April's been a tough month for Luckin Coffee (NASDAQ:LK). The Chinese coffee company's stock plunged on April 2 in light of an internal investigation into allegations of fraudulently fabricated transactions that involved a huge portion of its revenue during the last nine months of 2019. The share price remains more than 80% below where it traded on April 1.
In the wake of that scandal, Luckin is facing another challenge. Many law firms have sought to file suits against the coffee maker, making allegations of their own. With so much new litigation pending, it's natural for Luckin shareholders to be worried about the lawsuits. However, experienced investors know that lawsuits like this often pop up when a company faces a controversial situation.
The onslaught against Luckin Coffee
The press releases that law firms make in pursuing suits against companies are designed to get your attention:
- Luckin Coffee Stock Plummets; Securities Fraud Suit Deadline Next Week
- Luckin Coffee Shareholder Alert: Law Firm Investigating Claims on Behalf of Luckin Investors, Shareholders Encouraged to Submit Information to Learn More
- Luckin Case Expanded to Include IPO, SPO, and Other Purchasers; Investors With Losses in Excess of $100K Should Contact Firm
In all, dozens of different law firms are planning to file lawsuits against Luckin, and they're all looking for shareholders who've suffered losses from owning the stock.
2 choices for would-be plaintiffs
The common thread that all of these lawsuits have is that they're trying to recover damages suffered by shareholders. Plaintiffs have two main choices in these situations: they can become part of a broader class action, or they can file a shareholder derivative lawsuit on behalf of the corporation whose shares they own.
Most of the lawsuits against Luckin Coffee right now take the class action approach. They include allegations that the company itself withheld material information from investors that led them to buy shares that weren't actually worth as much as investors thought they were. Lawsuits like this have actually been pending ever since allegations of fraud cited by the research company Muddy Waters surfaced back in January, but the subsequent investigation has only added fuel to the fire.
The other choice plaintiffs could make is to file shareholder derivative lawsuits against third-party defendants on behalf of Luckin. To do so, shareholders would have to demonstrate that Luckin was refusing to take action against the third party -- in this case, probably suspended COO Jian Liu -- and that the shareholders were therefore forced to take action themselves.
Typically, financial realities define the best course of action. If a potential third-party defendant like Jian Liu has enough financial assets to allow for shareholders to collect a substantial amount, then a derivative lawsuit makes more sense. But if the third parties lack the resources to pay a verdict or settlement, then a class action against the company itself is the more common course.
The biggest problem with class action lawsuits
Yet class action lawsuits involving shareholders and companies have their own problems. Because the value of the shareholders' stock relies on the assets that the company has, winning a judgment against the company essentially takes money out of one pocket and moves it to the other pocket. For instance, if a company loses a class action and has to pay out all of its cash, then shareholders received payment for a portion of their damages -- but the value of the shares they might still own should go down by the amount of the payment.
In fact, shareholders as a group often suffer a net loss from the litigation. That's because law firms take a significant portion of the damage awards, essentially siphoning off shareholder value away from the company and its investors.
With the allegations against Luckin Coffee, you're likely to see higher concerns of fraud among Chinese stocks, and that could lead to greater amounts of litigation across the sector. But if you see a group of law firms asking shareholders to sign up for a class action lawsuit, you shouldn't take it the same way you would other types of suits. Class actions like this are extremely common, and you're likely to see them just about any time the price of your stock drops significantly.