What do Paulson & Co., Carlyle Group and Fidelity Investments all have in common? Each held between 14 and 22 percent ownership of a Chinese company whose stock has plummeted due to suspected fraud. These are hugely concentrated bets placed by what are generally believed to be sophisticated investors who are often investing money of fiduciaries. As such, you would think that they performed a thorough due diligence before investing.

I am not accusing these institutional investors of failing to perform a thorough due diligence. I think we are all learning new lessons as foreign investments become more and more part of our portfolios. Let’s review some of those lessons and recent developments regarding international investing.

Where Are Your Shares Purchased?

For decades, we believed that if you purchased stock in a foreign corporation, and that corporation lied about its financial results, an investor always could sue under the U.S. securities laws to recover the losses. However, you are not necessarily protected by U.S. law if the stock was purchased on an exchange outside the U.S.

Last summer, the U.S. Supreme Court held that the Securities Exchange Act of 1934 should be narrowly read to cover only transactions on U.S. exchanges. The implications of the Court’s decision cannot be ignored by fiduciaries of pension funds. If an investment in a stock goes haywire, you want the best access to a remedy. In today’s world, it is undisputed that U.S. law is the best.

Investors still often have the option to choose U.S. law. The securities of many foreign corporations trade on multiple exchanges. You, as a fiduciary, can insist that the investment officer give first priority to the U.S. exchanges.

Moreover, many foreign corporations issue American Depository Receipts (ADRs) that trade on the NYSE or NASDAQ, and represent a specified number of shares in a foreign corporation. The actual shares are usually held by a custodian bank in the foreign company’s country. Whether U.S. law provides a direct remedy over the foreign entities and individuals is not entirely settled. The prevailing view of the lower courts is that purchases of ADRs do have such protections.

The Supreme Court may not have the last word on this subject. The Dodd-Frank Wall Street Reform bill that passed last year directed the SEC to study the extent to which private rights of action under the antifraud provisions of the Securities Exchange Act of 1934 should be modified in light of the Court’s decision. The SEC expects to have its report to Congress finalized in the first half of 2012.

Now that we have made sure that we are buying shares in a foreign company on a U.S. exchange, and can utilize the U.S. securities laws to recover for any fraud, we have fully exercised our judgment and are protected, right? Wrong.

According to the Wall Street Journal, a long list of money managers and private equity firms, including Paulson, Carlyle, Maverick Capital, Tiger Global, Fidelity, Putnam, Janus, Vanguard Group, Citadel LLC, AQR Capital Management, Renaissance Technologies LLC, Oaktree Capital Management, Goldman Sachs Group Inc., Morgan Stanley and the California Public Employees’ Retirement System bought Chinese reverse merger stocks listed on U.S. exchanges only to see the stocks tank or trading halted as accounting scandals erupted and senior executives resigned.

The SEC has been investigating these reverse mergers since at least December of last year, as investors continued to pour into the domestic stocks of foreign companies. Reportedly, investigators are focusing on those who help these companies become publicly traded, and the auditors whose opinions allow the stocks to become or stay listed.

In what can best be described as “too little, too late,” on June 9th, the SEC finally issued a warning bulletin on these Chinese reverse merger stocks after halting trading on over a dozen stocks. To many investors and trustees, the SEC warnings in the bulletin come as a surprise. For instance, did you know:

• The SEC allows a company to enter the U.S. securities market by merging with a “shell company” with no assets or operations;

• The assets and business operations may be entirely overseas;
• The management and directors may be overseas too;
• The investment banks, if any, that bring these companies public are often small shops who churn out these companies and have few assets to withstand one or more judgments;
• The auditors may be overseas, overseas affiliates of a Big Four firm or a small U.S. auditor with insufficient resources to meet its auditing obligations.

All of this means, as stated by the SEC in a separate bulletin on international investing: “Even if you sue successfully in a U.S. court, you may not be able to collect on a U.S. judgment…”

In the recent spate of Chinese reverse merger cases, we have seen companies not answer complaints, with the threat of receiving a default judgment. We have seen the officers and directors who have been sued argue that they have not been properly served in China, and we have seen Big Four accounting affiliates argue that they are mere affiliates in name only, and that service on the U.S. Big Four accounting firms is insufficient.

To date, we have not seen a successful collection on a judgment in China as the result of securities fraud. With all of the assets of the individuals and companies in China, we are leery of Chinese willingness to enforce a U.S. judgment. To date we know of no attempt to sue in a Chinese court.

What this means to a pension plan trustee is that extra care must be exercised when investing in U.S. exchange traded stocks in foreign entities. Ask some basic questions before making a significant investment in a foreign company. Does the company have significant assets in the United States? Has the company disclosed significant officers and directors liability insurance? Are there third parties in the United States who have vouched for the company, such as significant investment banks and U.S. affiliates of the Big Four audit firms?

These are not just my opinions. The SEC explicitly states in issuing its bulletin on reverse mergers: “Given the potential risks, investors should be especially careful when considering investing in the stock of reverse merger companies,” said Lori J. Schock, Director of the SEC’s Office of Investor Education and Advocacy. “As with any investment, investors should thoroughly research the company – including ensuring there is accurate and up-to-date information – before making a decision to invest.”