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Burned by Luckin Coffee, US steps up scrutiny of China startups

Recent troubles reignite yearslong tug-of-war between SEC and accounting firms

Luckin Coffee, which debut on the Nasdaq Market later year to great fanfare, admitted to grossly inflating revenues.   © Reuters

SHANGHAI -- With the admission of fraudulent accounting by Luckin Coffee and TAL Education having shattered investor confidence, Chinese startups that debuted to fanfare on U.S. stock exchanges face ever-growing pressure to step up transparency.

Nearly 200 Chinese companies are currently listed on the New York Stock Exchange and the Nasdaq stock market. Many of them are audited by "Big Four" firms, as is Luckin, by Ernst & Young, and TAL Education, by Deloitte Touche Tohmatsu.

The auditors review these clients' books at their Chinese headquarters via local units. The SEC has long warned that this creates opportunities for fraud, since Chinese law bans sensitive disclosures from being taken overseas, making it harder to prove any improprieties.

Audit shortfalls on Chinese companies first came under the spotlight back in June 2011, with allegations of fraudulent accounting at Canada-listed Sino-Forest. The SEC launched an extensive investigation into Chinese companies listed in the U.S.

But the auditors refused to turn in key documents citing Chinese law, and the SEC responded by suing the Chinese units of the Big Four in 2012. Tensions continued to grow as the auditors told the SEC to pursue a diplomatic solution, while the SEC in 2014 barred their Chinese units from auditing U.S.-listed entities for six months.

Luckin Coffee, which once dazzled investors with astonishing growth, has admitted to fabricating revenues.    © Reuters

Attitudes on Chinese companies began to shift around September 2014, when e-commerce platform Alibaba Group Holding went public in a then-record initial public offering valuing the company at $230 billion. American investors embraced listings by other promising Chinese startups with open arms.

The exchanges themselves also welcomed Chinese companies rushing for an IPO, making it easier for them to go public in the U.S. than at home. The number of companies listed in the U.S. at the time had roughly halved from over 8,000 in 1996. "American exchanges used Chinese startups to restore their clout," a Chinese market insider said.

Just five Chinese companies listed in the U.S. in 2015. The figure surged to 28 in 2018. Luckin was one of 24 that went public in the U.S. last year, and was considered one of the most promising out of its cohorts.

The tide turned once again as the U.S.-China trade war intensified. A bipartisan group of lawmakers led by Sen. Marco Rubio introduced a bill in June 2019 pushing for U.S. access to financial records of Chinese companies trading in the U.S.

That same month, news broke that Alibaba was planning a secondary listing in Hong Kong -- which it did that November. Other key Chinese companies such as Baidu and JD.com are also considering a similar move to ensure they have a way to raise funds outside the U.S.

"U.S. exchanges allowed even Chinese companies with murky backgrounds to go public," said Takashi Nomura, an attorney at Nishimura & Asahi. "There's a reason why these accounting scandals happened."

The SEC in February reiterated the importance of proper auditing, and warned that the coronavirus could further impact the quality of audits in China. But it is unclear what more the auditing companies can really do. "Auditors can't really catch fraud if the books produced by their clients look fine," said a source at a major Chinese accounting company.

The Luckin scandal was uncovered not by its auditor, but by California-based short-seller Muddy Waters Research. Big changes will be needed to stamp out accounting fraud and restore investor confidence.

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