CHINA IPOS IN USA: DEEPER DUE DILIGENCE & STRONGER COMPLIANCE WILL SOOTH POST LUCKIN COFFEE JITTERS
Bashers who claim all PRC companies are frauds are silly. China is still a great place for growth and US exchanges are still good places for Chinese businesses to connect with investors.
Its almost like America’s short sellers were just waiting for Luckin Coffee (NASDAQ: LK) to come along. Less than six months after LK’s successful issuance of ADRs, an anonymous group of short sellers was funding an extensive undercover surveillance operation at dozens of LK’s restaurants, scooping up third party data relating to LK SG&A spending, and hunting for employee WeChat communications to build a case that LK’s books were cooked. On January 31st they struck, after building massive short positions, and well after LK’s management issued positive 3Q2019 results and 4Q2019 guidance. The announcement came via Twitter by Muddy Waters, with an unattributed white paper “research report” alleging LK’s management had committed fraud. After shares were halted by NASDAQ, deregistration notices followed, and the stock tanked, with short sellers such as Jim Chanos making huge profits on the 70% price plunge. A board-launched and still underway internal investigation has found LK’s CEO and COO responsible for inflating revenues by more than RMB 2 Billion (US$283 million), and contagion is now spreading to Car Inc (HKSE: 0699.HK), making LK a “two-for-one” parlay bet win for the short sellers, who can now be expected to capitalize on a wave of growing anti-China political sentiment in the US that is threatening to become a tsunami, as they look for their next political kill.
We’ve seen this cycle of US short sellers bashing PRC companies before. In 2011-2013, short sellers took on TSX Sino-Forest (TRE.TO) and a string of others. Then, when it became clear that not EVERY Chinese company was a fraud, and that China was a place for growth of some really great and interesting businesses, the shorts got stomped. So, now today the corollary to Newton’s law will likely still hold true: “What goes down must one day bounce back up”.
What was a decade ago remains true today: Bashers who claim all PRC companies are frauds are silly. China is still a great place for growth and US exchanges are still good places for Chinese businesses to connect with investors. As America goes negative on PRC companies, US stock exchanges are likely losing a major opportunity to connect their markets with China’s future growth.
With that said, here are a few issues that have arisen in the LK case that we find interesting.
One issue raised in the LK case is the realization that there continues to be asymmetry between extensive resources brought to bear by short sellers vs. the retainer fees paid to external auditors. Reading the anonymous report on LK, one comes away with a sense that short sellers were expending far more resources on site visits in the field than are asked for in a traditional external audit mandate. So far, LK’s auditor Ernst & Young, has not been accused of being at fault. FTI has been called in by a Special Committee at LK to review what happened, and EY has not yet been cleared. Time will tell us more about EY’s due diligence process, but the trend is already clear. Good Chinese companies that are preparing for listings on the HKSE and other exchanges are including in their mandates a requirement for deeper due diligence, with far more authorized but independent site visits than were historically performed – as a means of pre-empting today's short-sellers and China business bashers. It is good and growing practice for Pre-IPO Due Diligence to undertake these additional arms-length site visits, and we expect this trend will continue.
Further, fraud by Luckin’s directors didn’t just destroy foreign investor capital. They destroyed Chinese capital too. When the ADRs sunk from US$50 on January 17th to US$4.39 on April 7th, the cost of poor compliance was clear for everyone, including LK's Chinese investors. The loss of investor capital at LK won’t be lost on the wider multitude boardrooms of well-run, profitable Chinese companies delivering growth and value to investors. Board members and investors in Chinese companies can see the LK story for what it is: not an argument against a US listing, only an argument for better compliance to protect shareholder value.
Certainly the final chapter on LK has not been written. Even today, LK is making a case that it is on the rebound. As they say in the comic books: “stay tuned”.
I-OnAsia (www.ionasia.com.hk) is a Hong Kong headquartered specialist in the conduct of pre-transaction due diligence, including Pre-IPO due diligence at the request of great Chinese #business and #lawfirm clients. We have seen hundreds of good companies that utilize our due diligence services as they pursue listings. These enterprises are often at the forefront of #innovation and #technology, and have great #leadership.