K2 Integrity

Coffee fans may argue that a bad day with coffee is better than a good day without it, but Luckin Coffee is certainly putting that adage to the test for its investors. We began writing about the coffee company’s woes earlier this year, and things have definitely gotten worse. 

On December 16, 2020, Luckin, a recent darling of the market, agreed to pay a $180 million penalty to settle accounting fraud charges brought by the SEC. In its complaint filed the same day, the SEC claimed the company “intentionally and materially overstated its reported revenue and materially understated its net loss,” resulting in a $400 million fraud. The SEC’s investigation into Luckin is ongoing and may be receiving help from both Chinese and Swiss regulatory authorities. 

The coffee company settlement came two weeks after the Democratic controlled U.S. House of Representatives passed the Holding Foreign Companies Accountable Act (HFCAA), which could ban many Chinese companies from raising money from U.S. investors or listing shares on U.S. exchanges. The Republican controlled Senate unanimously passed the bill in May, and President Trump is expected to sign the bill into law before leaving office. Earlier in December he signed an executive order barring U.S. investments in Chinese firms owned or controlled by the military.

The HFCAA was introduced and passed under the premise that lax auditing and disclosure requirements pose a risk both to U.S. investors and to national security. If signed, the law would require foreign companies to allow the Public Company Accounting Oversight Board (PCAOB) to oversee the audits of their financial records in order to raise money on U.S. exchanges or with American investors. Sarbanes-Oxley created the PCAOB in the wake of the Enron scandal to “oversee the audit of public companies that are subject to the securities laws, and related matters, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies the securities of which are sold to, and held by and for, public investors.” Currently, all U.S. companies work with the PCAOB, but many foreign corporations do not.

The HFCAA amends Sarbanes-Oxley and closes loopholes for publicly listed companies that use an audit firm in foreign jurisdictions. The largest of these jurisdictions, both by size and number of companies, is China. If enacted, the new law would require these companies to give the PCAOB audit rights and would also place specific regulations on companies in China, such as providing documentation that the company is not controlled or owned by government authority and requiring annual disclosures regarding the audit firm. Failure to comply would result in mandatory delisting, although such delisting would not take effect until 2025 at the earliest. Currently, there are 31 companies that face delisting, but that list could grow to well over a hundred. 

The Biden administration has not provided any insight as to how it will enforce HFCAA if it is signed into law. Its imminent enactment will likely discourage new listings of China-based companies on U.S. exchanges and could result in discounts to currently listed Chinese companies as they face the risk of delisting. For example, the price of shares in Alibaba, China’s multinational conglomerate, has fallen significantly since the end of November. Rather than waiting for delisting, some companies might consider going private, or re-listing in more friendly jurisdictions. Only time will tell, so for now, there’s plenty of time for that second or even a third cup of coffee.