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A sweet aftertaste: The Luckin scandal’s silver lining could be tighter cross-Pacific collaboration

If the fear and indignation brewing because of Luckin leaks over to other areas, leading to an exodus of Chinese companies from the US, it would be a loss for global investors.

The People’s Republic of China and United States of America are at odds on many fronts, but there is still occasional collaboration between the two governments.

In early April, the US Securities and Exchange Commission (SEC), America’s capital market regulator, sent a letter to its counterpart across the Pacific, the China Securities Regulatory Commission (CSRC), requesting cooperation in an investigation into the accounting malpractice of a US-listed Chinese coffee chain startup, Luckin.

Not even a month passed before Luckin’s Beijing headquarters was raided by an investigative task force on April 27. The team was led by the CSRC and consisted of officials from several other government agencies, including the State Administration for Market Regulation, China’s top market watchdog. The fact that Luckin was in the crosshairs of three of the world’s most powerful financial market regulators underscored the severity of its crimes.

On top of that, the company is also being sued at home by investors who claimed that Luckin’s deceptive actions led to their financial damages.

Local media reported that the coffee startup’s executives were taken in for questioning. Chinese regulators instructed the company to hand over all of its operational data, including the “problematic data source” of an alleged USD 310 million fraud that is at the heart of a scandal engulfing the company since April 2, when it came clean to the SEC that an internal investigation concluded that Luckin’s executives fabricated as much as RMB 2.2 billion (USD 310 million) in sales last year.

Photo: Shutterstock

Luckin’s stock price plunged by more than 80% on the heels of the disclosure.

The company has been turning coffee beans and hot water into losses since its inception, and its meltdown didn’t come without a warning. As early as February, US short seller Muddy Waters released by tweet an “unattributed” report accusing Luckin of fraudulent accounting practices that inflated sales. Luckin countered the accusation by saying that the research methodology was flawed and that the evidence was unsubstantiated. The company also released a statement that said Muddy Waters’ report attacked its management team members with claims that were “either false, misleading, or irrelevant.”

At the time, Luckin had even managed to convince other parties that Muddy Waters could not be trusted. As a result, a number of other market researchers, including renowned short sellers like Citron Research, all cast their doubts regarding the report’s credibility. Citron actually said in a tweet that, according to its own analysis, Luckin’s business in China was “on fire.”

Read this: Luckin blames internal investigation and COVID-19 as reasons for missing annual report deadline

Two months later, as we know, Luckin told regulators of its discovery that the company’s sales records were cooked up by its management team.

Tracing through Luckin’s business tells us that it had successfully built the illusion of prosperity. It was only in January that Luckin had raised funds through two rounds of financing—post-IPO equity funding and by issuing more American depositary shares—just eight months after its debut on Nasdaq.

The researchers at Citron were right. Luckin’s business was on fire, one kindled by burned cash from external investments.

A percolated rise

It took just a year for Luckin, as a publicly listed company, to land itself in hot water with regulators. But even before the company acquired its own ticker symbol, LK, investors were overlooking many shortcomings, perhaps blinded by the prospect of a big pay day.

Luckin’s founders spun a tale that seems irresistible to some investors—a legend of high growth that comes with massive payoffs. It managed to convince some people that the tea drinkers of China were ready to switch over to a different kind of brew. By showing statistics of how each Chinese person drank an average of just six cups of coffee in all of 2018, as opposed to 388 cups by an average American and 279 by an average person in Japan, Luckin painted a picture of a massive consumer economy getting ready to demand torrents of caffeine. Another statistic drove the point home: in the 12 years from 2006 to 2018, coffee consumption in China grew by a whopping 500%.

Luckin attracts customers with coupons and discounts. Photo: Shutterstock.

Every time Luckin wanted to raise funds for more locations to mushroom in China, investors answered. Luckin’s drinks were roughly two-thirds the price of Starbucks’, and the company claimed that its deeply subsidized offerings garnered a secure clientele. By the end of 2019, Luckin had more shops in China than Starbucks. The company seemed committed to become the top dog at any cost.

Luckin’s assertions chimed perfectly with the profile of an industry trailblazer, particularly one that asymmetrically outpaced an established player. The catch was that Luckin’s narrative was too good to be true. To put it bluntly, selling coupons for your own stock wasn’t a viable long-term business plan.

Now it’s time for Luckin to own up to its misdeeds, and its investors need to wake up and smell the (burned) coffee. The company, we argue, is a product conceived by conditions facilitated by a capital market that places immediate profit over long-term viability. Luckin is just one instance of this phenomenon; there are others too.

Read this: Kingsoft Cloud makes solid Nasdaq debut after wave of scandals involving US-listed Chinese companies

WeWork’s IPO fiasco is one example. Like Luckin, the shared office operator was fanatically seeking growth at a global scale for several years, even though it was in bad financial shape. This became clear when WeWork filed its paperwork to go public, and regulators and the press were able to quiz the company about its path to profitability. By the end of 2019, WeWork would reportedly have been out of cash if the company failed to secure fresh financing.

Just a year before that, WeWork was a darling of global investors. It had raised more than USD 19.5 billion, making it one of the most heavily financed startups in the world. Investment firms poured cash into WeWork while ignoring its woeful financial status, justifying the act as part of the “strategic loss” that was permitted when startups light bonfires with other people’s money.

Cross-Pacific collaborative crackdown

Luckin’s accounting fraud opened Pandora’s box. A number of Chinese concept stocks were wrecked by short sellers in the wake of Luckin’s bombshell announcement. Global investors now wonder: Can Chinese companies still be trusted?

Other firms from the People’s Republic are now under scrutiny too. On April 7, Wolfpack Research said Chinese video streaming platform iQiyi was inflating its user count and revenue, claiming that the company is unable to “legitimately grow their business enough to true up their financial statements.” On the same day, Chinese education tech giant TAL said that its employees engaged in wrongdoing that magnified its sales numbers. One week later, another education tech company, GSX, was shorted by Citron, which said the firm inflated its 2019 revenue by up to 70%.

The SEC warned American investors that they should not to put their money into Chinese companies, citing the lack of transparency in terms of the operations of Chinese companies that are listed in the US. On the same day, the stock prices of Bilibili, Pinduoduo, VIPShop, Secoo, and other firms from China dipped.

Moving forward, we may see two key consequences for Chinese concept stocks in the US, according to a Chinese PE firm head who wishes to remain unnamed. The first is that existing public companies may see extra pressure and be examined more closely than before. Secondly, the SEC will likely tighten regulations for Chinese startups that seek IPOs in the US.

Luckin in mid-2019 signed an agreement with Kuwaiti Americana Group to co-develop Middle East and India market. Photo: company press release

Lao Zhiming, general manager of Huatai Securities, worked on the Qihoo 360 privatization deal in 2015. He believes that the current crisis will expedite overseas-listed Chinese businesses’ homecoming. Already, some companies have approached his firm for talks about the matter. “Privatizing China concept stocks will be a focus for us this year. We have made a list of which companies could come back and which ones should, and have set up project teams to pursue them,” according to Lao.

US-China relations have been deteriorating since the trade war began in 2018, and could tip the world toward a global recession. The issue of fraudulent Chinese companies being listed in New York may exacerbate tensions, fueling hawkish rhetoric of “decoupling” on both sides of the Pacific.

The disclosure of Luckin’s fraudulent practices exacerbated distrust between China and the US, leading to accusations pointing at other Chinese companies that abide by the rules and preserve the interests of their investors. New York is one of the world’s premier financial centers, and losing access to the US market, whether due to new regulations or general misgivings, would leave Chinese companies out of global capital networks.

Charlie Munger, Warren Buffett’s partner and one of the greatest investor minds on the planet, said in February that “the strongest companies in the world are in China, not America.” Or, at least, China is still undergoing unmatched growth, with great companies forming and maturing along the way. And if the fear and indignation brewing because of Luckin leaks over to other areas, leading to an exodus of Chinese companies from the US, it would be a loss for global investors.

Fraud has existed since before the emergence of money. An opinion piece published in April by China’s Securities Times applauded Muddy Water’s report on Luckin for its “meticulous investigation, abundant evidence, and accurate inference.” The author called for more research like that conducted by Muddy Waters to help regulate the market.

The joint operations between the US and China demonstrated how the two countries could work together and clamp down on cross-border financial fraud. Let’s hope it’s a step toward even tighter collaboration in the future.