Watchdog Transparency Blog

In our Blog we take a critical look at public company disclosures and focus on issues surrounding transparency, reliability and accuracy. It you are looking for cheerleading, you have come to the wrong place. We rely on information from the best sources available to gain insight into companies and make predictions about what will happen in the future. Nothing in business is certain, so sometimes we will be wrong, but we will always be an independent voice telling you the truth as we see it. We offer Retail Investors our Research Reports for Free.

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America Runs From Luckin: Corporate Governance Failures

Luckin Coffee’s massive fraud was discovered by its auditors, EY’s Chinese affiliate, Ernst & Young Hua Ming LLP. The affiliate probably would have discovered the fraud earlier if not for Luckin’s status as an Emerging Growth Company, but in this post we turn our attention to Luckin’s board of directors, who ought to serve as the first line of defense against fraud.

Sarbanes Oxley introduced extensive corporate governance rules to check management’s impulses and protect from fraud. At the heart of these rules is the involvement of “independent directors” on every company’s board of directors. What makes “independent directors” independent is that they are not beholden to management and have the best interests of the corporation in mind when making decisions. These “independent directors” sit on important committees and provide oversight of the management team and can take decisive action to correct problems they discover.

Whenever there is a big fraud at a company, you can be certain that there are flaws in the corporate governance. Some companies violate governance rules while others violate their spirit. But in the case of foreign filers, like Luckin, some companies do not even have to abide by the same governance rules as U.S. companies.

Loophole in Corporate Governance Requirements for Foreign Filers

Usually, to trade on the Nasdaq, the majority of directors on the board must be independent. In principle, a director is independent if they do not have personal or financial ties that management can leverage to make the director beholden to management. Additionally, the company must have an audit committee of three members, all of whom must be independent, and one of whom must be financially sophisticated (with a background in accounting or something similar).

Luckin did not have a majority of independent directors, in fact, of the eight members of the board, only two, Thomas P. Meier and Sean Shao were held out as independent directors. Foreign companies have always had a little-known exception to the requirement for a majority of board members to be independent if that rule contradicted local law. Foreign companies were permitted to request this exemption. Few firms applied initially because it was difficult to get a law firm to sign off on the request and there was no guarantee the regulators would grant such a request. So, companies petitioned for a change in the rule. This rule was relaxed in 2005, foreign firms no longer needed to request an exemption, instead they could just declare that they were taking one and relying on “home country practice.”

This change was not made in the best interests of investors, since foreign companies have legal and language barriers that make performing due diligence difficult. Unsurprisingly, Luckin opted to diminish the role on the board for these watchdogs:

The Listing Rules of the NASDAQ generally require that a majority of an issuer’s board of directors must consist of independent directors. However, the Listing Rules of the NASDAQ permit foreign private issuers like us to follow “home country practice” in certain corporate governance matters. We rely on this “home country practice” exemption and do not have a majority of independent directors serving on our Board of Directors.

There is no “home country practice” exemption for the Audit Committee however, which raises an important question, how could the audit committee have missed this fraud? How could the audit committee have missed a fabrication of more than half of the annual revenue? Or a substantial change costs and expenses? One contributing factor is that the rules allow companies to phase-in independent directors after an IPO.

Only two of the three audit committee members were independent. One member, Mr. Erhai Liu, was the founder and manager of Joy Capital and heavily invested in Luckin.

Were These “Independent Directors” Even Independent?

It also appears that Luckin broke the rules. The “independent” directors were Thomas P. Meier, the former president and CEO of Frankee Coffee Systems and Sean Shao. When Thomas Meier was still leading Frankee coffee systems, they and another manufacturer obtained a contract with Luckin in 2018 that was reported to quintuple sales for the manufacturer. It is possible that serving in that role ought to have disqualified Mr. Meier from qualifying as an independent director since the Nasdaq does not consider independent:

(D) a director who is, or has a Family Member who is, a partner in, or a controlling shareholder or an executive officer of, any organization to which the company made, or from which the company received, payments for property or services in the current or any of the past three fiscal years that exceed 5% of the recipient’s consolidated gross revenues for that year, or $200,000 ($1 million if the listed company is also listed on the New York Stock Exchange), whichever is more…

Mr. Meier left his position at Frankee in March 2019 to join Luckin as an independent director. Given the large contract with Luckin, it is likely that he ought to have been disqualified under the Nasdaq rules because he was an executive at Frankee Coffee Systems which likely had a contract with Luckin which exceeded both 5% of the revenue and $200,000. About three weeks after Luckin disclosed its fraud on April 21st, he resigned as an “independent” director and member of the audit committee. There was no explanation for his departure.

The other independent director, Sean Shao, has extensive experience as an independent director. He worked at Deloitte Touche Tohmatsu CPA Ltd for almost a decade before taking up the role of independent director at many companies. One of his longest tenures was with Agria Corporation from 2008-2017, where he was an independent director and chairman of the corporate governance committee. In 2018, Agria settled with the SEC for fraud relating to its operations in China from 2010-2013.

It is not uncommon for former auditors at the Big 4 to parlay their experience into lucrative careers as independent directors, but there is something about this kind of serial board membership that seems unsavory.

Conclusion

It is more difficult for the exchanges and regulators to effectively monitor foreign based firms for a host of reasons. That makes it critical for foreign firms to have effective independent directors to act as watchdogs and prevent fraud. However, the current rules permit these foreign firms more latitude than U.S. firms. If regulators want to make meaningful steps to bolster protections for investors in the wake of the Luckin fraud, then this would be a great place to start.

Contact us:

Retail Investors get free access to our Watchdog Reports. Institutional Investors and those interested in our Gray Swan Event Factor can subscribe, or call our subscription manager, at 239-240-9284.

If you have questions about this blog send John Cheffers, our Director of Research, an email at jcheffers@watchdogresearch.com. For press inquiries or general questions about Watchdog Research, Inc., please contact our President, Brian Lawe at blawe@watchdogresearch.com.

Watchdog Transparency Blog

In our Blog we take a critical look at public company disclosures and focus on issues surrounding transparency, reliability and accuracy. It you are looking for cheerleading, you have come to the wrong place. We rely on information from the best sources available to gain insight into companies and make predictions about what will happen in the future. Nothing in business is certain, so sometimes we will be wrong, but we will always be an independent voice telling you the truth as we see it. We offer Retail Investors our Research Reports for Free.

Sign up to get all of our blogs delivered directly to your inbox.


America Runs From Luckin: Corporate Governance Failures

Luckin Coffee’s massive fraud was discovered by its auditors, EY’s Chinese affiliate, Ernst & Young Hua Ming LLP. The affiliate probably would have discovered the fraud earlier if not for Luckin’s status as an Emerging Growth Company, but in this post we turn our attention to Luckin’s board of directors, who ought to serve as the first line of defense against fraud.

Sarbanes Oxley introduced extensive corporate governance rules to check management’s impulses and protect from fraud. At the heart of these rules is the involvement of “independent directors” on every company’s board of directors. What makes “independent directors” independent is that they are not beholden to management and have the best interests of the corporation in mind when making decisions. These “independent directors” sit on important committees and provide oversight of the management team and can take decisive action to correct problems they discover.

Whenever there is a big fraud at a company, you can be certain that there are flaws in the corporate governance. Some companies violate governance rules while others violate their spirit. But in the case of foreign filers, like Luckin, some companies do not even have to abide by the same governance rules as U.S. companies.

Loophole in Corporate Governance Requirements for Foreign Filers

Usually, to trade on the Nasdaq, the majority of directors on the board must be independent. In principle, a director is independent if they do not have personal or financial ties that management can leverage to make the director beholden to management. Additionally, the company must have an audit committee of three members, all of whom must be independent, and one of whom must be financially sophisticated (with a background in accounting or something similar).

Luckin did not have a majority of independent directors, in fact, of the eight members of the board, only two, Thomas P. Meier and Sean Shao were held out as independent directors. Foreign companies have always had a little-known exception to the requirement for a majority of board members to be independent if that rule contradicted local law. Foreign companies were permitted to request this exemption. Few firms applied initially because it was difficult to get a law firm to sign off on the request and there was no guarantee the regulators would grant such a request. So, companies petitioned for a change in the rule. This rule was relaxed in 2005, foreign firms no longer needed to request an exemption, instead they could just declare that they were taking one and relying on “home country practice.”

This change was not made in the best interests of investors, since foreign companies have legal and language barriers that make performing due diligence difficult. Unsurprisingly, Luckin opted to diminish the role on the board for these watchdogs:

The Listing Rules of the NASDAQ generally require that a majority of an issuer’s board of directors must consist of independent directors. However, the Listing Rules of the NASDAQ permit foreign private issuers like us to follow “home country practice” in certain corporate governance matters. We rely on this “home country practice” exemption and do not have a majority of independent directors serving on our Board of Directors.

There is no “home country practice” exemption for the Audit Committee however, which raises an important question, how could the audit committee have missed this fraud? How could the audit committee have missed a fabrication of more than half of the annual revenue? Or a substantial change costs and expenses? One contributing factor is that the rules allow companies to phase-in independent directors after an IPO.

Only two of the three audit committee members were independent. One member, Mr. Erhai Liu, was the founder and manager of Joy Capital and heavily invested in Luckin.

Were These “Independent Directors” Even Independent?

It also appears that Luckin broke the rules. The “independent” directors were Thomas P. Meier, the former president and CEO of Frankee Coffee Systems and Sean Shao. When Thomas Meier was still leading Frankee coffee systems, they and another manufacturer obtained a contract with Luckin in 2018 that was reported to quintuple sales for the manufacturer. It is possible that serving in that role ought to have disqualified Mr. Meier from qualifying as an independent director since the Nasdaq does not consider independent:

(D) a director who is, or has a Family Member who is, a partner in, or a controlling shareholder or an executive officer of, any organization to which the company made, or from which the company received, payments for property or services in the current or any of the past three fiscal years that exceed 5% of the recipient’s consolidated gross revenues for that year, or $200,000 ($1 million if the listed company is also listed on the New York Stock Exchange), whichever is more…

Mr. Meier left his position at Frankee in March 2019 to join Luckin as an independent director. Given the large contract with Luckin, it is likely that he ought to have been disqualified under the Nasdaq rules because he was an executive at Frankee Coffee Systems which likely had a contract with Luckin which exceeded both 5% of the revenue and $200,000. About three weeks after Luckin disclosed its fraud on April 21st, he resigned as an “independent” director and member of the audit committee. There was no explanation for his departure.

The other independent director, Sean Shao, has extensive experience as an independent director. He worked at Deloitte Touche Tohmatsu CPA Ltd for almost a decade before taking up the role of independent director at many companies. One of his longest tenures was with Agria Corporation from 2008-2017, where he was an independent director and chairman of the corporate governance committee. In 2018, Agria settled with the SEC for fraud relating to its operations in China from 2010-2013.

It is not uncommon for former auditors at the Big 4 to parlay their experience into lucrative careers as independent directors, but there is something about this kind of serial board membership that seems unsavory.

Conclusion

It is more difficult for the exchanges and regulators to effectively monitor foreign based firms for a host of reasons. That makes it critical for foreign firms to have effective independent directors to act as watchdogs and prevent fraud. However, the current rules permit these foreign firms more latitude than U.S. firms. If regulators want to make meaningful steps to bolster protections for investors in the wake of the Luckin fraud, then this would be a great place to start.

Contact us:

Retail Investors get free access to our Watchdog Reports. Institutional Investors and those interested in our Gray Swan Event Factor can subscribe, or call our subscription manager, at 239-240-9284.

If you have questions about this blog send John Cheffers, our Director of Research, an email at jcheffers@watchdogresearch.com. For press inquiries or general questions about Watchdog Research, Inc., please contact our President, Brian Lawe at blawe@watchdogresearch.com.

© 2020 Watchdog Research, Inc. All rights reserved.
Watchdog Transparency is a publication based on reports created by Watchdog Research, Inc.
Watchdog Research, Inc. is a financial research company providing due diligence information on public companies.

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