Before a company offers its stock to the public in an IPO, it is supposed to undergo an extensive vetting process. Part of this process is called underwriting, and it involves having investment banks act as intermediaries between the company and the public. The investment bankers conduct a substantial factual investigation of the company and its prospectus so that it can accurately price the stock.
The underwriters for Luckin’s IPO were Credit Suisse, Morgan Stanley, China International Capital and Haitong. This consortium of influential investment banks certainly had the resources to conduct a proper investigation of Luckin, but did they?
Less than a year after its IPO, Luckin Coffee revealed a massive fraud that implicated its COO, CEO, and its founder and Chairman. It is unclear just when this fraud began, but a WSJ investigation found evidence of fraudulent transactions predating the IPO by at least a month. This means that it is likely that Luckin was fabricating numbers while the underwriters were still supposed to be conducting their investigation.
You might think that the revelation of this fraud would spell bad news for the consortium of banks which underwrote the false prospectus, but that is probably not true. Generally, when plaintiffs pursue a securities fraud case they rely on Section 240.10b-5. However, the Supreme Court’s decisions over the years have neutered this as a private cause of action against defendants who are considered “aiders and abettors” to fraud, like investment banks.
Effectively Immune from Private Suit?
Underwriters received a boon from the Supreme Court in Central Bank v. First Interstate, 511, U.S. 164 (1994), when it decided that civil liability did not extend to “aiders and abettors” of fraud in the sales of securities (ending decades of tradition to the contrary). This decision was reinforced by Stoneridge Investment Partners v. Scientific-Atlanta, 552 U.S. 148 (2008) by holding that third parties are not liable for participating in corporate wrongdoing if they did not directly mislead investors.
These Supreme Court decisions have provided underwriters effective immunity from many securities lawsuits. This creates a moral hazard that encourages carelessness on the part of the underwriters because they do not bear the costs if their clients commit fraud.
One of the most significant results from the Central Bank and Stoneridge was the result in California Regents v. Merrill Lynch. In that suit, the Enron shareholders sued Merrill Lynch for assisting Enron in cooking the books by disguising loans as purchases so that executives at Enron would hit certain benchmarks for their compensation. The 5th Circuit dismissed the suit because Merrill Lynch and the other investment banks did not have a duty to investors and had made no false statements directly to investors. The Supreme Court denied certiorari, thereby ensuring that Enron’s investors were left holding the bag.
The Supreme Court went even further in Janus Capital Group, Inc. v. First Derivative Traders, 564 U. S. 135 (2011) to hold that a party does not “make” a statement unless they have ultimate authority over that statement. This would appear to have created an airtight defense for underwriters and other potential aiders and abettors for securities fraud under rule 10b-5. These legal protections create troubling incentives that undermine the underwriter’s role as gatekeepers for the capital markets.
However, recently the water has been muddied. In SEC v. Tambone, 550 F. 3d 106 (1st Cir. 2008), the first circuit held that underwriters can be held responsible for making false statements in the prospectus by implication because their duty to investigate the company and verify the facts in the prospectus. In Lorenzo v. SEC, (2018), the Supreme Court contradicted earlier decisions by deciding that persons did not need to make false statements, so long as they participated in the fraud “scheme.” Some enterprising plaintiff’s attorney could attempt to bring a case under Section 10-b5 against the banking consortium by arguing either an implied misstatement of fact via Tambone, or “scheme” via Lorenzo, but the odds would be stacked against them.
The 1933 Securities Act does allow underwriters to be sued in a private cause of action for false statements under a different section, but those claims are different, and the underwriters can raise “due diligence” as a complete defense.
The Due Diligence Standard
If the consortium can show they took “reasonable care” and conducted a reasonable investigation of Luckin, then they will have a complete defense. Determining whether the consortium actually exercised due diligence would be a fact-intensive inquiry, with the consortium providing pallets of documents supporting their contention that the investigation was reasonable. But at its core, due diligence requires independent verification, and it is hard to imagine the banking consortium truly verified the information in the prospectus in such a massive fraud.
The underwriters should rely on experts, like auditors, but they should not take an auditor’s report at face value. In an article on the topic posted to FindLaw, the authors make this point:
“Underwriters should … carefully scrutinize the auditor’s report and letters to management to determine whether potential problem areas were uncovered during the audit. Moreover, underwriters should look at general financial issues – including profits and revenue, budget concerns and the internal audit controls the issuer has in place – to reach a sufficient comfort level with the issuer’s overall financial condition. “
It will be interesting to see if substance will triumph over style in a court’s analysis of the consortium’s due diligence. Another wrinkle for potential litigation is that many of the events occurred in China, so a proper fact-finding investigation may not even be feasible.
It is concerning that the WSJ’s investigation uncovered fraudulent transactions prior to the IPO as well as a web of related party transactions revolving around Charles Lu. The underwriters could also potentially have discovered this information before signing off on the prospectus.
SEC is Last Line of Defense
The SEC has declared an investigation into Luckin’s fraud, and they might take a look at the banking consortium’s due diligence practices. One thing to note is that the SEC can bring a 10b-5 case against an entity that aids and abets a fraud. The publicity surrounding this case and the SEC investigation into Luckin raises the possibility that Credit Suisse and Morgan could be charged with aiding and abetting Luckin’s fraud, but once again a lack of information coming out of China may hamper any investigation.
The underwriters for Luckin’s stock will probably be sued because there is nowhere else for the defrauded investors to make a recovery. If there is a case, it will revolve around the idea of due diligence and we will see if substance triumphs over style in the analysis.
But this may be a chance for something bigger. The Supreme Court could get a chance to walk back its maligned Stonebridge decision. Something must be done to change the incentives at play here for the big investment banks, because if the incentives don’t change, regular people will continue to pay the price.
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