Lost In Translation; Securities Fraud In a Global Economy

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On the surface, the story is just another example of business in the global age.  The Chinese-born, California-based CEO of a U.S. company doing business almost entirely in China enters into a structured transaction with a Costa-Rica based investment firm, using 1.3 million shares of publicly traded (NYSE:CNAM) stock as collateral.  But dig a little deeper, and the story becomes one of fraud, and how the global economy could be brought to its knees by individuals and companies intent on circumventing national laws and regulations.

The man at the center of this case is Kexuan Yao, the CEO and General Manager of China Armco Metals, Inc (“CNAM”).  CNAM and its wholly owned subsidiary, Armco & Metalwise (H.K.) Ltd. (“Armco”), deal with metal and metal products, including the recycling of waste materials.  While the company is by its own admission “U.S. based,” its customers are located almost entirely within China, and their suppliers include India, Nigeria, Brazil and Turkey.  Being headquartered in the United States can, of course, bring numerous benefits, even for a company whose work is predominantly done elsewhere.  But the average American could be forgiven for thinking that along with such benefits come the responsibilities of operating in the U.S.

One such responsibility would be to conform to U.S. law.  The finances of American companies are regulated by the Securities and Exchange Commission (SEC), a regulatory body which has come under more strict oversight since the passing of the “Public Company Accounting Reform and Investor Protection Act” of 2002, nick-named Sarbanes-Oxley for its co-sponsors.  That act was passed to protect investors from the unscrupulous accounting practices engaged in by companies such as Enron, Adelphia, and WorldCom.  In short, Sarbanes-Oxley was meant to force companies to be more transparent in their accounting and eliminate fraud.

There is no question that what Yao and perhaps his entire company’s Board of Directors engaged in was the kind of fraud Sarbanes-Oxley sought to eliminate.  There is also no question that Sarbanes-Oxley, while a major deterrent to fraud, has not stopped people like Yao from trying to make money behind the backs of investors.  What is at issue in this case is whether language and cultural barriers will become a new legal defense. 

In the spring of this year Yao approached an intermediary with a proposition.  He sought to liquidate 1.3 million common shares of stock he owned in his company.  This would represent a little under 9% of the company’s over 15 million outstanding common shares, valued at $3.97 on the NYSE as of October 13, 2010. 

The intermediary, Ed Furman, got in touch with Costa Rica-based investment firm Crisnic Fund, S.A.  Anthony Gentile, principal of the firm, signaled that Crisnic would be willing to enter into a structured transaction agreement using the 1.3 million shares as pledged collateral.  The agreement could proceed on condition that the shares were unrestricted and available for trade. 

Furman explained the situation to Yao, who was asked to provide a letter stating that the shares were indeed unrestricted, and confirming that applicable SEC regulations regarding the trades of large sums of stock from an officer of a publicly-traded company were followed.  Yao apparently suggested to Furman that he had paid for such letters in the past, and expected Furman to do so in the case of this transaction.  Furman found an attorney in New York, J.S. Barkats, PLLC, who agreed to provide a letter stating that the shares could have any legend of restriction removed and were available for trade en masse.  He would do so based solely on a letter from Yao.

Yao confirmed to Barkats in a signed letter that the 1.3 million shares in question did not exceed either 1% of the total outstanding company stock or the greater of either 1% or the average daily trading volume on the NYSE in the four weeks preceding the agreement.  Based on this information alone, Barkats issued a legal opinion that the stock could have any legend on it lifted and could be used in an unrestricted manner.  The legal opinion clearing the transfer of stock titles was written on June 25, 2010.

But in the meantime Yao had already signed before a notary a structured transaction agreement with the investment firm, Crisnic.  In the agreement notarized June 21, 2010 Yao assigned to Crisnic all control over the 1.3 million pledged shares, agreeing that Crisnic had absolute privilege to treat the stock in any way it saw fit, including selling the stock outright. 

Moving even further back in time to June 15, 2010, the Action Stock Transfer Corporation received irrevocable instructions from Yao and the China Armco, Inc. CFO, Fengtao Wen, to transfer the stock to Crisnic and to remove the restricted legend from the certificates.  This letter, stamped with the seal of China Armco Metals, Inc., was received on June 28, 2010. 

It is not difficult to trace the fraudulent path trod by Yao in his attempt to monetize his stock under the radar of the SEC.  First, he lied in stating that the 1.3 million stock in question represented less than 1% of CAM’s total outstanding stock.  Second, he lied to Crisnic in representing that the 1.3 million stock they would receive as a pledged collateral was free of any restricted legend.  Third, the order of events – ordering the lifting of the restricted legend on the stock before receiving the legal opinion to back up the order – showed an intent to defraud from the very start.  But perhaps most troubling is the irrevocable order, signed by the CNAM CFO and sealed with their stamp, which revealed that more than one corporation officer was complicit in the plan.

If this was the end of the case, it would be bad enough.  But it was on June 30 that things began to get more interesting.  On that date James Schneider, a lawyer with the Boca Raton, Florida law firm of Schneider Weinberger & Beilly, LLP, revealed that an investigation of the transaction was now under way.  The firm, announcing themselves as the counsel for China Armco Metals, Inc., told the compliance department of one of the firms responsible for handling the shares that the transaction may have been “a device or machination to circumvent the provisions” of the Securities Act of 1933.  The firm further stated that J.S. Barkats, PLLC could no longer render any opinions or instructions on these shares.  It should be noted that this letter was sent well after the agreement with Crisnic was signed, well after Yao stated that shares he owned did not exceed 1% of his firms outstanding shares, and well after CAM CFO Wen countersigned the irrevocable transfer order for the shares.  This seems a strange time indeed to begin involving a firm’s corporate counsel.

Even stranger is the statement from the firm’s Boca Raton counsel that “no disposition of any of the Shares or distribution of proceeds” may be undertaken “without the authorization of China Armco.”  If the CFO and CEO can not speak on behalf of their company, then who exactly is to speak for them?  Who, exactly, at China Armco is performing the investigation into “the facts and circumstances concerning this transaction”?

Clearly the Board of Directors, if not guilty of fraud themselves, is at least guilty of being unaware of what is occurring in their own corporation.  From the period of June 2010 through September 2010, the filings of CAM with the SEC contained none of the compulsory indications that an investigation was on-going against one or more of its officers, nor did they contain any mention of the transfer of over 1.3 million shares in stock in exchange for payment by its CEO.  In point of fact, on July 2, 2010 Yao did file a Form 4 with the SEC disclosing the purchase of 400,000 shares of stock at $5 a share.  But there was no mention of the 1.3 million which were already disposed. 

On August 24, 2010 Yao filed for a restraining order against Crisnic Fund, S.A. against the sale of any portion of the amount pledged to them in contract.  In a classic case of “the truth will out,” this filing has revealed more criminal wrongdoing.  Yao’s lawyer admits that any proceeds from the sale of the 1.3 million shares are “ill-gotten,” since the stock should have been restricted and could not be sold.  Should is the operative word, since Yao’s lawyer also admits that the shares were never properly registered with the SEC in the first place.  Yao’s attorney also admits in the filing that Yao could be prosecuted by the SEC for securities violations and held liable, and be barred from serving as an officer or director of a U.S. corporation indefinitely.

Yao claims, for his part, to be confused by all of this.  English is not his strong suit, and the maze of American legal requirements are difficult for him to navigate.  This is not a case of fraud, but a case of things being “lost in translation,” as it were.  This is what raises the most difficult question posed by this whole case.  In an economy becoming ever more global, how can investors be protected?  Will it be possible for CEOs, CFOs, and Boards of Directors to enrich themselves at consumers’ expense with impunity, by using language and cultural barriers as a legal defense?

The old proverb states that “ignorance of the law is no defense.”  Perhaps it is time to add ignorance of the law’s language as an unacceptable defense as well. But then again this is just my opinion.