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US Securities and Exchange Commission

SEC Fines Chinese Chain Luckin $180 Million for Accounting Fraud, But Chinese Government Must Sign Off on Payment

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

By Soyoung Ho

The SEC filed charges against U.S.-listed Chinese company Luckin Coffee Inc. for inflating revenue and misstating expenses and net operating loss in order to give the false impression to analysts and investors that its business is rapidly growing as well as to meet the company’s earnings estimates. In particular, Luckin fabricated about $311 million in retail sales from at least April 2019 through January 2020.

Luckin has agreed to pay a fine of $180 million to settle the charges, but some investor protection advocates criticized the settlement as the ability for the SEC to collect the fine depends on the approval of the Chinese government. And they fear Americans may never get to see a dime from the settlement.

“Without admitting or denying the allegations, Luckin has agreed to a settlement, subject to court approval, that includes permanent injunctions and the payment of a $180 million penalty,” the SEC said in announcing the settlement. “This payment may be offset by certain payments Luckin makes to its security holders in connection with its provisional liquidation proceeding in the Cayman Islands. The transfer of funds to the security holders will be subject to approval by Chinese authorities.”

The SEC’s complaint alleges that the company—which competes against Starbucks—overstated its reported revenue by more than 27 percent for the period ending June 30, 2019, and 45 percent for the period ending September 30, 2019, in its financial statements. At the same, Lucking understated its net loss by about 15 percent and 34 percent, respectively, the SEC said on December 16, 2020.

Luckin’s American Depositary Shares stopped trading on Nasdaq on July 13.

“This settlement with the SEC reflects our cooperation and remediation efforts, and enables the Company to continue with the execution of its business strategy,” Luckin Chairman and CEO Jinyi Guo said in a statement. “The Company’s Board of Directors and management are committed to a system of strong internal financial controls, and adhering to best practices for compliance and corporate governance.”

Regulatory Abdication for U.S.-Listed Chinese Companies?

The settlement comes as the SEC has allowed Chinese companies to list on U.S. stock exchanges even though the regulator knew that they would disregard American securities laws. All publicly traded companies must comply with U.S. federal securities laws, which include PCAOB’s audit inspections designed to give confidence to investors that their financial statements are up to snuff.

However, Chinese government forbids companies to open up to PCAOB inspections. American regulators have failed to get an agreement from Chinese authorities for a joint inspection despite more than 13 years of negotiations. The main sticking point has been Chinese fears that audit work papers may contain state secrets, and the Chinese Communist Party also believes that it infringes on its sovereignty.

Even though Chinese companies do not abide by the rules that the rest of the companies and accounting firms registered with the SEC and the PCAOB follow, U.S. regulators have allowed Chinese companies to register with the SEC and audit firms previously registered with the PCAOB to audit U.S.-listed Chinese companies, leaving American investors at an increased risk.

This is despite the fact that Chinese companies have been involved in many accounting frauds over the years.

In Luckin’s case, it began its operations in October 2017 and did an initial public offering (IPO) which includes audited financial statements. The SEC declared the IPO effective in January 2020. However, by the time the commission said it was ok to sell shares to American investors, the company had already been perpetrating fraud. Since its IPO, the company has not released a subsequent set of audited financial statements.

“For the past two decades, the SEC has turned a blind eye to noncompliance with its regulations by Chinese companies, disadvantaging American companies and contributing to huge losses by investors,” said former SEC chief accountant Lynn Turner.

Resolution Perhaps in Sight

However, there will likely be a course correction in the future. President Donald Trump and Congress have recently stepped in to fill the regulatory void.

After being instructed by President Trump earlier in the year, the President’s Working Group (PWG) in August issued five recommendations for the SEC and the PCAOB to take action. The most significant one requires Chinese companies to grant PCAOB access to audit work papers of the principal audit firm. Companies that cannot grant access because of government restrictions can satisfy this standard by providing a co-audit from an accounting firm “with comparable resources and experience” that the PCAOB determined can conduct proper reviews.

Congress in early December also passed legislation that would delist a company after three consecutive non-inspection years. Trump has yet to sign into law as of December 17 afternoon.

 

This article originally appeared in the December 18, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.

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