Circuit breaker! Luckin Coffee plunges 78%, why did it "self-expose" 2.2 billion yuan in financial fraud?

  Luckin's "self-exposure" shocked the industry.

Yesterday (April 2), US-listed company Luckin Coffee announced that after issues were discovered during the audit of its 2019 annual report, the board of directors established a special investigation committee. The committee found that between the second and fourth quarters of 2019, the company fabricated 2.2 billion yuan in transaction volume, with related costs and expenses correspondingly inflated.
 

Luckin Coffee shocked everyone by publicly "self-exposing" its financial fraud. Its stock price plummeted 75.6% that day, and its market value shrank to $1.6 billion.

The signs seemed to have been there all along. Two months ago, Muddy Waters Research, a short-selling firm that strikes fear into the hearts of many China-concept stocks, publicly released an anonymous short report accusing Luckin Coffee of financial fraud, alleging that its store sales, product prices, advertising expenses, and net revenue from other products were all exaggerated, and that Luckin’s store operating profit in the third quarter of 2019 was overstated by 397 million yuan.
 

However, at that time, Luckin Coffee issued an announcement on the SEC's official website firmly denying all allegations in the report, stating that the report was based on unfounded speculation and malicious interpretation of events.

Since its establishment in 2017, controversy has followed this company every step of the way. It has been questioned for burning cash on subsidies and for a business model deemed unsustainable, yet in just two short years, it raised over US$1 billion in funding, opened more than 4,500 coffee stores, and set the record for the fastest IPO by a Chinese concept stock.
 

Why would such a star company air its own dirty laundry? Who deliberately shorted and investigated Luckin after the fraud came to light? Who is the mastermind behind this scam? And what does the future hold for Luckin?
 

Ran Finance interviewed over a dozen insiders and professionals to reveal the full story of how Luckin Coffee's financial fraud came to light.

 Why did Luckin Coffee “self-expose”?

In hindsight, the mysterious short-selling report from two months ago did not bring Luckin down completely, but it was the trigger for Luckin's "self-exposure."

Exactly two months passed between Muddy Waters releasing the short report and Luckin admitting to fraud. During these two months, three extremely important events occurred.

First, class-action lawsuits. As the stock price fell, investors suffered losses, and several law firms began initiating class-action proceedings against Luckin.

Second, it coincided with financial reporting season. Starting at the end of February, Chinese concept stock companies began disclosing their financial reports for the fourth quarter of 2019 and the full year of 2019. Before Luckin's self-exposure, most Chinese concept stocks had already completed their financial disclosures, but Luckin had yet to disclose its reports.

Third, the change of independent directors. On April 2, Luckin established a special committee and added two independent directors, one from FTI, a well-known investigative auditing firm in the industry, and the other from Kirkland & Ellis, a world-class prestigious litigation law firm.

 Let's sort out the timeline of the entire incident:

· In the early hours of Friday, February 1, Muddy Waters released a short-selling report, and Luckin's stock price fell by as much as 26.5% during intraday trading.

· On the evening of February 3 (Monday), Luckin issued a public response with the SEC, firmly denying all allegations.

· Starting from February 4, Luckin's stock price began to recover day by day, and by February 10, it had returned to the level before the short-selling attack.

· On February 5, some US law firms began to initiate a class action lawsuit against Luckin.

Starting February 10, Luckin issued 15 consecutive important announcements regarding "disclosure of holdings exceeding 5%," involving shareholder equity matters.

· On March 27, Luckin announced the appointment of two new independent directors, with Liu Erhai stepping down from the audit committee.

On April 2, Luckin established a "Special Committee" to initiate an internal investigation and "self-exposed" that the company had committed 2.2 billion yuan in financial fraud. Luckin's stock price plummeted 75% overnight.

A managing director at an international investment bank told Ran Caijing that Luckin Coffee's "self-exposure" was a chain reaction after being targeted by short sellers. Because Luckin had previously been shorted, a short-selling fund took it to court. In accordance with U.S. Securities and Exchange Commission requirements, Luckin had to establish a special committee to conduct a self-inspection, which then uncovered the shocking fraud case involving 2.2 billion yuan.

"The United States uses the class action system to let the public monitor listed companies. After a short-selling report is released, the U.S. Securities and Exchange Commission will require the company to make a public response or initiate an investigation," said the aforementioned investment bank director.

Interestingly, the timing of the short-selling report coincided with the eve of the earnings disclosure season.

A CEO of an asset management company who has long studied US stocks told Ran Caijing, "Luckin Coffee was forced to self-expose because its annual report audit ran into problems. If it fails to submit the audited annual report on time, it will directly lead to delisting. Now that the problem has been discovered, if handled properly, the worst outcome may still be avoided."

Ni Fuhua, a senior lawyer and member of the International Investment Business Committee of the Shanghai Bar Association, and Feng Bin, founder of PiCapital, which specializes in research on China concept stocks, said in a joint interview with Ran Caijing that the two grounds for the class action against Luckin Coffee are misstatement and omission of material fact. For omission, the constituent elements are having a disclosure obligation but failing to disclose, which may mislead investors. This is also why Luckin disclosed the fact immediately after discovering the fraudulent behavior. Such an act is also a legal measure to reduce its future liability.

In the short-selling report released on February 1, Luckin was accused of financial fraud, with store sales, product prices, advertising expenses, and net revenue from other products all being exaggerated. In the third quarter of 2019, Luckin's store operating profit was overstated by 397 million yuan.

Although Luckin denied everything in its response to the SEC, the upcoming fourth-quarter earnings report will serve as compelling evidence to determine who is lying.

However, before investors could get their hands on this financial report, Luckin had already initiated a self-investigation procedure, and a special ad hoc body——the Special Committee——was established.

The body is composed of three independent directors, two of whom joined on March 27 and one on April 2. All three are members of the audit committee, following the recent resignation of Liu Erhai, founder of Joy Capital, from his position on the audit committee.

Many people have speculated about the timing of Liu Erhai's resignation. In response, Joy Capital told Ran Caijing that Liu Erhai's departure is a normal board reshuffle carried out in accordance with Securities Law requirements after his one-year term. In addition, Joy Capital also stated that it has not sold any Luckin Coffee shares to date.

An investment banking professional stated, "Under U.S. securities regulations, it is the responsibility of listed companies to ensure their own legal and regulatory compliance. In U.S.-listed companies, power is structured as a series of checks and balances: auditors oversee accounting, and independent directors oversee executive directors. Therefore, in this case, it is Luckin Coffee itself that has hired an external institution to audit its own operations."

The Special Committee brought to the Board's attention that, beginning in the second quarter of 2019, the Company's COO and Director Jian Liu, along with several of his subordinates, were allegedly engaged in misconduct involving fabricated transactions, and that the total sales amount associated with the fabricated transactions from the second quarter of 2019 to the fourth quarter of 2019 was approximately RMB 2.2 billion. During this period, certain costs and expenses were also substantially inflated as a result of the fabricated transactions.

Luckin Coffee went public on May 17, 2019. This means that most of the sales data after Luckin Coffee's IPO was fabricated.

"Once a company commits fraud, either the executive director or the independent director will be penalized. To avoid liability for inadequate oversight, the independent director must shift the responsibility for the fraud onto the executive director. If the independent director does not engage an institution to investigate the executive director, the executive director can argue in court that the independent director failed in oversight, and the independent director will then need to compensate the victims," said an industry insider.

Thus, before the financial report was disclosed, Luckin initiated a "self-exposure" process. A special committee composed of three independent directors exposed Luckin's previous response to the short-selling report. Luckin's financial fraud officially surfaced. (This part is sourced from Ran Finance, original title "A Thorough Investigation of Luckin Coffee's 2.2 Billion Yuan Fraud")

 A lawyer from Guangdong Zhiming Law Firm stated,Under U.S. law, investors who purchased stocks based on reliance on the information disclosed by listed companies can file civil lawsuits against the stock issuer. At the same time, Luckin Coffee's provision of false financial reports and intentional securities fraud are likely to be investigated by the U.S. Department of Justice, and key personnel involved in the fraud may also face criminal charges.

 Even if Luckin is listed overseas, it may still be held accountable within China.

Under the new Securities Law, “where securities offering and trading activities outside the territory of the People’s Republic of China disrupt the market order within the territory of the People’s Republic of China and harm the lawful rights and interests of domestic investors, they shall be handled and legal liability shall be pursued in accordance with the relevant provisions of this Law.”

If domestic investors were misled by Luckin Coffee into participating in investments and suffered losses, Luckin Coffee may be held legally liable for this.

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