Prospect of US-China Cross-jurisdictional Enforcement against Financial Fraud of China-based Overseas-listed Companies

Posted by Wang, Yi on May 1, 2020

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Potential violations of reporting, internal control, books & records and anti-fraud regulations of certain overseas-listed China-based companies emerge initially with the self-disclosure by Luckin Coffee on April 2, 2020.  As of April 30, the alleged financial fraud scheme in Luckin Coffee case has led to investigations by China’s CSRC and then SEC in tandem, for the first time. The characters under or to be investigated might also take advantage of ongoing US-China trade conflict to divert the public resources and attentions, however, with uncertain ramifications to investors, stakeholders and regulators.

1. Executive Summary

As of April 30 (today), in China the controversy has promoted multiple Chinese regulators’ joint investigation into the underlying unfair and deceptive practices, empowered by both China’s own unfair competition regime as well as China’s newly amended Chinese Securities Law, which blocks foreign investigations without proper and prior approval by CSRC and relevant Chinese authorities, pursuant to article 177 of the Securities Law (effective on March 1, 2020). It remains to be seen how the separate Chinese blocking statute against foreign criminal investigation will intervene and shape the investigative process and outcome, and informed counsel by experienced compliance team / function will be critical to decision-makers.

These ongoing investigations will influence not only the extent of accountability of the controlling shareholders and managerial personnel, but also the procedural and substantive aspects of future US-driven enforcement under its anti-bribery and anti-fraud regimes. The characters under or to be investigated might also take advantage of ongoing US-China trade conflict to divert the public resources and attentions, however, with uncertain ramifications to investors, stakeholders and regulators.

Monitoring closely and complying with the complex and parallel enforcement could become new norm, and integrity-driven actions should be prioritized, ideally before investigations become imminent.

2. Analysis

Below is our analysis from trade compliance and corporate counsel perspectives.

2.1 Background.

Luckin Coffee Inc is a Cayman Islands company, who is China-based, NASDAQ-listed company, rivaling Starbucks and went public in May 2019 (“Luckin Coffee” or “Luckin Coffee – Cayman”).  On April 2, 2020, Luckin Coffee Inc. disclosed that its internal investigation revealed that its senior executives and employees fabricated sales transactions totaling 2.2 billion yuan ($310.77 million), which accounts nearly 50% of its projected revenue in 2019.   Trading of Lucyin Coffee has suspended so far since April 7, 2020.  On April 3, 2020, China Securities Regulatory Commission (CSRC) announced “strong condemnation” against the alleged financial misconducts and to verify according to “international regulatory cooperation arrangements.”  Chinese State Administration for Market Regulation raided the company on April 26, 2020.  On April 29, 2020, “the Securities and Exchange Commission is investigating Luckin Coffee Inc.’s disclosure,” according to WSJ.

Prominent investment banks and private equity firms involved in its fundraising journey include China International Capital Corp (CICC), Singapore’s GIC, Morgan Stanley, as well as BlackRock, a significant investor of Starbucks. (See chart below).

At the time of writing, these investigations remain ongoing with limited information available to the public.

Table 1: Financing History of Luckin Coffee

In terms of corporation structure, Luckin Coffee Cayman, through a two-layer, BVI-HK holding companies, established its wholly owned foreign enterprises (WFOEs) in China, one of which also controls and manages a domestically incorporated operational vehicle established by key shareholders, through contractual arrangement of variable interest entities (VIE) (See diagram below).

Table 2: Corporate Structure of Luckin Coffee

2.2. Key Issues Needed to be Investigated Thoroughly: US & China Perspectives.

The investigations will likely focus on violations of the reporting, books and records, internal control provisions and anti-fraud statutes, with China-based evidence and fact-depending direction to be conducted and shaped likely by multiple Chinese regulators. 

Based on the public information, we summarize the likely issues and potential violations below, subject to the actual facts and determinations by the investigating authorities eventually involved:

• Related Transactions: Failure to disclose or even concealment of transactions with its founding and controlling shareholders, and engagement in fraud or deceit as such, potentially violating Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 (“Securities Act”).

• Reporting & Disclosure: Failure to make factually accurate reports filed with the SEC, which failed to include financial reports with accurate information and file with misleading reports, potentially violating Section 13(a) of the Exchange Act of 1934 (“Exchange Act“).

• Internal Control: Failure to devise and maintain effective and sufficient internal controls over revenue recognition, allowing Luckin’s revenue to be inappropriately recognized and even overstated, along with failure to maintain true and accurate books and records, potentially violating Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act; in addition, it would give rise to violation of section 13(b)(5) of the Exchange Act, if the facts prove that Luckin Coffee and/or any wrongdoer(s) “knowingly circumventing or knowingly failing to implement” effective and sufficient internal controls

• False Compliance Certification: Derivative violations of Sarbanes Oxley Act, e.g., if Luckin Coffee had presented false compliance certifications to its external auditor(s) and counsels, Luckin Coffee and/or its executives may face potential criminal corporate and/or personal liabilities and fines.

• Aiding & Abetting: Other parties such as the suppliers / personnel involved in fabricating the underlying data of inflated sales and understated cost of production might face liabilities if they had aided and abetted these misconducts.

• FCPA Violation: Notably, Luckin Coffee’s “high-affordability” business models not only include B2C but also B2B services, with terminal delivery centers at universities and business buildings, some of which might be state-owned; “customers” in such context might involve counter-parties who may be deemed as “foreign government officials” under Foreign Corrupt Practice Act of 1977 (“FCPA“). It remains to be verified if this is “purely” fraudulent misconduct or in addition, there exists any separate, illicit provision of value to secure or maintain these contracts in violation of FCPA.

Because these alleged misconducts took place within the territory of China rather than in US, Chinese regulators enjoy jurisdictions under various statutes from securities fraud, unfair competition to anti- (commercial) bribery as follows:

• Securities Fraud: Article 2 of the Chinese Securities Law empowers CSRC to investigate and penalize overseas-listed Chinese companies, whereby “the offering and trading of securities outside the People’s Republic of China disrupt the order of the domestic market of the People’s Republic of China and infringe upon the lawful rights and interests of domestic investors.” Criminal liabilities will be available to the wrongdoing corporate and individuals who compromise the accuracy and integrity of financial reports and disclosures.

• Joint Enforcement with SEC: as highlighted by SEC Chairman’s statement on April 21, 2020, “without the ‘approval of its securities regulator and various components of the Chinese government,’ no entity or individual in China may provide documents and information relating to securities business activities to overseas regulators.” It remains to be seemed how such joint enforcement will work out, with respect to assistance extended by CSRC under the 1994 US-China MOU on securities regulation cooperation and multi-lateral IOSCO framework. Under these bilateral and multilateral cooperation framework, “assistance will not be denied based on the fact that the type of conduct under investigation would not be a violation” of Chinese law. As of April 27, 2020, CSRC has spoken with unequivocal and proactive position to support “cross-jurisdictional regulatory cooperation” with SEC and stress joint investigation, zero-tolerance approach.

• Unfair Competition: two major wrongdoings may trigger violation of the Chinese trade regulation statutes administered by the State Administration of Market Supervision (formally SAIC). Firstly, the “recycling” of the alleged misrepresentation made public through Luckin Coffee’s announcements of its already compromised revenue figures. Such misrepresentation might give rise to violation of Chinese Anti- Unfair Competition Law which prohibited misleading or false advertisement and publicity. Secondly, if the revenue-inflating allegations about systemic and digitized fabrication of online transactions through computer programs (Shua Dan in Chinese 刷单), it might give rise to engaging in severe “false transactions” violating article 8 of the Chinese Anti- Unfair Competition Law.

2.3. Unfolding Implications to the Thoroughness and Direction of Investigations.

The limited nature of administrative remedy of either “false transactions” or “false/misleading commercial publicity” is notable. “False transactions” or “false/misleading commercial publicity” only triggers administrative fines, but not disgorgement of illegal gains. This is unique under article 20 of the Chinese Anti- Unfair Competition Law. Disgorgement of illegal gains will be available only for scenarios involving commercial bribery and/or trade secret infringement under the Chinese Anti- Unfair Competition Law.

We cannot exclude the likelihood that companies might take advantage of these administrative investigations to “mitigate legal consequences.”

On April 26, 2020, Wall Street Journal reported that the State Administration of Market Regulation raided Luckin Coffee’s headwaters. As such, further joint efforts by SEC and CSRC are desirable and acute, because administrative proceedings might legitimately provide the wrongdoers with a better chance to control the “demolition.” This is because the above-mentioned nuance of the Chinese Anti- Unfair Competition Law lacking disgorgement of illegal gains against false transactions and publicity.

By contrast, direct, joint investigations by both Chinese and US securities regulators directly on the ground, respecting all applicable Chinese law, could be more lethal than the efficiency of such administrative “raids.”

Also, it’s worthwhile to monitor the exact evidential and procedural aspects that would shape the outcome, e.g., how the individual raiding personnel take direct custody of the evidence – the allegedly falsified data and personnel/third parties involved in data generation / manipulation, with whom the interviews to be conducted, by whom, with whose presence on-site, as well as clues of interest to the direction of these investigation(s).

Moreover, in light of the volatile US-China trade relationships and xenophobia of the few at present in both markets, any appearance of protectionism could also be utilized to divert the public’s attention to “Chinese authorities,” rather than the root causes and crucial facts of the alleged wrongdoings.

3. Outlook

US-China Security Review Commission has warned in 2014 the trade policy ramifications by seeming isolated, company-specific fraudulent practices as well as seemingly legitimate and even common practice to bypass Chinese government’s own regulation for overseas listing, such as delisting as punishment against non-compliant Chinese companies.

As Luckin Coffee states in its prospectus for IPO: “If we fail to implement and maintain an effective system of internal controls to remediate our material weaknesses over financial reporting, we may be unable to accurately report our results of operations, meet our reporting obligations or prevent fraud, and investor confidence ….”

However, Luckin Coffee is not alone to have a mindset that treats compliance as “not now,” but future investment (cost to be absorbed by other people’s money?), after scaling up. It states, also in its prospectus, that “as we continue to grow in scale and significance, we expect to face increased scrutiny, which will, at a minimum, result in our having to increase our investment in compliance and related capabilities and systems.”

The scandal of Luckin Coffee also coincides with the recent wave of self-disclosure policies and their enforcement at the Department of Justice (DOJ) side. (See, e.g., DOJ’s announcements on December 13, 2019, and earlier in March 2019. Although currently these self-disclosure initiatives focus on export control violation only, it “signals the Department’s continued emphasis on corporate voluntary self-disclosure.”)

Monitoring closely and complying with the anti-fraud and broader anti-bribery regimes, in both US and China, will be critical for companies navigating through during and beyond the current COVID-19 pandemic.

Not only MNCs, but also startups with ambition to become a lasting business, through and with effective compliance control, must take compliance-driven actions to ensure no deficiency / irregularity with respect to their own internal controls, business records and relevant function supports, ideally before investigations become imminent.

Please feel free to contact us at yi.wang@mind-re.org for any questions.

About the author: Yi Wang, trade and business attorney with public and private sector experience to tackle with regulatory/business challenges. He was one of the two defense counsels to MOFCOM in first Sino-US WTO dispute on semiconductors in 04′, and thereafter, counseled and managed cross-border transactions, regulatory clearance for transactions and trade/FCPA litigation at leading law firms in US/China from 02′ to 14′, and further served with GE Plastics/SABIC from 14′ to 17′. From 17′ to present, he is co-founder of Mind Realizing Law advising international businesses and institutions in operational excellence and private equity transactions with robust anti-corruption / trade compliance perspectives.

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