The much-coveted Chinese market promises much, but pitfalls can leave a bitter taste in the mouth, as one fast-growing US telecoms company found out. UTStarcom provides a cautionary tale for corporate lawyers. Justin Scheck and Kellie Schmitt report

In the autumn of 2003, executives from Californian tech company UTStarcom stopped at a countryside restaurant in Vietnam to celebrate securing $30m (£14.4m) worth of telecoms contracts.

A cobra was slaughtered and its heart presented to Tim Donovan, then head of global marketing. "It was still beating," recalled a former UTStarcom employee who was there. "It was probably the size, of a golf ball. He just ate it."

Donovan confirmed the account. Four years later, he is not the only person left with a bitter aftertaste. Over the past couple of years, the company has admitted to backdating stock options for executives, investigated its own employees for paying bribes across Asia, and admitted improperly recording hundreds of millions in revenue.

UTStarcom was taken public by lawyers at Wilson Sonsini Goodrich & Rosati in 2000, and was seen as a way to play the Chinese telecoms boom. Instead, it has become an example of what corporate lawyers can face when trying to square business practices common in China – such as paying bribes and recognising income before it is in company coffers – with corporate disclosures required by US regulators.

More than $300m (£144m) in revenue has come off the books. The chief financial officer (CFO) has gone, the Securities & Exchange Commission (SEC) says it plans to sue the company's chief executive, and the stock price has fallen more than 90% from its 2003 high.

Industry observers and former employees say the company grew amid hyperbolic projections and questionable overseas practices. The telecoms market was in the middle of a slowdown, and UTStarcom's biggest contracts were dependent on a technology expected to rapidly become obsolete.

Founded in 1995 when Unitech Telecom merged with Starcom Networks, the company was led by a group of Asian-born, American-educated executives who saw China, and later Vietnam and India, as important emerging markets. The notion of a company regulated in the US but with access to fast-growing foreign economies attracted investors who might have shied away from investing in corporations based in relatively unregulated developing nations.

But the perception that it was a safe way to invest in overseas telecoms markets has been punctured by a series of SEC filings over the last two years. In several instances, the company has blamed problems on overseas executives, whose operations accounted for a large percentage of the company's profits.

Last year, UTStarcom also reported that chief executive officer (CEO) Hong Lu had been told that the SEC planned to sue him as part of an insider trading probe. Board member Chauncey Shey settled insider trading charges with the SEC this summer.

The company's CFO left last year. Russell Boltwood, who had been the general counsel, moved into a lower-ranking job earlier this year, and was replaced by Susan Marsch, who had been the general counsel at AltaVista. Representatives of Wilson Sonsini declined to discuss UTStarcom.

Problems like those seen at UTStarcom are one reason why US firms are finding so much work in China. In the youthful and fast-growing corporate culture there, insider trading, bribes and revenue manipulation are common, say lawyers who practise there.

"The problem is endemic," said Christopher Stephens, managing partner for Orrick Herrington & Sutcliffe's Asia offices. "A lot of foreign law firms are heavily engaged in investigation and counselling Chinese companies in investigations into allegedly corrupt activities, and negotiating with regulators."

"There is sometimes tension between the expectations in the US market for a large quantity of sensitive information and the broader culture of secrecy in Chinese business," he added.

Operations in China "keep things interesting", one SEC enforcement lawyer acknowledged. He said insider trading is common, because Chinese businesses do not see it as inherently problematic. "It is not a notion they are shocked at," agreed Scott Kline, a corporate and securities lawyer at Thelen Reid Brown Raysman & Steiner, who has represented several dozen Chinese companies.

"It is not that they are not as upfront and loyal and ethical as US officers and directors," Kline said. "It is just they have not had to perform under the same kind of full disclosure. It is
just different."

UTStarcom's situation touches on a range of pitfalls as it continues its effort to dig itself out of its compliance mess. The company is deep in a securities fraud class action filed by Coughlin Stoia Geller Rudman & Robbins seeking recompense on behalf of burned investors. It is also facing a multifaceted effort by the SEC to find out whether its problems are the result of fraud or, as the company has said, a lack of proper internal controls.

Lawyers representing the company and its members, from firms including Orrick, Wilson Sonsini and Shearman & Sterling, declined to comment.

When it comes to the options problem, it is difficult to tell how much former and current executives benefited, since the company has not itemised which past options were improperly handled. But SEC filings show that at the time executives were dining on snake offal, several top officers sold millions of dollars in stock. During late 2003 and early 2004, they cashed in options that were awarded at quarterly low share prices between 2000 and 2004, the period during which the company acknowledges backdating.

As a result of the backdating, the company had to restate its expenses for 1998 to 2006 by about $27m (£12.9m). That is in addition to the more than $300m (£144m) in restatements stemming from problems with how Asian offices booked revenue. UTStarcom's market cap is about $400m (£192m).

Before its problems started, UTStarcom trumpeted in an early 2004 press release its "continued ability to deliver market-leading products" as "a testament to the strength of our technological innovation and dedication".

In hindsight, technological innovation – or a lack thereof – was one
of the company's first obstacles. Much of UTStarcom's business in Asia was based on 'personal access system' (PAS) technology connecting portable handsets with landlines, a stop-
gap for fast-growing economies where the demand for mobile phones outstripped the growth of cellular infrastructure. By late 2003, PAS phones were on their way out.

"It looked like everything was falling off a cliff in terms of shipments," said one former insider involved in the preparation of public revenue numbers. CFO Mike Sophie left the company last year. In 2005 CEO Lu submitted his resignation, though he has since decided to remain in the role until next year.

In February, UTStarcom said in SEC filings that it had begun a review of "approximately 1,200 contracts in all of our five regions in China" after an employee claimed that revenue was
routinely being reported earlier than was proper.

In its quarterly report earlier this month, the company's audit committee blamed its $270m (£130m) restatement on a "lack of proper management oversight, unclear record retention policies and procedures relating to systems contracts, and inadequate employee training".

The report added: "Certain employees in China have either been terminated or placed on suspension for failure to provide adequate oversight of activities."

That came atop a separate $49.6m (£23.8m) restatement last year for premature recording of income from a contract in India as well as other transactions.

The Department of Justice's reviews of foreign bribes and possible violations of US immigration laws continues, the company reported, as does the SEC's probe of whether Lu tipped off Shey, the former board member who settled insider trading charges with the commission.

Litigators expect failures of oversight – especially when it comes to foreign bribery – to continue dogging US-regulated companies over the next few years as they push to expand in Asia.

But looking beyond the immediate future, corporate attorneys working in China say things should improve. "The Chinese are very eager to be seen to want to address corruption because it causes a lot of problems," Orrick's Stephens said.

Last year, said Sheppard Mullin Richter & Hampton's William Zheng, a government investigation brought down a top Shanghai official and numerous others, causing government employees to grow more skittish when offered the favours that used to be commonplace.

"Now they are saying they can take a look," Zheng said. "Before, they could promise the sky."

A version of this article appeared in The Recorder, a US sister title of Legal Week.