(CN) – An investment trust may sue Morgan Stanley for selling it shares in a Chinese company based on paperwork that vastly inflated the company’s profits and claimed substantial revenues from a factory that was not in operation, a federal judge ruled.
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ShengdaTech is a Chinese company incorporated under U.S. law in Nevada. It owns five Chinese companies from which ShengdaTech gets all its revenues.
When the company first registered with the SEC in 2006, the SEC allegedly refused to review ShengdaTech’s registration statement because it was so poorly prepared. After several revisions, ShengdaTech made its first stock offering in 2008.
In a private offering in 2010, ShengdaTech issued an additional $90 million worth of convertible notes underwritten by Morgan Stanley.
The Miller Investment Trust bought $8 million worth of these notes.
However, in March 2011, the NASDAQ suspended trading on shares of ShengdaTech after an audit revealed a number of unexplained transactions made by the company’s CEO. ShengdaTech filed for bankruptcy a few months later.
In Massachusetts federal court, the trust sued Morgan Stanley and ShengdaTech’s auditor, KPMG Hong Kong, claiming that the 2010 offering documents “vastly overstated its financial performance.”
ShengdaTech’s wholly-owned Chinese subsidiaries allegedly reported far lower revenues to the Chinese Administration of Industry and Commerce (AIC) than the company reported to the SEC. However, these documents were not available for review at the offering, the trust said, and neither Morgan Stanley nor KPMG reviewed these filings when they agreed to participate in ShengdaTech’s offering.
In the Private Placement Memorandum, partly drafted by Morgan Stanley and given to the trust with the offering documents, ShengdaTech reported that one of its facilities started production in late 2009 and reached 100 percent capacity in January 2010.
In fact, the facility was still under construction and did not begin trial production until the beginning of 2010.
The trust argued that if Morgan Stanley and KPMG had investigated ShengdaTech’s revenue claims before the 2010 offering, they would have uncovered this fraud and numerous other serious accounting discrepancies.
U.S. District Judge Joseph Tauro refused to dismiss the trust’s claims against Morgan Stanley.
“Here, plaintiff’s complaint does not sound in fraud, but alleges that if defendant Morgan Stanley had exercised due diligence in preparing the private placement memorandum, it would have uncovered the discrepancies in ShengdaTech’s Chinese and American financial reporting. Crucially, plaintiff pleads that the Chinese and American accounting standards are substantially similar on the issue of revenue recognition, that Chinese penalties for failure to file accurate reports are more likely to affect Chinese companies incorporated in the United States than SEC penalties, and that ShengdaTech’s Chinese subsidiaries were the sole source of its revenue.
“It is clear, therefore, that plaintiff has met Rule 8 ‘s requirement to make a ‘short and plain statement of the claim showing that the pleader is entitled to relief,'” Tauro said.