Current News: Luckin Coffee

Introduction

This paper discusses a very recent news about a Chinese company which was relevant to fraud.

According to this news, I will give a detailed description of the fact, then I will answer these questions: Under American law, what will Luckin coffee face? What legal consequences will Luckin coffee face in case of financial fraud? Can the so-called Dong Jian Gao liability insurance cover the capital loss caused by Luckin coffee counterfeiting case? Do audit and recommendation agencies need to be punished? How should investors protect their rights? Does China have jurisdiction?

Keywords: fraud, Sarbanes act, class action

Background

On the evening of April 2, Luckin Coffee (LK.NASDAQ) submitted a notice to the securities and Exchange Commission (SEC) to publicly admit financial fraud, saying that the self inspection found that the company’s chief operating officer (COO) Liu Jian and other financial fraud, involving about 2.2 billion yuan of trading volume. Affected by this, Ruixing coffee closed at $6.40/share on the same day, down 75.57% from the previous trading day. The China Securities Regulatory Commission (CSRC) has made a statement on April 3, paying close attention to and strongly condemning it. It will check the relevant situation according to law, resolutely crack down on securities fraud and effectively protect the rights and interests of investors. Some lawyers roughly calculate that in case of class action, Ruixing coffee will face a total compensation of about 11.2 billion US dollars.

The article mentioned that Muddy water is just an open platform for shorting, and real shorting forces (hedge funds) will hide behind the muddy water – the report is submitted anonymously, only released by muddy water on behalf of them. Hedge funds short a company to make a profit. The common operation of shortening is: before issuing the shorting report, they will borrow shares from the securities companies and sell them at a high price, and then release the report to suppress the corresponding companies. After the share price falls, they will buy the corresponding shares at a lower price and return them to the securities companies, and the profit they get is the price difference between the buying and selling. However, it is clear that hedge funds will not personally do field work in China. When a company with potential problems is locked in, they usually entrust domestic investigation companies to look for relevant evidence, including on-the-spot investigation (Statistics of orders, calculation of store flow), secret interview, etc. The hedge fund will pay these research companies according to the workload.

Several US law firms have filed a group action against Luckin Coffee, accusing Luckin of making false and misleading statements in violation of US Securities Law. At present, the group action has been filed in the Southern District Court of New York on February 13. April 13 is the deadline for the chief plaintiff of group action

Relevant Laws

1. Sarbanes act, regulations show that crimes of intentional securities fraud are punishable by imprisonment for up to 25 years, and penalties for individuals and companies guilty of fraud can be up to $5 million and $25 million, respectively; the CEO and CFO of a company must guarantee the legality and fair presentation of financial reports submitted to the SEC, and violation of this provision will result in a penalty of $500000 A fine or a sentence of five years
2. According to the enforcement of the court in the United States in the past, financial fraud companies will not only face criminal liability, but also be subject to class action by investors. ‘For qualified shareholders and investors, it is likely to file civil securities litigation against the company’s directors, senior executives, investment banks, lawyers, accountants and other professional service institutions during the period of fraud and claim huge compensation.’
3. Because the main responsible person of the company is not in the United States, as long as they ‘depend’ on the country, the United States can not enforce them to go to jail

Analysis

• Why is it important?
• What companies will care about this news?
• What will its impact be?

If there is evidence to prove that there is collusion in Ruixing’s suspected fraud, the intermediary agencies such as the accounting chamber must bear legal responsibility. If we should find out the fraud from the professional point of view, we should also bear the civil liability of compensation to investors for the negligence.

According to the Sarbanes act of the United States, the violation of the accounting firm is mainly investigated and punished by the public company accounting supervision committee (hereinafter referred to as PCAOB). However, the punishment procedure of PCAOB is subject to the supervision of the SEC, which can increase or reduce the punishment it makes, or modify or cancel its punishment decision.

The forms of punishment and sanctions imposed by PCAOB on accounting firms and individuals include: temporarily or permanently revoking registration; temporarily or permanently prohibiting individuals from practicing in accounting firms; temporarily or permanently restricting the practice activities and functions of accounting firms or individuals; for intentional, knowingly committed, reckless acts or repeated negligent acts, natural persons can be punished with less than $750000 The fine shall be no more than 15 million US dollars for the unit, no more than 100000 US dollars for the negligent act, no more than 2 million US dollars for the unit, condemnation, compulsory requirement for additional professional training and education, and other forms of punishment.

It can be seen that if Ernst & Young is sentenced to bear criminal responsibility in this case, the highest penalty may be permanent revocation of the firm’s license, a fine of 15 million US dollars, etc. In addition, if the SEC considers the circumstances to be serious, it may further increase the penalty.

Can Insurance Claims be Settled?

According to Ruixing’s prospectus, the company has purchased directors’ and supervisors’ liability insurance for relevant personnel, while it has not purchased business liability insurance and interruption insurance. According to media reports, there are about ten insurance companies in the form of coinsurance. Among them, Ping An said that it was further processing the claim application filed by the insured. Taibao property insurance also said that it participated in the coinsurance business of Ruixing coffee liability insurance in the form of documentary, and has made prudent reinsurance arrangements. Up to now, we have not received the formal notice of the main contractor.

The full name of the directors’ liability insurance is ‘Directors’ and supervisors’ and senior management’s liability insurance’. As the name implies, the directors’ liability insurance is used to protect the potential personal liability risks faced by the directors, supervisors and senior executives in the performance of their management duties, including the personal losses caused by ‘improper behaviors’ (negligence, error, misleading statements, etc.) in the performance of their duties, as well as legal costs, etc.

By definition, Dong’s liability insurance covers ‘unintentional acts’. ‘The insurance of directors’ liability insurance does not include the liability for compensation caused by the intentional violation of the law by the directors and senior executives. So it’s not covered by compensation. ‘ Some lawyers also pointed out that Dong’s liability insurance is a necessary insurance for China capital stock, which is specially used to deal with class action. In this incident, Luckin’s Coffee behavior is intentional and false. Unless the two parties have a special agreement in advance, the insurance company will probably not make compensation.

It is worth noting that in the ‘self disclosure’ announcement of Luckin Coffee, Liu Jian, the company’s COO (chief operating officer), and some of its subordinates fabricated transactions in the second quarter to the fourth quarter of 2019, increasing false sales by up to 310 million US dollars (about 2.2 billion yuan).

In this regard, some analysts said that the intentional behavior in property insurance business generally corresponds to the insured, involving the personal level, basically refers to the legal person. Luckin Coffee emphasizes that the responsibility is cool, then the Luckin company will consider that the company’s behavior is not intentional, so it is in line with the insurance claims. However, how to divide the ultimate responsibility depends on the results of the SEC investigation and court decisions.

‘This systematic and whole process fraud (ultimately to be determined by the facts) is unlikely to be done by the COO alone, so it is more likely that the management will fully participate in the fraud under the instruction of the actual controller.’ Unless Luckin’s internal control system is all formality and controlled by individuals, it is less likely.

In my opinion, there has been a business model: quickly occupying the market through ‘free’ and ‘subsidy’, financing several rounds of capital and listing on NASDAQ. Take the way of low price promotion, the revenue will certainly not cover the cost, and all the money burned is the investors’ money. Losing money is done by people, mainly because they are based on the assumption that after eliminating competitors, they will raise prices and make profits. This assumption seems reasonable, but in fact it has logical defects. Low prices can open up the market, but most of those customers are speculators. They are attracted by low prices. After raising the price, they go away without loyalty.

Reference

1. Caplinger, D. (2020, April 11). Will Luckin Coffee Stock Ever Trade Again? Retrieved from https://www.fool.com/investing/2020/04/11/will-luckin-coffee-stock-ever-trade-again.aspx
2. BobPisani. (2020, April 3). Luckin Coffee is a painful reminder of ‘the extreme fraud risk’ of some China-based companies. Retrieved from https://www.cnbc.com/2020/04/03/luckin-coffee-debacle-is-a-painful-reminder-of-fraud-risk.html
3. This is the link of the article
4. https://technews.tw/2020/04/06/why-luckin-coffee-is-fraudulent-chinese-enterprise-management-reappears/