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.


America Runs From Luckin: Clash Over the PCAOB

In April, just as the America was in the grip of the coronavirus originating from Wuhan, Luckin Coffee initially reported that it had discovered a fraud by the COO fabricating over half of the company’s revenue. We wrote an in-depth report arguing the fraud was far more pervasive. Since then, Luckin has been delisted, the WSJ wrote an exposé detailing far more extensive fraud than originally reported, the CEO was also implicated by Luckin, and now Luckin’s chairman and founder is reportedly facing charges.

Luckin’s massive fraud hints at systemic problems in the Chinese markets. At the root, there is a fundamental difference in how financial information is perceived in the West to how it is perceived by the Chinese Communist Party (CCP). The West holds that financial information should be shared with the investing public, and there are several safeguards to ensure that the information is accurate. For the CCP, financial information is a tool used to meet the goals of the Party. Luckin’s fraud raises the possibility that the CCP has allowed or even encouraged Chinese companies to bilk money out of Western investors as a point of policy.

Consequently, this story has reignited a dormant dispute between China and the U.S. about the regulatory oversight of Chinese auditors. Even though some Chinese audit firms in China are registered with the PCAOB, including affiliates of the Big 4, the CCP has not permitted the PCAOB to conduct investigations of any of its auditors. We consider this so significant that our reports assign a red flag to any company whose auditor is not subject to meaningful supervision by the PCAOB.

In the aftermath of the fraud at Luckin, the Senate unanimously passed a bill that would delist any companies from U.S. exchanges whose auditors were not subject to inspection by the PCAOB. As a practical matter, this could result in the delisting of Chinese companies worth over a trillion dollars and trigger a big kerfuffle in U.S.-Sino relations.

China’s Longstanding Refusal to Allow Oversight of Their Auditors

After the Enron scandal, Congress created the PCAOB. The PCAOB ia a quasi-independent regulator that provides oversight of audit firms; every publicly traded company on a U.S. exchange must have an auditor registered with the PCAOB. The PCAOB conducts inspections of these auditors and can deregister them if they do not meet professional standards.

The PCAOB’s influence has expanded internationally, as many countries have agreements where the PCAOB will conduct joint inspections with the regulators from other countries to assure every nation has the same high standards for its auditors. China has never agreed to allow these inspections.

Instead the CCP has steadily tightened its grip on the profession. In 2012, the CCP ordered the Big Four affiliates to phase in Chinese nationals to replace foreigners in senior management. And just this year, the CCP passed a law outlawing cooperating with foreign regulators without express permission. It is very likely that many of the senior partners in these affiliates are Party members, potentially undermining their professional integrity.

China’s refusal to allow PCAOB inspections first came to a head after systemic fraud was revealed in Chinese companies that had accessed U.S. markets via reverse merger. Oftentimes these were shell companies without any actual operations. Even the most cursory oversight would have prevented many of these companies from defrauding investors. In the wake of the reverse merger wave, there was a huge outcry from investors to have more oversight of Chinese firms. The CCP flatly refused.

Impotence in the Face of CCP Defiance

By 2012, concerns over the lack of oversight were coming to a head. The SEC sued the Big Four affiliates in China for their refusal to hand over their work papers for inspection. However, the affiliates had never promised to hand over their work papers for inspection because it is the policy of the CCP that these papers were “state secrets.”

Westerners may have scoffed at this idea, but for an authoritarian regime like the CCP, all information is the state’s business. The CCP will never permit accurate and truthful numbers to be recorded and transmitted to its own people and to the West; even something as innocuous as a balance sheet can cause a revolution because truth always poses a danger to propagandists.

The SEC and PCAOB did not have the clout to force the CCP to change its position, which left them with a dilemma. Either they could take decisive action and potentially delist all the Chinese companies listed on the U.S. exchanges and deprive every multinational company of the ability to have its Chinese operations audited by a registered affiliate, or they could largely give in while making a few face-saving gestures.

The SEC gave in. No one should have been surprised either, the public policy implications of enforcing the rules were too broad. Decisions concerning international relations are public policy decisions that require leadership in Washington. The administration at that time had expressed support for closer investment links with China, rendering untenable any course of action that would have alienated the CCP. So, the SEC settled their case for $2 million and the PCAOB signed a Memorandum of Understanding that allowed Chinese firms to register in exchange for vague promises.

Unsurprisingly, those vague promises never amounted to anything. Recently, with the new administration, the SEC and the PCAOB seemed to be more willing to discuss their concerns with China. They issued a joint statement warning investors that Chinese firms were not subject to proper oversight, but failed to full explain the issues involved or do anything to correct the problem. This Caveat Emptor attitude is incongruous with current American customs and law, since economic liberalism and the robber barons it spawned have been confined to the dustbin of history.

So, for several years Chinese audit firms have been permitted to register with the PCAOB, even though they are not subject to inspections. This has worked well for Chinese companies, who get a premium price for listing on U.S. exchanges, and it has worked well for Chinese audit firms who register with the PCAOB since they also can charge a premium. Whenever a fraud is revealed, individual investors are left holding the bag.

Without leadership from Washington on this issue, nothing could change. There had been some talk over the years, but it had not yielded any fruit. For example, Sen. Marco Rubio touted the EQUITABLE Act last year, a bill he introduced that would have potentially delisted Chinese companies if their auditors were not subject to inspection. But the bill languished.

The one small step that SEC and the PCAOB took after the Luckin story broke was to require companies in China to disclose the fact that their auditors are not subject to inspections by the PCAOB in all relevant financial statements. Buyer Beware.

Leadership in Washington?

That changed in May, when the Senate unanimously passed a bill that would delist Chinese companies unless the CCP permits the PCAOB to oversee their auditors. Frankly, we were shocked when this bill was passed because it takes real steps to address a real problem.

It seemed this bill passed because of the confluence of two stories: first, the emergence of the coronavirus from Wuhan coupled with credible reports that the CCP’s lies had made the impact of the virus worse, and second, the disclosure of a massive fraud at Luckin. Public opinion turned decisively against China, creating the perfect environment for this bill to pass.

It is unclear if this ostensibly bipartisan bill will be introduced and passed in the House of Representatives. The moment has passed. Reports on riots have finally displaced the unceasing coverage of the coronavirus which had monopolized the airwaves for months. The CCP looks as if it will arrest Charles Lu, the chairman and founder of Luckin, since people were not satisfied with the COO as a scapegoat (nor with the CEO who was served up a month later).

There is a powerful lobby that would like to see this bill scrapped, or at least neutered either in its final form or its enforcement. Many investors know that the CCP will not budge on this issue, but they are guessing that Washington will fold. If there is a change in the White House in November it is unlikely that this bill, and the hardline on the CCP that it represents, will last.

Issue Unaddressed by the Bill

This bill may be helpful for investors, but it omits a crucially important issue. Francine Mckenna, an independent reporter whose work is now available on The Dig, has pointed out more than once that multinational companies like Pfizer and Walmart rely on Chinese audit firms to conduct the audits of their Chinese operations. This means that there are potential blind-spots in the audits of some of the biggest and most important companies in the world.

Concerns about the Chinese operations of multinational companies are warranted, and the senate bill does nothing to address that issue. However, this problem may already have an informal albeit makeshift solution. Even though the Chinese audit firms are supposed to do everything locally, it is likely that they consult with their U.S. counterparts when doing a multinational audit. This probably allows the Big Four to exercise some influence over their foreign affiliates in China, even if the official story is that no “sensitive” work-papers ever cross borders.

Conclusion

Shockingly, the Senate has passed a bill that could actually protect investors. However, there is undoubtedly pressure from pro-China lobbyists to scrap the essence of the bill in exchange for some token victory. This victory could be the arrest of Charles Lu or perhaps some “corrupt” CCP officials who supported him.

Even if the bill passes, it may not have the effect intended. Chinese companies incorporated in the U.S. or in Tax Havens and only attached to the Chinese operations through contractual agreements (most “Chinese” companies already have one of these “VIE” arrangements) may be permitted to stay on the exchanges without any PCAOB oversight of their auditors.

If the U.S. wants to really ensure that Chinese companies have proper oversight, Washington must continue to lead and show resolve. However, the stories that drove the passage of this bill are already fading from memory and Washington is a place where resolve is in short supply…

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.


America Runs From Luckin: Clash Over the PCAOB

In April, just as the America was in the grip of the coronavirus originating from Wuhan, Luckin Coffee initially reported that it had discovered a fraud by the COO fabricating over half of the company’s revenue. We wrote an in-depth report arguing the fraud was far more pervasive. Since then, Luckin has been delisted, the WSJ wrote an exposé detailing far more extensive fraud than originally reported, the CEO was also implicated by Luckin, and now Luckin’s chairman and founder is reportedly facing charges.

Luckin’s massive fraud hints at systemic problems in the Chinese markets. At the root, there is a fundamental difference in how financial information is perceived in the West to how it is perceived by the Chinese Communist Party (CCP). The West holds that financial information should be shared with the investing public, and there are several safeguards to ensure that the information is accurate. For the CCP, financial information is a tool used to meet the goals of the Party. Luckin’s fraud raises the possibility that the CCP has allowed or even encouraged Chinese companies to bilk money out of Western investors as a point of policy.

Consequently, this story has reignited a dormant dispute between China and the U.S. about the regulatory oversight of Chinese auditors. Even though some Chinese audit firms in China are registered with the PCAOB, including affiliates of the Big 4, the CCP has not permitted the PCAOB to conduct investigations of any of its auditors. We consider this so significant that our reports assign a red flag to any company whose auditor is not subject to meaningful supervision by the PCAOB.

In the aftermath of the fraud at Luckin, the Senate unanimously passed a bill that would delist any companies from U.S. exchanges whose auditors were not subject to inspection by the PCAOB. As a practical matter, this could result in the delisting of Chinese companies worth over a trillion dollars and trigger a big kerfuffle in U.S.-Sino relations.

China’s Longstanding Refusal to Allow Oversight of Their Auditors

After the Enron scandal, Congress created the PCAOB. The PCAOB ia a quasi-independent regulator that provides oversight of audit firms; every publicly traded company on a U.S. exchange must have an auditor registered with the PCAOB. The PCAOB conducts inspections of these auditors and can deregister them if they do not meet professional standards.

The PCAOB’s influence has expanded internationally, as many countries have agreements where the PCAOB will conduct joint inspections with the regulators from other countries to assure every nation has the same high standards for its auditors. China has never agreed to allow these inspections.

Instead the CCP has steadily tightened its grip on the profession. In 2012, the CCP ordered the Big Four affiliates to phase in Chinese nationals to replace foreigners in senior management. And just this year, the CCP passed a law outlawing cooperating with foreign regulators without express permission. It is very likely that many of the senior partners in these affiliates are Party members, potentially undermining their professional integrity.

China’s refusal to allow PCAOB inspections first came to a head after systemic fraud was revealed in Chinese companies that had accessed U.S. markets via reverse merger. Oftentimes these were shell companies without any actual operations. Even the most cursory oversight would have prevented many of these companies from defrauding investors. In the wake of the reverse merger wave, there was a huge outcry from investors to have more oversight of Chinese firms. The CCP flatly refused.

Impotence in the Face of CCP Defiance

By 2012, concerns over the lack of oversight were coming to a head. The SEC sued the Big Four affiliates in China for their refusal to hand over their work papers for inspection. However, the affiliates had never promised to hand over their work papers for inspection because it is the policy of the CCP that these papers were “state secrets.”

Westerners may have scoffed at this idea, but for an authoritarian regime like the CCP, all information is the state’s business. The CCP will never permit accurate and truthful numbers to be recorded and transmitted to its own people and to the West; even something as innocuous as a balance sheet can cause a revolution because truth always poses a danger to propagandists.

The SEC and PCAOB did not have the clout to force the CCP to change its position, which left them with a dilemma. Either they could take decisive action and potentially delist all the Chinese companies listed on the U.S. exchanges and deprive every multinational company of the ability to have its Chinese operations audited by a registered affiliate, or they could largely give in while making a few face-saving gestures.

The SEC gave in. No one should have been surprised either, the public policy implications of enforcing the rules were too broad. Decisions concerning international relations are public policy decisions that require leadership in Washington. The administration at that time had expressed support for closer investment links with China, rendering untenable any course of action that would have alienated the CCP. So, the SEC settled their case for $2 million and the PCAOB signed a Memorandum of Understanding that allowed Chinese firms to register in exchange for vague promises.

Unsurprisingly, those vague promises never amounted to anything. Recently, with the new administration, the SEC and the PCAOB seemed to be more willing to discuss their concerns with China. They issued a joint statement warning investors that Chinese firms were not subject to proper oversight, but failed to full explain the issues involved or do anything to correct the problem. This Caveat Emptor attitude is incongruous with current American customs and law, since economic liberalism and the robber barons it spawned have been confined to the dustbin of history.

So, for several years Chinese audit firms have been permitted to register with the PCAOB, even though they are not subject to inspections. This has worked well for Chinese companies, who get a premium price for listing on U.S. exchanges, and it has worked well for Chinese audit firms who register with the PCAOB since they also can charge a premium. Whenever a fraud is revealed, individual investors are left holding the bag.

Without leadership from Washington on this issue, nothing could change. There had been some talk over the years, but it had not yielded any fruit. For example, Sen. Marco Rubio touted the EQUITABLE Act last year, a bill he introduced that would have potentially delisted Chinese companies if their auditors were not subject to inspection. But the bill languished.

The one small step that SEC and the PCAOB took after the Luckin story broke was to require companies in China to disclose the fact that their auditors are not subject to inspections by the PCAOB in all relevant financial statements. Buyer Beware.

Leadership in Washington?

That changed in May, when the Senate unanimously passed a bill that would delist Chinese companies unless the CCP permits the PCAOB to oversee their auditors. Frankly, we were shocked when this bill was passed because it takes real steps to address a real problem.

It seemed this bill passed because of the confluence of two stories: first, the emergence of the coronavirus from Wuhan coupled with credible reports that the CCP’s lies had made the impact of the virus worse, and second, the disclosure of a massive fraud at Luckin. Public opinion turned decisively against China, creating the perfect environment for this bill to pass.

It is unclear if this ostensibly bipartisan bill will be introduced and passed in the House of Representatives. The moment has passed. Reports on riots have finally displaced the unceasing coverage of the coronavirus which had monopolized the airwaves for months. The CCP looks as if it will arrest Charles Lu, the chairman and founder of Luckin, since people were not satisfied with the COO as a scapegoat (nor with the CEO who was served up a month later).

There is a powerful lobby that would like to see this bill scrapped, or at least neutered either in its final form or its enforcement. Many investors know that the CCP will not budge on this issue, but they are guessing that Washington will fold. If there is a change in the White House in November it is unlikely that this bill, and the hardline on the CCP that it represents, will last.

Issue Unaddressed by the Bill

This bill may be helpful for investors, but it omits a crucially important issue. Francine Mckenna, an independent reporter whose work is now available on The Dig, has pointed out more than once that multinational companies like Pfizer and Walmart rely on Chinese audit firms to conduct the audits of their Chinese operations. This means that there are potential blind-spots in the audits of some of the biggest and most important companies in the world.

Concerns about the Chinese operations of multinational companies are warranted, and the senate bill does nothing to address that issue. However, this problem may already have an informal albeit makeshift solution. Even though the Chinese audit firms are supposed to do everything locally, it is likely that they consult with their U.S. counterparts when doing a multinational audit. This probably allows the Big Four to exercise some influence over their foreign affiliates in China, even if the official story is that no “sensitive” work-papers ever cross borders.

Conclusion

Shockingly, the Senate has passed a bill that could actually protect investors. However, there is undoubtedly pressure from pro-China lobbyists to scrap the essence of the bill in exchange for some token victory. This victory could be the arrest of Charles Lu or perhaps some “corrupt” CCP officials who supported him.

Even if the bill passes, it may not have the effect intended. Chinese companies incorporated in the U.S. or in Tax Havens and only attached to the Chinese operations through contractual agreements (most “Chinese” companies already have one of these “VIE” arrangements) may be permitted to stay on the exchanges without any PCAOB oversight of their auditors.

If the U.S. wants to really ensure that Chinese companies have proper oversight, Washington must continue to lead and show resolve. However, the stories that drove the passage of this bill are already fading from memory and Washington is a place where resolve is in short supply…

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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