ONTARIO

SUPERIOR COURT OF JUSTICE

COURT FILE NO.: 11-CV-436360-00CP
DATE: October 9, 2012

BETWEEN:

JERZY ROBERT ZANIEWICZ and EDWARD C. CLARKE
Plaintiffs

– and –

ZUNGUI HAIXI CORPORATION, E&Y, FENGYI CAI, JIXU CAI, YANDA CAI, MICHELLE GOBIN, MICHAEL W. MANLEY, PATRICK A. RYAN, ELLIOTT WAHLE, MARGARET CORNISH, CIBC WORLD MARKETS INC., CANACCORD GENUITY CORP. (f.k.a. CANACCORD FINANCIAL LTD)., GMP SECURITIES LP and MACKIE RESEARCH CAPITAL CORPORATION (f.k.a. RESEARCH CAPITAL CORPORATION)
Defendants

Douglas M. Worndl for the Plaintiffs

Kurt K. Pereira for the Defendant Zungui Haizi Corporation
Margaret L. Waddell for the Defendant Michelle Gobin
Patrick J. O’Kelly for the Defendants, Patrick A. Ryan, Elliott Wahle, and Margaret Cornish
Linda L. Fuerst for the Defendant E & Y.
Kristin Jeffrey for the Defendants CIBC World Markets Inc., Canaccord Genuity Corp. (f.k.a. Canaccord Financial Ltd.) and Mackie Research Capital Corporation (f.k.a. Research Capital Corportion and GMP Securities LP.

Proceeding under the Class Proceedings Act

HEARD: October 9, 2012

PERELL, J.

REASONS FOR DECISION

A. INTRODUCTION

[ 1 ] This is a proposed class action under the Class Proceedings Act, 1992 , S.O. 1992, c. C6. In this motion , the Plaintiffs , Jerzy Robert Zaniewicz and Edward C. Clarke seek leave to assert an action against the Defendants Fengy Cai, Jixu Cai, and Yanda Cai. The Plaintiffs move pursuant to section 138.8(1) of Part XXIII.1 of the Ontario Securities Act , R.S.O. 1990, c. S.5 and, if necessary, the concordant securities legislation in the other Canadian provinces .

[ 2 ] The Cais have not defended the action to date, and they were noted in default on August 10, 2012. They have been served with the material for these motions and have not appeared to defend the motions.

[ 3 ] The Plaintiffs also sue Zungui Haizi Corporation (“Zungui”), E&Y, Michelle Gobin, Michael W. Manley, Patrick A. Ryan, Elliot Wahle and Margaret Cornish, (the “Standstill Defendants”). The Standstill Defendants have entered into a standstill agreement in respect of the limitation period applicable to proposed claims under Part XXIII.1 on the Ontario Securities Act .

[ 4 ] The Plaintiffs also sue CIBC World Markets Inc., Canaccord Genuity Corp., GMP Securities LP, and Mackie Research Capital Corporation in their proposed class action.

[ 5 ] The motion for certification of the action under the Class Proceedings Act, 1992 and the motion for leave under Part XXIII.1 of the OSA, as against the Standstill Defendants are not being argued on this motion, but will be argued at a later date.

[ 6 ] For the reasons that follow, the Plaintiffs’ motion is granted.

B. FACTUAL BACKGROUND

[ 7 ] Before describing the factual background, I note that my findings and rulings on this motion, which is against the Defendants Fengy Cai, Jixu Cai, and Yanda Cai, are without prejudice to the Standstill Defendants and to CIBC World Markets Inc., Canaccord Genuity Corp., GMP Securities LP, and Mackie Research Capital Corporation.

[ 8 ] The following description of the factual background is largely taken from the Plaintiffs’ Fresh as Amended Statement of Claim. It is also taken from the documents alleged to contain misrepresentations and from the affidavit evidence before the Ontario Securities Commission of Linda Zhu, who was the E&Y audit engagement partner for the audits of Zungui in 2009 , 2010, and 2011, and Patrick Ryan, who was a director of Zungui and the chairman of its audit Committee.

[ 9 ] The Plaintiffs, who have a personal interest in seeking compensation for the losses alleged caused by the defendants, delivered affidavits deposing as to their interest and good faith in pursing these proceedings.

[ 10 ] Nicholas Charles Baker, an Associate in the class actions department of Siskinds LLP, lawyers for the Plaintiffs in this proceeding, deposed as to the procedural background and provided evidence about the proceedings before the Ontario Securities Commission.

[ 11 ] The Plaintiffs also submitted the opinion evidence of Alan Mak and Paul Mulholland. Mr. Mak is a chartered accountant, a member of the Institute of Chartered Accountants of Ontario and a member of the Association of Certified Fraud Examiners. Mr. Mulholland is a Certified Public Accountant (American Institute of Certified Public Accountants) and a Certified Valuation Analyst (National Association of Certified Valuation Analysts, USA).

[ 12 ] Zungui is an Ontario public company that indirectly owned Shishi Mengshida Shoes Co. Ltd. (“Mengshida”), a shoe company incorporated and operating in the People's Republic of China. Zungui was a reporting issuer under the O ntario S ecurities Act .

[ 13 ] Zungui's common shares were publicly traded on the TSX Venture Exchange and other trading venues. Zungui was required to comply with the Ontario S ecurities A ct and NI 41-101 General Prospectus Requirements in the presentation of its IPO Prospectus. This mean s that Zungui was required to provide full, true and plain disclosure in the prospectus of all material facts relating to the securities issued or proposed to be distributed. Further, because Zungui was an Ontario corporation, it was required to prepare its annual financial statements in accordance with Canadian Generally Accepted Accounting Principles ("GAAP") and as a reporting issuer, Zungui was required to file with the System for Electronic Document Analysis and Retrieval of the Canadian Securities Administrators ("SEDAR") financial statements prepared in accordance with GAAP in the form and within the time limits provided for by securities laws.

[ 14 ] Fengyi Cai, Yanda Cai and Jixu Cai (the "Cai Brothers") reside outside Canada, and they were at all material times, officers and or directors of Zungui.

[ 15 ] Fengyi Cai was a promoter for Zungui's IPO. In his capacity as a Director of Zungui, he was required to approve Zungui's audited annual financial statements for the year ended June 30, 2010, and approve or delegate to the audit committee the approval of all of its unaudited interim financial statements.

[ 16 ] In his capacity as a Director of Zungui, Jixu Cai was required to approve or delegate to the audit committee the approval of Zungui's unaudited interim financial statements for the reporting periods ended December 31, 2009 and March 31, 2010.

[ 17 ] In his capacity as a Director of Zungui, Yanda Cai was required to approve Zungui's audited annual financial statements for the year ended June 30, 2010, and approve or delegate to the audit committee the approval of all of its unaudited interim financial statements.

[ 18 ] In December 2009, Zungui's made an initial public offering ("IPO") and it raised approximately $40 million in Ontario's capital markets.

[ 19 ] Zungui and its directors and officers had a statutory obligation under the Ontario Securities Act to provide Zungui's investors with timely and accurate disclosure regarding the business and affairs of Zungui, including disclosure by way of Zungui's interim and annual financial statements.

[ 20 ] In its interim and annual financial statements, Zungui and the Cai Brothers assured the investing public that Zungui's financial statements presented fairly, in all material respects, the financial position of the Company as at the date of such statements in accordance with GAAP and that the Zungui IPO offering documents contained full true and plain disclosure of all material facts relating to the offering of securities.

[ 21 ] The Plaintiffs are residents of Ontario. Each purchased common shares of Zungui that were offered by the IPO Prospectus. Mr. Clarke also purchased common shares of Zungui in the secondary market.

[ 22 ] On August 22, 2011 Zungui issued a press release announcing that its auditors, E&Y had suspended its audit of Zungui's financial statements for the year ended June 30, 2011. With that announcement, Zungui's shares immediately lost 77% of their value. Zungui's shares have remained the subject of various temporary and permanent cease trade orders ever since, and they are now virtually worthless.

[ 23 ] On September 22, 2011, Zungui's Chief Financial Officer and all independent members of the Board resigned, in part, because the special committee formed to investigate E&Y's concerns had been prevented from fulfilling its mandate.

[ 24 ] On September 23, 2011, E&Y resigned as Zungui's auditor. E&Y withdrew its opinions that Zungui's financial statements were GAAP compliant.

[ 25 ] On February 2, 2012, the O ntario S ecurities C ommission (“OSC”) ruled that Yanda, Fengyi , and Zungui Cai had engaged in conduct contrary to the public interest, and on August 28, 2012, the OSC ordered, among other things, that Yanda and Fengyi shall resign as directors or officers of Zungui and are permanently prohibited from acting as directors or officers of any issuer.

[ 26 ] The OSC investigation revealed that when E&Y resigned it advised that all of its audit opinions that formed part of the IPO Prospectus, as well as Zungui's June 2010 financial statements could no longer be relied upon.

[ 27 ] The OSC found that Fengyi Chai: (a) authorized, permitted or acquiesced in the commission of violations of the Ontario Securities Act and engaged in conduct contrary to the public interest by failing to cooperate with Zungui's audit committee and its special committee in addressing E&Y's concerns and in obstructing an independent investigation of those concerns by the special committee and its consultant, which was hired to assist, notwithstanding his original assurance that he would do so, and by failing to respond to Staff inquiries and to produce documents relevant to the business of Zungui that had been requested by Staff of the OSC on numerous occasions.

[ 28 ] The OSC found that Yanda Cai: (a) authorized, permitted or acquiesced in the commission of violations of the Ontario Securities Act by Zungui (failing to file 2011 audited annual financial statements and failing to maintain an audit committee) contrary to s. 129.2 of the Act and contrary to the public interest; (b) engaged in conduct contrary to the public interest by imposing limitations on the scope of the audit procedures of E&Y during its audit of Zungui's financial statements for the year ended June 30, 2011; and, (c) engaged in conduct contrary to the public interest by failing to cooperate with Zungui's audit committee and its special committee in addressing E&Y's concerns and in obstructing an independent investigation of those concerns by the special committee and its consultant, which was hired to assist, notwithstanding his original assurance that he would do so, and by failing to respond to Staff inquiries and to produce documents relevant to the business of Zungui that had been requested by Staff of the OSC on numerous occasions.

[ 29 ] On October 3, 2011, Mr. Zaniewicz, commenced the action by the issuance of a Notice of Action. On November 2, 2011, he filed his Statement of Claim. On February 7, 2012, varied February 10, 2012, I made orders granting leave to amend the Statement of Claim to add Mr. Clarke as a plaintiff and to correct the description of two of the Underwriters incorrectly described in the style of cause.

[ 30 ] On February 8, 2012, the Plaintiffs filed their Fresh as Amended Statement of Claim.

[ 31 ] In th is Action, the Plaintiffs sue not only Zungui and the Cai Brothers, but others allegedly responsible for ensuring that Zungui's public disclosure in support of the IPO and subsequently to secondary market investors was timely and accurate in accordance with securities law. The Plaintiffs allege various statutory claims under the Ontario Securities Act and also common law claims.

[ 32 ] The Plaintiffs allege that Zungui's IPO Prospectus was misleading as it contained material misrepresentations. The Plaintiffs allege that the representations were materially false, and Zungui's financial statements contained in the IPO Prospectus, and other financial statements later prepared and disseminated in the secondary securities market, were neither accurate nor reliable in respect of reported revenues, net income, assets and shareholders' equity. Moreover, the Plaintiffs allege that the financial statements did not fairly present, in all material respects, the financial condition, results of operations and cash flows of Zungui for the reporting periods presented.

[ 33 ] The pleadings against the Cai Brothers include th e allegation that they made misrepresentations in the secondary market continuous disclosure documents of Zungui.

[ 34 ] Mr. Mak’s opinion was that the audits conducted by E&Y were not in accordance with GAAS and that E&Y's unqualified audit opinions should not have been given for the 2006 through 2010 reporting periods.

[ 35 ] Mr. Mulholland’s opinion was that if E&Y declined to provide a clean audit opinion in 2010, as it did in 2011, then the market would have reacted in 2010 as it was observed to have reacted in August 2011. He opined that, assuming that the clean audit opinion should not have been given in 2010, then Zungui's shares had a significantly inflated trading price from at least June 2010 to the end of the proposed Class Period.

C. DISCUSSION

[ 36 ] S ection 138.8 of the Ontario Securities Act states:

Leave to proceed

138.8 (1) No action may be commenced under section 138.3 without leave of the court granted upon motion with notice to each defendant. The court shall grant leave only where it is satisfied that,

(a) the action is being brought in good faith; and

(b) there is a reasonable possibility that the action will be resolved at trial in favour of the plaintiff.

[ 37 ] Part XXIII.1 mandates a preliminary low-level merits based leave test. In order for leave to be granted, the Plaintiffs must demonstrate that the proposed action against the Cai Brothers is brought in good faith and that there is a reasonable possibility that the proposed action will be resolved at trial in the Plaintiffs' favour.

[ 38 ] To date, three Ontario Courts have considered this test and all have agreed on the standard, described in Imax as "a relatively low threshold" depending "on the evidence that the parties put before the court." See: Silver v Imax Corporation (2009), 2009 72342 (ON SC) , 66 BLR (4th) 222 at para 25 (S .C .J .) ; Dobbie v Arctic Glacier Income Fund et al, 2011 ONSC 25 at para 129 ; and Green v Canadian Imperial Bank of Commerce , 2012 ONSC 3637 at para 373 .

[ 39 ] There is no issue about or reason to doubt the good faith of the Plaintiffs in pursuing this action.

[ 40 ] The Plaintiffs have established the required reasonable possibility of success at trial. Because the Cai Brothers have been noted in default, they are deemed to admit the truth of all allegations of fact made in the Fresh as Amended Statement of Claim: Rules of Civil Procedure , R.R.O. 1990, Reg. 194, rule. 19.02(1)(a). The Cai Brothers' deemed admissions of the factual allegations are sufficient to satisfy the test under s. 138.8 of the Ontario S ecurities Act .

[ 41 ] The evidence provided on this unopposed motion is also sufficient to satisfy the test for leave.

[ 42 ] Accordingly , leave to proceed against the Cai Brothers under Part XXIII.1 of the Act is granted.

D. CONCLUSION

[ 43 ] Order accordingly.

Perell, J.

Released: October 9, 2012

Zaniewicz v. Zungui Haixi Corporation 2012 ONSC 6061

ONTARIO

SUPERIOR COURT OF JUSTICE

BETWEEN:

JERZY ROBERT ZANIEWICZ and EDWARD C. CLARKE

Plaintiffs

‑ and ‑

ZUNGUI HAIXI CORPORATION, E&Y, FENGYI CAI, JIXU CAI, YANDA CAI, MICHELLE GOBIN, MICHAEL W. MANLEY, PATRICK A. RYAN, ELLIOTT WAHLE, MARGARET CORNISH, CIBC WORLD MARKETS INC., CANACCORD GENUITY CORP. (f.k.a. CANACCORD FINANCIAL LTD)., GMP SECURITIES LP and MACKIE RESEARCH CAPITAL CORPORATION (f.k.a. RESEARCH CAPITAL CORPORATION)

Defendants

REASONS FOR DECISION

Perell, J.

Released: October 9, 2012.