In January 2020, China-based Luckin Coffee was riding high. Established just three years earlier, Luckin Coffee had grown to have more coffee shops in China than Starbucks, and its stock traded on the Nasdaq exchange at just over $50 per share. But by April 2020, it all came crashing down. At that time, Luckin Coffee announced that it had fabricated $310 million of sales during three quarters in 2019—over 40% of its revenue during that period. Soon after, Luckin’s stock price plummeted, executives were fired, and the Nasdaq soon de-listed its shares. Luckin Coffee is but one of several major accounting scandals affecting Chinese companies in recent years.
In the wake of these scandals, China last year adopted new procedures meant to expand the ability of investors to file group or representative litigation in Chinese courts. China’s National People’s Congress adopted new revisions to its securities laws that took effect in March 2020, and in July 2020 the Supreme People’s Court of China issued the Provisions on Issues of Representative Securities Litigation, which interpreted and implemented the new legislation.
The revised law establishes two types of representative actions that investors may bring based on misrepresentations, market manipulation, or insider trading: Ordinary Representative Litigation and Special Representative Litigation. According to Chinese authorities, the new representative action procedures are aimed at protecting individual investors in China with small to medium volume investments. By some estimates, upwards of 95% of investors in China fit into this category. Thus, Chinese courts have reduced certain fees for bringing representative securities actions and instituted other procedures to make bringing these types of actions more convenient and less costly for individual investors.
Importantly, Special Representative Litigation is based on an “opt-out” participation model, where investors are included in the action unless they actively opt out or withdraw from the litigation. But, as discussed below, Special Representative Litigation appears to operate much differently than a U.S.-style opt-out class action.
Ordinary vs. Special Representative Litigation
Ordinary Representative Litigation is based on an “opt-in” model and must meet three criteria. First, claimant (i.e., plaintiff) groups bringing this type of litigation must number at least 10 persons, and the dispute the claimants want to bring against the defendant must be of the same subject matter. Second, two to five claimants must be elected as representatives of the claimant group. Third, the claimants must submit prima facie evidence of unlawful conduct. Examples provided of evidence that would meet this requirement include an administrative punishment decision, a criminal judgment, an admission by the defendant, or disciplinary punishment by a stock exchange.
The provisions for Ordinary Representative Litigation allow for notice to be provided by the Chinese court and a period of time for investors to register to be part of the litigation. As is typical of opt-in litigation, those who register for the case will be bound by the court’s decisions and will be able to benefit from a monetary recovery, while those who do not register will not.
Special Representative Litigation is based on an “opt-out” model, but works differently than class actions in the U.S. In China, Special Representative Litigation is brought only by certain investor-protection institutions who have been given a mandate by at least 50 investors to pursue claims. Currently, there are apparently only two investor-protection institutions authorized to bring these types of actions—China Securities Investor Service and China Securities Investor Protection Fund Corporation Limited—both of which are affiliated with the Chinese government. The investor-protection institution acts on behalf of all aggrieved investors unless an investor affirmatively opts out or withdraws from the litigation. At least one commentator has noted that the Special Representative Litigation appears more akin to the collective securities actions in the Netherlands, where certain investor-led institutions, called foundations, can bring claims on behalf of other investors. But there, investors have more freedom in establishing foundations, while in China, it appears that only certain government-sponsored institutions can prosecute group litigation on an opt-out basis.
Impact on U.S-based Investors Remains Unclear
For investors in the U.S. who may have investments in Chinese companies, it remains to be seen whether these new procedures for representative actions will have much impact. Several questions remain unanswered, including whether Special Representative Litigation will be aggressively pursued by the state-controlled investor-protection institutions, or whether such litigation will be rare. We will learn more as cases are prosecuted under this new legal regime.