]. Market watchers have attributed the low remuneration and significant liabilities of independent directors as the drivers of the mass resignation[52]. It is however, unclear how many of these were triggered by the Kangmei ruling[53]. Most of the companies cited personal reasons for the resignation of the directors. Following the resignations, some of the affected companies fell short of the mandatory requirement of having at least one-third of board members being independent directors[54]. Independent directors are now being described as a “high-risk occupation”, with many companies preparing to increase their remuneration[55].
Generally, it is rare for independent directors to be held personally liable in civil litigation in China[56]. The mass departures, according to Bloomberg, highlights “a growing wariness among corporate executives as Chinese regulators crack down on the nation’s private sector”[57].
The court’s decision revealed the role of independent directors and renewed long-standing criticisms of the system, whereby most independent directors are selected based on their ties to the company or to boost the company’s reputation and to attract investments[58]. The lack of real independence amongst independent directors is a pertinent issue which impedes their ability to act as independent monitors and advisers, according to CSRC expert, Fang Zhong[59]. One commentator said that the era of “laying down and making money” for independent directors of listed companies is over, and the future will test the “true skills” of independent directors of listed companies[60].
The ruling has also sparked debate on how intermediaries, such as auditors, should be evaluated in terms of due diligence and how evaluation standards on accountability can be clarified to make judgments more equitable[61]. Li Shoushang, a partner specializing in capital market litigation at Dentons stated that the risk for intermediaries being held jointly liable is “rising sharply” and that “everyone working for an intermediary agency is at risk, with accountants probably facing the highest risk”[62].
The Chinese Legal System
Chinese regulators are taking an increasingly hard stance towards punishing corporate wrong-doers, vowing “zero tolerance” against accounting fraud and other capital market “tumors”[63].
Prior to the Securities Law amendment, shareholders in China could only sue listed companies individually through a complex and tedious process that did not allow them to collectively sue the company. Historically, retail investors in China have had little success in making their voices heard, with small investors often describing legal action as “ants fighting elephants”[64]. To better protect shareholders’ interest, Chinese lawmakers set up a mechanism allowing investors to act and be compensated collectively[65].
Under China’s Securities Law, a representative action can only be pursued in two ways[66]. The first is via an ordinary representative lawsuit where several shareholders file a single lawsuit representing everyone who has applied to join. The other is via a special representative company acting on behalf of all eligible shareholders who are automatically included unless they specifically opt out. These eligible shareholders do not have to pay court fees in advance to have the case processed or attorney fees[67]. At present, the CSISC is the only entity allowed to act as a special representative. The latter approach is considered a class-action as it can mobilise thousands of plaintiffs which is similar to the typical class-action litigation in countries like the U.S. In the U.S, the class-action system can be abused by law firms and plaintiffs who file litigation motivated solely by monetary benefits[68]. In contrast, China’s system is designed around public interest and investor protection, according to an explanation of the special representative litigation system on CSRC’s website[69]. Unlike the U.S system, class actions in China must be launched by government bodies such as CSISC[70], making abuse of the special representative litigation system difficult.
Furthermore, the CSRC stated that the new class action mechanism would greatly reduce investors’ cost of suing listed companies[71] through simplified procedures[72] while helping to reduce malpractices in China’s capital market[73]. Hao Junbo, Chief Lawyer at the HAO Law Firm in Beijing, said that with the reduced cost of litigation, it is expected that small investors will have a higher tendency to readily resort to the class-action mechanism to enforce their rights protection[74]. The Chinese government has vowed to improve the class-action litigation mechanism and push for special representative action suits on a regular basis[75].
Note: Mak Yuen Teen is a professor and a corporate governance advocate. Wesley Loo was a student in his corporate governance and risk management course. This article is written from public sources.
References
[1] Yu, X. (2019, August 24). Why is Kangmei Pharmaceutical, found to have committed one of China’s biggest financial frauds, rallying? South China Morning Post. https://www.scmp.com/business/companies/article/3024084/why-kangmei-pharmaceutical-found-have-committed-one-chinas
[2] Ibid.
[3] He, Y., & Gao, J. (2020). P. 6. Case Study of St. Kangmei’s Financial Fraud Based on GONE Theory. Web of Proceedings. https://webofproceedings.org/proceedings_series/ESSP/ICEBMI%202020/IM1006.pdf
[4] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[5] Xue, G. (2020). Analysis of Kangmei Pharmaceutical’s Financial Restatement Behavior from the Perspective of Corporate Governance. E3S Web of Conferences, 218, 2. https://doi.org/10.1051/e3sconf/202021802016
[6] Ibid.
[7] Ibid.
[8] Ibid.
[9] Liao, S., & Laine, E. (2021, March 22). CSRC Fines Auditor GP Certified for Its Part in China’s Worst Financial Scandal at a Public Firm. Yicai Global https://www.yicaiglobal.com/news/csrc-fines-gp-certified-public-accountants-usd88-million-for-chinese-bourses-largest-fraud-
[10] Yu, X. (2019, August 24). Why is Kangmei Pharmaceutical, found to have committed one of China’s biggest financial frauds, rallying? South China Morning Post. https://www.scmp.com/business/companies/article/3024084/why-kangmei-pharmaceutical-found-have-committed-one-chinas
[11] He, Y., & Gao, J. (2020). P. 6. Case Study of St. Kangmei’s Financial Fraud Based on GONE Theory. Web of Proceedings. https://webofproceedings.org/proceedings_series/ESSP/ICEBMI%202020/IM1006.pdf
[12] Liao, S., & Laine, E. (2021, March 22). CSRC Fines Auditor GP Certified for Its Part in China’s Worst Financial Scandal at a Public Firm. Yicai Global. https://www.yicaiglobal.com/news/csrc-fines-gp-certified-public-accountants-usd88-million-for-chinese-bourses-largest-fraud-
[13] Yu, X. (2019, May 17). Chinese MSCI constituent firm Kangmei Pharmaceutical faces 600,000 yuan fine for misstating cash position. . . South China Morning Post. https://www.scmp.com/business/banking-finance/article/3010713/chinese-msci-constituent-firm-kangmei-pharmaceutical-faces?module=perpetual_scroll_0&pgtype=article&campaign=3010713
[14] Xuan, S., & Murphy, M. (2021). Guangzhou Intermediate Court Rules in First Shareholder Class Action in China. Https://Www.Hg.Org/. Retrieved December 15, 2021, from https://www.hg.org/legal-articles/guangzhou-intermediate-court-rules-in-first-shareholder-class-action-in-china-60673
[15] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[16] Xue, G. (2020). Analysis of Kangmei Pharmaceutical’s Financial Restatement Behavior from the Perspective of Corporate Governance. E3S Web of Conferences, 218, 2. https://doi.org/10.1051/e3sconf/202021802016
[17] China’s Kangmei Pharma sinks by daily limit as watchdog accuses it of fraud. (2019, May 21). Reuters. https://www.reuters.com/article/china-stocks-kangmei-idUSL4N22X1G6
[18] Xue, G. (2020). Analysis of Kangmei Pharmaceutical’s Financial Restatement Behavior from the Perspective of Corporate Governance. E3S Web of Conferences, 218, 2. https://doi.org/10.1051/e3sconf/202021802016
[19] He, Y., & Gao, J. (2020). P. 7. Case Study of St. Kangmei’s Financial Fraud Based on GONE Theory. Web of Proceedings. https://webofproceedings.org/proceedings_series/ESSP/ICEBMI%202020/IM1006.pdf
[20] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[21] Ibid.
[22] Liao, S., & Laine, E. (2021, March 22). CSRC Fines Auditor GP Certified for Its Part in China’s Worst Financial Scandal at a Public Firm. Yicai Global. https://www.yicaiglobal.com/news/csrc-fines-gp-certified-public-accountants-usd88-million-for-chinese-bourses-largest-fraud-
[23] Taylor, K. (2020, September 3). Troubled Kangmei Pharma’s Shares Hit Limit Up on Gov’t Takeover. Yicai Global. https://www.yicaiglobal.com/news/troubled-kangmei-pharma-shares-hit-limit-up-on-govt-takeover
[24] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[25] Ibid.
[26] Ibid.
[27] Ibid.
[28] Ibid.
[29] Ibid.
[30] LaCroix, K. (2021, November 15). First-Ever Chinese Collective Investor Action Results in $385 Million Damages Verdict. The D&O Diary. https://www.dandodiary.com/2021/11/articles/securities-litigation/first-ever-chinese-collective-investor-action-results-in-385-million-damages-verdict/
[31] Reuters. (2021, November 12). Chinese court rules against Kangmei in “milestone” case. https://www.reuters.com/business/healthcare-pharmaceuticals/chinese-court-rules-against-kangmei-milestone-case-2021-11-12/
[32] Xuan, S., & Murphy, M. (2021). Guangzhou Intermediate Court Rules in First Shareholder Class Action in China. HG.Org. Retrieved December 15, 2021, from https://www.hg.org/legal-articles/guangzhou-intermediate-court-rules-in-first-shareholder-class-action-in-china-60673
[33] Ibid.
[34] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[35] Xuan, S., & Murphy, M. (2021). Guangzhou Intermediate Court Rules in First Shareholder Class Action in China. HG.Org. Retrieved December 15, 2021, from https://www.hg.org/legal-articles/guangzhou-intermediate-court-rules-in-first-shareholder-class-action-in-china-60673
[36] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[37] Xuan, S., & Murphy, M. (2021). Guangzhou Intermediate Court Rules in First Shareholder Class Action in China. HG.Org. Retrieved December 15, 2021, from https://www.hg.org/legal-articles/guangzhou-intermediate-court-rules-in-first-shareholder-class-action-in-china-60673
[38] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[39] Xuan, S., & Murphy, M. (2021). Guangzhou Intermediate Court Rules in First Shareholder Class Action in China. HG.Org. Retrieved December 15, 2021, from https://www.hg.org/legal-articles/guangzhou-intermediate-court-rules-in-first-shareholder-class-action-in-china-60673
[40] Ibid.
[41] Chen, Q., Jiang, S., & Yang, V. (2021, December 3). Chinese Court delivers decision on first securities class action: Implications for the D&O market. CLYDE&CO. https://www.clydeco.com/en/insights/2021/12/chinese-court-on-first-securities-class-action
[42] Ibid.
[43] Ibid.
[44] Ibid.
[45] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[46] Reuters. (2021, November 12). Chinese court rules against Kangmei in “milestone” case. https://www.reuters.com/business/healthcare-pharmaceuticals/chinese-court-rules-against-kangmei-milestone-case-2021-11-12/
[47] Huang, Y. (2021, November 29). High liability vs low benefit: Companies see an exodus of independent directors. SHINE. https://www.shine.cn/biz/company/2111298833/
[48] Reuters. (2021, November 12). Chinese court rules against Kangmei in “milestone” case. https://www.reuters.com/business/healthcare-pharmaceuticals/chinese-court-rules-against-kangmei-milestone-case-2021-11-12/
[49] Huang, Y. (2021, November 29). High liability vs low benefit: Companies see an exodus of independent directors. SHINE. https://www.shine.cn/biz/company/2111298833/
[50] Ibid.
[51] Bloomberg. (2021, November 22). A Chinese court fined five independent directors hundreds of millions of dollars. Now China’s board members are quitting. Fortune. https://fortune.com/2021/11/22/china-kangmei-pharmaceuticals-fine-independent-corporate-board-directors-quit/
[52] Heavy fines levied on Kangmei Pharmaceutical trigger ‘resignation wave’ of independent directors in Chinese bourses. (2021, November 23). Global Times. https://www.globaltimes.cn/page/202111/1239720.shtml
[53] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[54] Bloomberg. (2021, November 22). A Chinese court fined five independent directors hundreds of millions of dollars. Now China’s board members are quitting. Fortune. https://fortune.com/2021/11/22/china-kangmei-pharmaceuticals-fine-independent-corporate-board-directors-quit/
[55] Kangmei case sentenced over 60 independent directors to resign in full month | Kangmei case_Sina Technology_Sina.com. (2021, December 12). Breaking Latest News. https://www.breakinglatest.news/business/kangmei-case-sentenced-over-60-independent-directors-to-resign-in-full-month-kangmei-case_sina-technology_sina-com/
[56] Bloomberg. (2021, November 22). A Chinese court fined five independent directors hundreds of millions of dollars. Now China’s board members are quitting. Fortune. https://fortune.com/2021/11/22/china-kangmei-pharmaceuticals-fine-independent-corporate-board-directors-quit/
[57] Ibid.
[58] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[59] Ibid.
[60] Kangmei case sentenced over 60 independent directors to resign in full month | Kangmei case_Sina Technology_Sina.com. (2021, December 12). Breaking Latest News. https://www.breakinglatest.news/business/kangmei-case-sentenced-over-60-independent-directors-to-resign-in-full-month-kangmei-case_sina-technology_sina-com/
[61] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[62] Ibid.
[63] Reuters. (2021a, April 16). China launches first class-action lawsuit in war against corporate fraud. https://www.reuters.com/article/china-markets-classaction-idUSL4N2M93GB
[64] Ibid.
[65] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[66] Ibid.
[67] Ibid.
[68] Ibid.
[69] Chinese Securities Regulatory Commission. (2021, March 20). Keynote Speech by Chairman YI Huiman at the CSRC Roundtable of China Development Forum 2021_CSRC. http://www.csrc.gov.cn/csrc_en/c102030/c213f127c306f4c0bb1362a80975100cd/content.shtml
[70] Reuters. (2021a, April 16). China launches first class-action lawsuit in war against corporate fraud. https://www.reuters.com/article/china-markets-classaction-idUSL4N2M93GB
[71] Ibid.
[72] Guo, Y. Z. (2021, December 2). Payout in Kangmei shareholder suit to empower Chinese investors. Nikkei Asia. https://asia.nikkei.com/Spotlight/Caixin/Payout-in-Kangmei-shareholder-suit-to-empower-Chinese-investors
[73] Reuters. (2021a, April 16). China launches first class-action lawsuit in war against corporate fraud. https://www.reuters.com/article/china-markets-classaction-idUSL4N2M93GB
[74] Update: China’s first securities class-action suit rules in favor of investors；lead fraudulent executive sentenced to 12 yrs and fined 1.2m yuan. (2021, November 12). Global Times. https://www.globaltimes.cn/page/202111/1238837.shtml
[75] Ibid.
