We tracked and analyzed 326 chinese companies listed in the U.S. from 1999 to 2017 and found that some Chinese companies lacked understanding of “compliance” and other factors, leading to financial fraud. This is the most important part of our reflection after the Luckin incident.
Luckin’s shareprice on Nasdaq plunged 76 percent on April 2, when its total sales for the second and fourth quarters of 2019 were inflated by about Rmb2.2bn. More than two months ago, luckin, the world’s leading short-singa, gave a short-siton, and Luckin denied everything.
Luckin is not the first in the company’s integrity crisis. There are four firewalls in the United States to prevent financial fraud by public companies, but there is still no way to prohibit the occurrence of financial fraud, whether it is a Chinese stock or a U.S. company, similar incidents occur. The author and Professor Lu Hai of Guanghua School of Management, Peking University, followed and analyzed 326 chinese companies listed in the United States from 1999 to 2017 and found that some Chinese enterprises lack edify “compliance” and other factors, leading to the emergence of financial fraud. This is the most important part of our reflection after the Luckin incident.
First: U.S. Securities and Exchange Commission (SEC)
Second way: shorting institutions, external investors
Third way: accounting firm
The fourth way: Class action
Sample study: 269 Chinese companies (non-state-owned) listed in the U.S. from 1999 to 2011, and 57 Chinese companies listed in the U.S. from 2013 to 2017. In 2012 and 2013, the path for Chinese companies to list in the U.S. was disrupted by a crisis of confidence.
The study found that 15 of the 269 companies in 1999-2011 were punished by the SEC, accounting for 6%, and 70, or 26%, were subject to class action by investors. Fifty-seven companies listed between 2013 and 2017 have not been fined by the SEC, but 19 have faced class-action lawsuits, or 33.33 percent. That proportion is not low compared with u.S.-based companies.
The mid-cap crisis triggered by short-sing agencies
First, it’s not the first time that luckin’s financial fraud has occurred. This kind of financial fraud occurred in China, in the early days of Internet companies listed, such as NetEase in 2006 was also investigated by the SEC punishment; Subsequent investigations found that these companies listed in reverse acquisitions are more likely to have financial fraud problems. The problem is relatively small, but there are, companies that go public through a formal IPO (initial public offering) process. For example, in 2012 the more famous Southeastern melting case, at that time caused a lot of concern.
Overall, in 2011 and 2012, the outbreak of the Sino-Chinese stock crisis was the case with some of the market’s best-known short-sellers, using their own unique investigative techniques to make allegations, triggering investors’ distrust of listed companies and causing share prices to plummet.
This will have really fake enterprises, but also by mistake, by mistake injured enterprises also have more effective examples of coping.
New Oriental, for example, once plunged because of the VIE structure, which was also sold out by murky water companies. But what New Oriental has done better is that it has taken the initiative to disclose and communicate with the SEC, which plays an important role in boosting investor confidence. In addition, after the stock price crash, New Oriental’s chairman and founder communicated with some institutional investors, whose recognition of the founders themselves, as well as their own business, helped the stock price recover quickly.
In 2018, Learn and Think have also suffered short selling by murky water companies. Hundo has its own approach to investigation and the logic of understanding the business. Its investigative approach is admirable, but its understanding of some evidence and facts, and some assumptions about the business model, are problematic. So good future although the short-selling share price fell by more than 30 percent, but after a few months the share price is back.
In general, China’s shares in the United States listed nearly 20 years, in fact, this kind of financial fraud has been a storm. Among them, 2011 and 2012 were so serious that no Chinese companies were listed in the U.S. in the following year, which is equivalent to the loss of confidence in Chinese companies in the capital markets as a whole.
This leads to an important point: how can investors trust you when many Chinese companies go public and go public in different ways? When there is a crisis of confidence, new companies have to go public again, at a great cost.
For example, when it went public in 2012, it was actually called “bloody listing”. Because in the market environment at the time, its market valuation was very low. But by the end of 2014, the share price had risen more than 40-fold.
What does this example say? In the market, investors’ trust in the enterprise is crucial. If that trust is gone, companies will have a greater cost if they want to get financing. The price is that, first, no one wants to issue shares. Second, there may be people who are willing to, and will not, be subscribed at a great discount, at the expected value of the enterprise.
The role mechanism of the U.S. market is not the same as the Chinese market, there are several mechanisms in the U.S. market. The first is government regulation, such as SEC investigations and penalties, such as the Securities Regulatory Commission, just as China has regulators such as the China Securities Regulatory Commission. However, regulation will always face a very important problem, that is, its regulatory power, manpower is not enough. So there is a second power in the United States, which comes from the power of market participants, such as some short-sellers. In layman’s terms, investors can use these institutions’ unique means of information gathering, unique understanding, to produce judgment of the enterprise.
The information-gathering methods used by these agencies are often special, such as field research, follow-up, etc. In Luckin’s case, institutions can video in stores and squat in stores for a week to see what the flow is, so as to estimate the store’s passenger flow, revenue, cash flow. Through this sampling approach, the data is expanded to estimate the overall volume of business. Such institutions generate a judgment on the value of the enterprise through this unique way of collecting and analysing information. If there are enterprises themselves low value, but “blow”, put themselves up, some investors believe, the stock price went up, but if some other investors use their professional judgment, proprietary information, to judge the actual situation of the enterprise and the said, the enterprise exaggerated, investors will be through the short-selling action expressed. This is an important market force, which is to collect information through investors and allow them to trade in the market at the institutional level using the information they collect. This is a very important second mechanism within the American system.
Encounter the organization short, the enterprise’s coping strategy
Looking at luckin’s crisis, luckin’s share price fell more than 30 per cent on the day after a short report in late January and early February. But then may investors have different understanding, different views, many investors do not agree, the stock price has risen back, but also a lot of rise. It is worth noting how companies should react when outside investors make such allegations? The first strategy is to ignore it, but it also means that the information in the market may be dominated by information from short-sellers.
The second strategy, as Luckin does, is to refute it. But his rebuttal seems to me to be quite pale, why? The rebuttal is based on facts, but there’s not much detail in Luckin’s response.
The premise of the first two strategies is that the enterprise itself knows what is done within the enterprise. Executives, founders, and boards of directors know the company’s situation, and on this basis can choose both strategies. But there may be a third scenario: the board does n’go, and executives and founding teams hide the truth from the board.
But the problem is that in the process, the loss of the enterprise is huge. If it’s the third scenario we’ve said before, when someone outside accuses the company, the board of directors doesn’t know what the actual situation is, it’s a bad thing, it’s a bad thing, it’s a bad governance structure and a poor governance. Bad news can cause share prices to fall, and prices fall below a certain amount, say less than a dollar, and companies may be delisted. After the de-listing, it will be difficult for companies to re-list.
In luckin case, the third firewall is not yet working.
There are several “firewalls” in the U.S. market to prevent corporate fraud, the first “firewall” is a government regulator, and the second “firewall” is an external investor using the information they collect to make accusations and force companies to disclose the true situation. There is also a third very important “firewall”, that is, the role of intermediaries, such as accounting firms.
Luckin’s intermediary is EY, one of the big four accounting firms. As we can see, Luckin’s 2019 annual report is not yet available, which means that Luckin’s revenue, profits, cash flow, etc. in the 2019 quarters have not been verified by auditors. In layman’s terms, the auditors didn’t check the accounts. This suggests that the third “firewall” we call is not yet in effect. Because normal accounting firms like Ernst and Young, the big four in the world, conduct on-site investigations if it wants to conduct an audit. In particular, the chain of stores such as Luckin Coffee, as an auditor, must be the necessary audit procedures will visit the site, in addition to the company headquarters, must be to the stores to do the investigation. If you do it more carefully, you can find the information presented by the short-seller.
Through the audit institutions to the enterprise “squeeze water”, is conducive to the real disclosure of information. Because if you don’t squeeze out water, you’re going to have a very important problem, and the auditors are responsible.
Luckin’s biggest problem is that the accounting firm’s firewall is not working yet. Luckin’s announcement referred to the board’s investigation as a result of an annual report audit. An important issue is that the auditor signed the audit opinion only on the annual report, but Luckin is now falsifying the quarterly report – the second and third quarters of fraud, and if the firm has not yet started the audit, it is not responsible itself. If the fraud period involves 2018, EY, as auditor, is certainly responsible.
Synergy between the two governments
From luckin, we return to another very important topic, why do there be financial scandals that occasionally break out of the US-listed Chinese stock market? There is a very central reason, lies in the mechanism, there are 2 mechanisms, even 2 to 3 mechanisms may have problems. The important reason behind this is that there is a certain gap and problem in regulatory cooperation between the United States and China.
This is a central point in my research article with Professor Lu Hai. According to our research, the SEC is also considering how to regulate after the “China-U.S. stock crisis” in 2012. It took some action, the first being to stop the reverse takeover (also known as buy-to-let listing). Before that, a large number of Chinese companies went public through reverse takeovers, and it blocked the road for you. So after 2012, there was no way for Chinese companies to go to the U.S. to go back to the U.S. and go through IPOs.
Reverse takeover, why is it easier to go wrong than an IPO? First, because reverse acquisition does not require a second or even third level. When it goes public, it does not need investors to ask for an inquiry, to do a roadshow, there is no such procedures, of course, there are investors will ask questions, but the process of information disclosure will be much less. Second, if a company is IPO, you need to disclose annual report information, and auditors have to play a role in it, but reverse takeovers don’t need that, which is the equivalent of missing a barrier. So, then it was stopped.
Recalling the typical case of the integrity crisis encountered overseas in 2011-2012, we had to mention the “Southeast Melting Case”, which went public in 2007 and had the reputation of “the first domestic software company listed on the New York Stock Exchange”, and on August 31, 2011, because of suspected financial fraud, the Southeast Financial Exchange announced its dissolution. The important point of this case is that the auditors at the time were reviewed by the four accounting firms, equivalent to its annual report accounting firm signed, but why did there is financial fraud? One of the most important issues is that I just mentioned that there are problems with regulatory cooperation between the United States and China.
At that time, the SEC, the U.S. Public Company Accounting Oversight Committee (PCAOB), to investigate the accounting firm, it is not just for the Southeast accommodation itself, but to investigate the overall chinese stock. Because more than 70% of these IPO companies close to 80%, are audited by the four major international accounting firms. The U.S. is worried that it’s not just a business that’s wrong, they care if it’s a systemic problem.
But the four international companies in China to audit these listed companies, subject to Chinese law, the Chinese government supervision. U.S. regulators do not have the authority to verify the workpapers. This directly causes the regulator’s own power to fail, and the accounting firm’s gate is also problematic. Whether the accounting firm has carefully examined, done the work is good or bad, the U.S. regulators do not know.
Therefore, since 2012, China and the United States have actively cooperated in their efforts to advance and solve this problem.
After the mid-2012 crisis, when Mr Obama was in office, there was a back-and-forth discussion of cross-border regulation between the two countries, with a focus on joint regulation of financial fraud, and the “mouth” of collaboration being torn apart step by step.
Step 1 is to allow U.S. regulators to follow suit when Chinese regulators conduct inspections; step 2, the U.S. side to investigate a specific company, the Chinese side to come forward to retrieve the accounting firm’s draft, to check you; step 3, finally reached a cooperation agreement, signed a regulatory memorandum of cooperation.
We note that after 2012, none of the Chinese companies have been listed in the United States for a year. The reason is that financial fraud cases are frequent, without the trust of the market, listing is impossible to talk about. Until the signing of the memorandum of cooperation in May 2013, including JD.com, Alibaba and other listings, by U.S. investors.
The important reason for this change is that the 1st and 3rd firewalls, through cooperation between the Chinese and American governments, are beginning to work, and the review of accounting firms is working, giving investors more confidence. That’s why Luckin was able to launch successfully in the U.S. in just 18 months, but it has some historical background.
Enforcement Challenges in Class Action
The fourth firewall, a class action, is that many companies face class-action lawsuits because of disclosure problems, either by stating false information or concealing information. For investors, whether to buy shares of the company, he is based on information to make decisions, which is a cornerstone. If I don’t have confidence in your business, what do you make about it? In fact, many U.S.-listed Chinese companies have suffered such class-action lawsuits in the past 20 years.
Companies should be aware that if insufficient disclosure triggers a plunge in share prices, they are likely to bring in class-action lawsuits that ultimately result in financial compensation, whether in court or in private. When class action becomes the norm, businesses have to be careful. As a public company, first and foremost, your compliance becomes important. Compliance, not just that you meet the legal requirements or requirements is enough, but more importantly, the business to meet the expectations of investors. What is this expectation? When investors want you to disclose more information, you should satisfy them. This is a broader requirement for compliance.
Our research found that some Chinese companies have suffered class-action lawsuits, and the courts have ruled that you lost. But in the course of execution, it is found that it is not possible to enforce, and the bank accounts or assets of U.S.-based companies are easier to be frozen by banks and executed by the courts. But many Chinese enterprises in the United States have no assets, the final court to enforce, said compensation, but there is nothing, the so-called “long arm principle” in The United States justice can not solve this problem.
The difficulty of execution means that there is a problem with the 4th firewall. If, to the extreme, from a civil case to a criminal case, the judiciary will institute criminal proceedings against the founder and founding team, and under the extradition clause, the United States can enforce it in Hong Kong, Macau or elsewhere.
After the 2013 memorandum between China and the United States, we found two interesting changes.
First, if the Chinese company had sales in North America, the possibility of a class action would be greater. Because it’s easier for the U.S. to freeze assets. The second important signal is that founders or executives are more likely to take a class action if they have a personal social network in North America, such as a green card or a degree. This is an interesting change we found in our study.
Back in luck, it could later face a class-action lawsuit from investors, an SEC investigation, or even criminal liability. Of course, it remains to be seen whether regulators will take action to investigate next. Our current academic research has found that in the Past few decades in the United States, U.S. regulators have investigated and regulated foreign companies as strongly as they do on local companies, and may be limited by people and energy.
Luckin’s case has taught Chinese companies another lesson.
In the United States, the four firewalls or four regulatory restraint mechanisms that constrain public companies are at work. What does that mean? Means that Chinese enterprises to go, we must realize that there are these four mechanisms, if the mind of a ghost, to fake, will be punished by the market. U.S. investors are not fools, and 80 per cent are institutional investors who will assess and judge.
You can only honestly and truthfully increase disclosure and do more on “compliance.” I have repeatedly emphasized “compliance” as meeting investors’ requirements and expectations for corporate disclosure. Companies can’t say that if the regulator didn’t ask me to disclose, I won’t disclose it. You have to think from the investor’s point of view. If you do not work hard in compliance, there is a lucky mentality, then in the end, “out of the mix, always to return.”
(The author is an associate professor, associate dean, executive director, senior management education center, Department of Accounting, Guanghua School of Management, Peking University)