Circuit breaker! Luckin Coffee plummets 78%, why did it "self-destruct" by revealing 2.2 billion in financial fraud?

　　 Luckin Coffee's "self-exposure" shocks the industry.

Yesterday (April 2), Luckin Coffee, a U.S.-listed company, announced that after discovering issues during the audit of its 2019 annual report, the board established a special investigation committee. The committee found that the company fabricated 2.2 billion yuan in transaction amounts from the second to the fourth quarter of 2019, with related costs and expenses also inflated accordingly.
 

By publicly "self-exposing" financial fraud, Luckin Coffee stunned everyone. Its stock price plummeted 75.6% that day, reducing its market value to $1.6 billion.

Signs of trouble seemed to have emerged earlier. Two months ago, Muddy Waters Research, a short-selling firm that strikes fear into many Chinese concept stocks, released an anonymous short-seller report accusing Luckin Coffee of financial fraud, alleging that store sales, product prices, advertising expenses, and net revenue from other products were inflated, with the company's third-quarter 2019 store operating profit exaggerated by 397 million yuan.
 

However, at that time, Luckin Coffee issued a statement on the SEC website firmly denying all allegations in the report, calling it based on baseless speculation and malicious interpretation of events.

Since its founding in 2017, controversy has followed the company. It has been criticized for burning cash on subsidies and having an unsustainable business model, yet within just two years, it raised over $1 billion, opened more than 4,500 coffee stores, and set the record for the fastest IPO among Chinese concept stocks.
 

Why would such a star company expose its own "dirty laundry"? Behind the exposure of fraudulent practices, who is deliberately shorting and investigating Luckin? Who is the mastermind behind this scam? 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 "self-destruct"?

Looking back now, the mysterious short report from two months ago did not completely bring down Luckin, but it was the spark that triggered its "self-destruction."

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 the earnings reporting season. Starting at the end of February, Chinese concept stocks began disclosing their Q4 2019 and full-year 2019 financial reports. Before Luckin's self-disclosure, most Chinese concept stocks had already completed their earnings reports, but Luckin had yet to disclose.

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

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

· At 1:00 AM on February 1 (Friday), Muddy Waters released a short-selling report, and Luckin's stock price fell by up to 26.5% during trading.

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

· Starting February 4, Luckin's stock price gradually recovered, and by February 10, it had returned to its pre-short-selling level.

· On February 5, some U.S. law firms began initiating class-action lawsuits against Luckin Coffee.

· Starting February 10, Luckin issued 15 consecutive major announcements of "over 5% disclosure," involving shareholder equity matters.

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

· On April 2, Luckin established a "special committee" to launch an internal investigation, "self-disclosing" that the company had 2.2 billion yuan in financial fraud, causing Luckin's stock price to plummet 75% overnight.

· A director from an international investment bank told Rancaijing that Luckin's "self-disclosure" was a chain reaction after being shorted. Because Luckin had been shorted before, a short-selling fund took it to court. As required by the U.S. Securities and Exchange Commission, Luckin had to set up a special committee for self-investigation, which uncovered the shocking 2.2 billion yuan fraud case.

· "The U.S. uses class-action lawsuits to allow the public to monitor listed companies. After a short-selling report is released, the SEC will require the company to respond with an announcement or launch an investigation," the investment bank director said.

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 U.S. stocks told Burning Finance, "Luckin Coffee was forced to self-disclose because of issues with its annual audit. If it fails to submit the audited annual report on time, it could directly lead to delisting. Now that the problem has been identified, if properly resolved, the worst outcome might still be avoided."

Ni Fuhua, a senior lawyer and member of the Shanghai Bar Association's International Investment Business Committee, and Feng Bin, founder of PiNan PiCapital, which specializes in Chinese concept stocks, said in a joint interview with Burning Finance that the two grounds for the class action lawsuit against Luckin Coffee are misstatement and omission of material fact. Regarding omission, the key element is a failure to disclose when there is a duty to do so, which may mislead investors. This is why Luckin disclosed the fraud immediately after discovering it. Such an action is also a legal measure to reduce its future liability.

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

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

However, before investors could see that earnings report, Luckin had already initiated an internal investigation, establishing a special temporary body—the Special Committee.

This committee consists 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 resignation of Joy Capital founder Liu Erhai from his position on the audit committee.

Many have speculated about the timing of Liu Erhai's resignation. In response, Joy Capital told Burning Finance that Liu Erhai's term had reached one year, and his resignation was a routine rotation required by securities law. Additionally, Joy Capital stated that it has not sold any Luckin Coffee shares to date.

A banking professional said, "According to U.S. securities regulations, listed companies are responsible for their own legal compliance. In U.S.-listed companies, power is interconnected: audits oversee accounting, and independent directors oversee executive directors. So, this time, Luckin itself hired an external firm to investigate itself."

The special committee informed the board that starting from the second quarter of 2019, the company's COO and director Liu Jian, along with several of his subordinates, were suspected of engaging in misconduct involving fabricated transactions. From the second quarter of 2019 to the fourth quarter of 2019, the total sales amount related to false transactions was approximately RMB 2.2 billion. During this period, certain costs and expenses were also significantly inflated due to the false transactions.

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

"Once a company commits fraud, either the executive directors are penalized, or the independent directors are penalized. To avoid liability for inadequate oversight, independent directors must shift the blame for fraud onto the executive directors. If independent directors do not hire an institution to investigate the executive directors, the executive directors can take the independent directors to court for failing to supervise, and the independent directors would then need to compensate the victims," said an industry insider.

So before the financial report was disclosed, Luckin initiated a "self-exposure" procedure. A special committee composed of three independent directors exposed Luckin's previous response to the short-seller report. Luckin's financial fraud officially came to light. (This part is from Burning Finance, original title "The Full Story 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.

According to the new Securities Law, "Securities issuance and trading activities outside the People's Republic of China that disrupt the domestic market order of the People's Republic of China and harm the legitimate rights and interests of domestic investors shall be handled and legal liability pursued in accordance with 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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