Luckin Coffee fraud has big implications for Chinese US-listed brands

Luckin Coffee’s share price dropped more than 80% at the beginning of April 2020 after the company issued findings from an internal investigation uncovering RMB2.2 billion (US $311 million) in fabricated sales from the second to the final quarter last year.

The spectacular fallout of a Chinese company that had recently been valued at $4 billion will have wider and long-term ramifications, experts claim. The coffee chain's explosive growth has long been celebrated by many marketing and CX experts as evidence of a Chinese brand succeeding through digital innovation and by putting customer service and convenience first.  Fewer observers outside of the financial analyst community have pointed out its cash-burning ways. 

“One rotten apple is ruining a whole barrel,” Haitong’s analyst wrote in a briefing to investors. “All the Chinese companies listed in the US will likely suffer collateral damage.” As one of Luckin Coffee’s four IPO underwriters, Haitong initiated an internal investigation into the matter, according to an executive at the bank speaking on grounds of anonymity to FinanceAsia.

The analyst was referring to Chinese American depositary receipt (ADRs), certificates issued by a US bank that represents shares in foreign companies and trades on exchanges. Chinese ADRs were already facing weak investor demand, with only six out of 34 companies listed in 2019 still above their IPO price, according to Bloomberg data.

The Luckin Coffee news has also potentially exposed more rotten eggs. TAL Education, an education service provided, subsequently admitted it had previously fabricated sales. China streaming platform iQiyi has also been accused of fraud by short seller Wolfpack Research, but has described the  report as "unsubstantiated" and "misleading". 

Due diligence demand

At the heart of the issue is the capacity for investors, and the infrastructure that supports them, to do their homework. Better rules that allow more independent auditors to operate freely in China is necessary, particularly if the capital markets are to further open and win international investor trust.

“Sometimes it is hard to verify authenticity only by reviewing documentation,” Keith Williamson, managing director of Alvarez & Marsal told FinanceAsia. “Especially under the current situation when everyone is working from home. Investors should be wary, thinking about the best way to check due diligence. It is always better to get full access to all the records.”

Luckin Coffee’s behavior only goes to back up the growing bipartisan support for nations to “strengthen regulation on Chinese companies”, said Chesley Tam, a Morningstar analyst speaking on a conference call when responding to question about Luckin Coffee.

Particularly as market valuations are coming down, “we have seen increasing concerns about corporate governance in China,” Tam continued.

At a regular Luckin coffee shop in Nanjing, customers display freshly purchased luckin coffee drinks on April 3, 2020. Source: Getty Images

Muddying the waters

Sales accountability at Luckin Coffee surfaced back in January 2020 when Muddy Waters, a Chinese company due diligence research house and short seller, cited a third-party report highlighting operational irregularities in the business. At the time of the announcement, management at Luckin Coffee brushed off the report and although its stock price fell in late January, with the price rallying in February, investors didn’t appear immediately bothered.

Muddy Waters founder Carson Block said on CNBC that “this is again a wake-up call for US policymakers, regulators, and investors about the extreme fraud risk China-based companies pose to our markets”.

China’s regulators are also unhappy. The China Securities Regulatory Commission issued a rare notice on April 3 condemning the Luckin Coffee fraud. A month prior it updated its securities law, under which Luckin Coffee could face lawsuits from Chinese investors to compensate for the loss after the short report was published.

“For those bookrunners, auditors and lawyers [working for a fraudulent company], the reputational damage can [be more painful] than a penalty from the regulators,” one Beijing-based compliance lawyer told FinanceAsia.

This article has been edited from its original publication in FinanceAsia