A Tug of War Over Record Books: How a Coffee Shop Scandal Could End a Decade-Long Deadlock Between the SEC and Chinese Regulators

By: Haodi Dong

Wikimedia Commons

Wikimedia Commons

In 2002, Congress passed the Sarbanes-Oxley Act (“SOX”), setting a series of new regulations and penalties for all U.S. public companies. SOX aimed to protect investors from fraudulent financial activities by requiring companies to certify the accuracy of their financial information. Specifically, Title I of SOX established the Public Company Accounting Oversight Board (“PCAOB”) under the Securities and Exchange Commission (“SEC”). The PCAOB “oversee[s] the audit of public companies . . . ; establish[s] audit report standards and rules; and inspect[s], investigate[s], and enforce[s] compliance . . . of registered public accounting firms.” 

The PCAOB inspects registered accounting firms globally and has inspected firms in 50 different non-U.S. jurisdictions. However, certain countries’ foreign privacy and data protection laws prohibit the SEC and the PCAOB from conducting any examination. Some foreign authorities also prevent the PCAOB from inspecting non-U.S. audit firms despite their registration with the PCAOB.

China, the most prominent country among them, has been blocking both the SEC and the PCAOB from inspecting the books, records, and audit works for U.S. enlisted companies whose main operations are based in China by invoking national security reasons. Both sides had numerous talks hoping to reach a deal. In 2013, the PCAOB entered into an enforcement cooperation agreement with Chinese regulators, but the PCAOB still could not strike a deal on inspections. However, only through inspections can the PCAOB make sure the audits of these U.S. listed companies are up to standards.

A recent scandal, however, could break this decade-long deadlock between the SEC and Chinese regulators. Luckin Coffee, determined to challenge Starbucks in China, went public on Nasdaq last May and raised $561 million in IPO. But earlier this year, an 89-page anonymous report alleged Luckin Coffee of committing serious fraud. The report claimed that Luckin inflated at least 78% of the items sold during the last two quarters of 2019 to exaggerate revenue. Luckin denied the validity of the report initially, but later it disclosed a regulatory filing with the SEC in April stating that the Company’s Board had formed a committee to oversee an investigation into the audits of the 2019 financial statements. Luckin further disclosed that starting from April 2019, its Chief Operating Officer “had engaged in certain misconduct, including fabricating certain transactions,” and the fabricated sales alone “amounts to around RMB 2.2 billion,” or $310 million. Luckin’s stock plunged 89% before Nasdaq halted its trading on April 8, and Nasdaq subsequently decided to delist Luckin Coffee on May 15.

Shortly following Luckin’s shocking scandal, both Nasdaq and U.S. officials introduced new regulations hoping to protect investors. Nasdaq set new requirements for listing, including a $25 million minimum IPO, which could prevent numerous small Chinese companies from going public. The Senate passed Senate Bill 945, the Holding Foreign Companies Accountable Act by unanimous consent, and it is currently waiting for the House approval. Senate Bill 945 will prohibit some companies from listing and trading on any U.S. securities exchanges if the PCAOB cannot review the companies’ audits. This could also potentially delist foreign companies from U.S. securities exchanges.

But these measures will not be implemented without strong objections and sacrifices from both investors and regulators. As of December 31, 2019, ten U.S. listed public companies with China-based operations have a combined market capitalization of $1.4 trillion. A sudden trading ban of these companies could hurt investors around the world. Furthermore, these companies can always pull their capitals from the U.S. and go public elsewhere. In fact, China has already begun to urge companies to list in London. For now, the SEC’s and PCAOB’s attempts to gain access to China-based companies’ financial records will likely remain a tug of war.

 

Haodi Dong is a second-year law student at Wake Forest University School of Law. He holds a Bachelor of Science in Applied Mathematics and a Minor in Philosophy from the University of California, Davis. After graduation, he intends to practice corporate and intellectual property law.