How Many More Luckin Coffees? SEC To Discuss Listed Chinese Firms' Lax Accounting Standards, Fraud

A group of American investors have alleged that some Chinese-based companies listed on U.S. stock exchanges are fraudulent entities without accounting transparency that could harm U.S. investors. The Securities and Exchange Commission planned a roundtable conference on the issue on Thursday.

The conference comes only weeks after Nasdaq decided to delist China’s Luckin Coffee over allegations of accounting fraud related to fabricated sales figures.

In comment letters to the SEC in the past two months, dozens of investors and traders have cited instances of Chinese firms committing various acts of fraud.

For example, Carson Block, founder and chief investment officer of Muddy Waters Capital, an investment research firm based in California, wrote to the SEC: “Chinese-based [stock] issuers have committed -- and continue to commit -- fraud on a stunning scale in the [U.S.] capital markets… Protecting individual investors from the devastating financial impact of these frauds requires a profoundly different policy and regulatory approach.”

Block cited the aforementioned Luckin Coffee as an example. While Luckin Chairman Charles Lu was removed from his position, he remains the company’s largest investor wielding heavy influence. Block noted that no auditors of Luckin have resigned since the scandal broke.

Many of the letters to the SEC focused on a Chinese education and language school company called GSX Techedu, which trades on the New York Stock Exchange under the symbol GSX.

GSX shares traded at $81 per share as of midday Thursday and the company has a market cap of $19.3 billion.

“The SEC's continued inaction on known China-based frauds is disheartening,” wrote investor David Monroe. “GSX has been clearly and unequivocally shown to be a fraud, and yet, the SEC has chosen to sit by idly. Please act on GSX and the other half dozen demonstrably fraudulent U.S.-listed companies from China before more investors… pile into these stocks and lose [most or all] of their money during the inevitable collapse.”

Thomas Forrest, a senior consultant of learning and development, also singled out GSX as a fraudulent company “that does not have staff commensurate to its filings to the SEC or compared to its valuation.”

Another investor named Janson You wrote that GSX might be a “Pearl Harbor” moment for U.S. stock markets.

“If you [SEC] don’t have a clear investigation of GSX, one way or the other, [the] U.S. stock market will be invaded by the Chinese way of creative fraud, and U.S. investors will lose billions of dollars and eventually their trust [in] SEC.”

John Yetimoglu, a portfolio manager, wrote that GSX “is an absolute fraud and the company needs to be investigated immediately. They are faking their user numbers and revenue by using 'brusher' companies in China to inflate user numbers through bot farms. Numerous fraud reports have come out outlining the details of the operation from reputable sources and past employees of the company.”

Some letter writers had more general complaints.

Tariq Ahmad, a partner at Indus Capital, wrote: “While the objective of seeking accounting transparency and access to working papers is critical, the bigger issue is of what investors actually own of the listed entity, given the unenforceability of the legal structures whose economic interests are in the listed company. How do you seek to ensure that investors are protected?”

Richard Smatt, a professor of math business at Flagler College in Florida, wrote that he discovered many Chinese companies that trade on U.S. exchanges are not properly audited.

“If you dig deeper you can find that several companies use brushing or deceiving practices to make their financials look better than what they are,” he wrote. “If China allowed U.S. auditors in to audit their internal controls these practices wouldn't happen… If they don’t follow our standards they should be delisted.”

SEC Chairman Jay Clayton, who will preside over the meeting, stated: “This is a fundamental issue in emerging market investing that I believe investors, particularly our Main Street investors, should better understand.”

Clayton will be joined at the roundtable by representatives from the New York Stock Exchange, the Department of Justice, Starbucks (SBUX) and the Public Company Accounting Oversight Board, or PCAOB, the nonprofit agency that oversees audits of all U.S. companies seeking to raise money in public markets.

Clayton said the purpose of the roundtable will be to find ways to “raise investor awareness of these risks and explore potential additional steps that can be taken to mitigate them.”

The movement to pressure Chinese companies has already been gaining steam in Washington.

In late May, the U.S. Senate overwhelmingly passed a bill – the Holding Foreign Companies Accountable Act – that could ultimately delist scores of foreign, including Chinese stocks, from U.S. exchanges.

Among other things, the bill would require foreign companies to prove they are not controlled by a foreign government and submit to an audit that would be reviewed by the PCAOB, which was established by The Sarbanes-Oxley Act of 2002.

The bill remains subject to passage by the House of Representatives before it can be signed into law by President Donald Trump.

In late May, Nasdaq itself proposed tighter rules for companies seeking a listing on the exchange – including a requirement to raise at least $25 million in their initial public offerings or, alternatively, at least one-quarter of their post-listing market capitalization. The rules were designed to thwart companies with thin trading volumes and excessive insider ownerships.

Secretary of State Mike Pompeo praised Nasdaq for its move.

“I applaud Nasdaq for requiring auditing firms to ensure all listed companies comply with international reporting and inspection standards. Nasdaq’s announcement is particularly important given a pattern of fraudulent accounting practices in China-based companies” said Pompeo.

Roger Silvers, an accounting professor at the University of Utah who has worked for the SEC, said Thursday’s roundtable should be seen as part of a larger effort to build a case against China for preventing access to their companies’ financial statements and audit records.

“China has been very obstructionist” he said. “There is a growing sense of frustration with China, and now with the trade wars and the Covid-19 outbreak there is a growing appetite to pick a fight with China. There is a change in the geopolitical climate.”

As for what the SEC may actually do, Silvers suggested they “might be able to make a rule that said, you are not allowed to have subsidiaries that are not audited by firms that can’t be inspected by us… But if that happens, you are talking about an all-out trade war.”

Silvers added: “There is a part of me that says disclosure to investors is key. Caveat emptor: If you invest in China, you do it at your own risk.”