Chinese State Capitalism and the Holding Foreign Companies Accountable Act

In an age of unicorns that “[m]ove fast and break things,”1Chinese startup Luckin Coffee Inc. (“Luckin Coffee” or “Luckin”) moved at exceptional speed. Founded in October 2017, the Chinese Starbucks-equivalent2 grew from a single Beijing location to nearly 4,400 self-operated stores, over 1,600 partnership stores, and about 1,100 Luckin Coffee “EXPRESS” machines in over 220 cities in China by the end of 2021.3 Yet while the company was achieving tremendous growth—quickly overtaking Starbucks as the leading coffee chain in China—company management attempted to make the company appear even more successful through a series of fraudulent financial statements. Among other things, company executives created a “fake operations database,” altered bank records, and engaged in sham sales designed to create the appearance of faster growth, while simultaneously hiding their misconduct from regulators and their own finance department.4 The company overstated its revenues by 27% in the second quarter of 2019, and by 45% in the third quarter of 2019, while also understating its net losses for those quarters by 15% and 34%, respectively.5

Luckin provided these false statements in earnings calls with investors and in filings with the U.S. Securities and Exchange Commission (“SEC”), including offering documents for its 2020 initial public offering of $418 million in stock and its convertible bond issuance of $446.7 million.6 However, some investors were suspicious, and a “cryptic email” sent to numerous short sellers in January, 2020, warned that a “new generation of Chinese Fraud 2.0 has emerged,” with “[c]ompanies that start off as fundamentally and structurally flawed business model [sic] that evolves into fraud.”7 The email offered to share customer receipts and videos from Luckin locations, and included an eighty-nine-page report about the company that the anonymous sender suggested could be published under the name of one of the short sellers. Carson Block, an investor and founder of Muddy Waters LLC, posted the report on Twitter on January 31, 2020.8

The stock price hardly moved after the posting, with much of the information in the report seemingly having already been impounded into the market price before it was broadly disseminated. But the stock took a tumble several weeks later as new information emerged and the full extent of the scandal began to take shape. Among other things, investigations later revealed that Luckin executives engaged in conflicted transactions, such as the sale of vouchers for tens of millions of cups of coffee to companies tied to Luckin’s controlling shareholder and chairman, Charles Lu.9

Luckin Coffee’s fraud was a large but not unusual kind of corporate scandal. Similar (and even larger) accounting scandals contributed to the bursting of the Dot-Com Bubble in 2000, including frauds at HealthSouth, Tyco, WorldCom, and Enron. As a result of these scandals, Congress passed the Sarbanes-Oxley Act of 2002,10 which imposed a series of measures designed to ensure that corporate financial statements are accurate and fairly present the financial position of the company. Part of these regulations included the creation of a new quasi-governmental regulator, the Public Company Accounting Oversight Board (“PCAOB”),11 which was designed to scrutinize the auditors who themselves scrutinize the financial statements of public companies. For the PCAOB to properly perform its work in protecting against accounting frauds, it must have access to the information that the auditors used to perform their audits.

The PCAOB’s access requirement brings the PCAOB in conflict with recently enacted Chinese law and policy, which not only limits what Chinese companies can share with external parties but also formally prohibits their cooperation with the PCAOB.12 In response to China upping the ante in a high-stakes game of sovereignty over financial regulation, the United States recently played its strongest hand: the SEC, at the direction of Congress, blacklisted Chinese companies listed on U.S. securities exchanges, threatening them with expulsion from U.S. securities markets unless the Chinese government allows access to the PCAOB. The blacklisting regulation, promulgated under the Holding Foreign Companies Accountable Act (“HFCAA” or “the Act”), includes not only suspect companies like Luckin Coffee but also any company headquartered in China and operating under Chinese law. Further, preventing accounting fraud is only part of the purpose of the HFCAA, and a fulsome understanding of the Act requires consideration of the political, economic, and regulatory context from which the Act emerged.

The HFCAA gambit seems to have been successful, as Chinese regulators recently agreed to allow PCAOB officials review audit records in Hong Kong—though some practitioners are skeptical that the agreement reached between Chinese and U.S. regulators will ultimately hold.13 Much is at stake because, while the HFCAA helps protect investors against accounting frauds of the type Luckin is alleged to have committed, the effects of the Act are subtler and more far-reaching, and the Act’s purpose in blacklisting foreign companies is as much (if not more) about foreign policy as it is about investor protection.

This Essay examines market blacklisting—a term the Essay uses to describe extraordinary government restrictions that limit a corporation’s ability to trade freely in U.S. markets—as a regulatory tool used to deny the benefits of U.S. markets to Chinese firms. Analyzing and recharacterizing the recently enacted HFCAA as a foreign-policy-oriented regulation, this Essay argues that jarring and serious accounting frauds such as Luckin’s are not the most important—or even primary—target of the Act. While capital markets blacklisting operates in opposition to the traditionally open posture of U.S. financial markets, blacklisting can also serve to achieve strategic foreign policy goals. In particular, the passage of the HFCAA demonstrates that, in response to recent Chinese investment activity, the United States increasingly considers its financial markets as a rivalrous national resource and is becoming less willing to share that resource with its greatest economic competitor.


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