Coffee, Fraud, and Political Tensions

The coronavirus pandemic has created a dangerous climate of distrust and skepticism, as we’ve seen through the U.S’s changing relationship with China. A recent revenue scandal from the viral Chinese beverage chain Luckin Coffee has only aggravated these tensions, and has raised concerns about regulating foreign firms on U.S markets.

By Sasha Agapiev

As the world scrambles to deal with the ongoing coronavirus pandemic and global economic standstill, confusion, anger, and paranoia have become commonplace as a means for dealing with the uncertainty. It’s all nice and well while countries innovate and their economies prosper, but it’s always easier to see society’s true character when unforeseen challenges emerge and threaten destruction. Conversations about the true origins of COVID-19 and concerns regarding China’s handling of the initial outbreak have escalated to federal levels, and this has translated to a troubling rise in distrust and xenophobia.¹ Beneath the clear challenge of defeating coronavirus, we must also fight to prevent these circumstances from clouding our judgement and negatively altering our belief systems, because as Thurgood Marshall said, “the measure of a country’s greatness is its ability to retain compassion in times of crisis.”² Considering this, the recent Luckin Coffee revenue scandal was precisely not what we needed right now, as the outrageous circumstances surrounding Luckin’s fraudulent numbers have only lowered American investors’ trust in China and Chinese brands.  

Up until last month, Luckin Coffee was a smash hit both for Chinese coffee enthusiasts and foreign investors. The company, which has been described as the Chinese version of Starbucks, is a coffee chain that originated in Beijing back in 2017. Despite Starbucks’s large presence in China and the stereotype of Asian markets not endorsing coffee as much as Western countries, Luckin managed to grow at an unprecedented rate. Through three profitable years, Luckin Coffee cemented its position as the largest Asian coffee chain by number of locations by opening over 4,500 stores around China, surpassing Starbucks’s 4,300 stores in the region.³

Luckin employed a number of the latest business development strategies to uphold their growth, including the idea of maximizing the number of new locations by building small kiosk-like stores instead of expensive amenity-filled cafes. They also use AI software to find optimal locations for new stores and run free espresso promotions through their mobile app, which has boosted their reputation as a modern coffee brand. Their business statement is simple, yet poignant: They deliver consistent, quality coffee drinks to a market that has long been neglected. Luckin’s straightforward business plan and ever-growing market share unsurprisingly impressed Wall Street investors, and so the company went public on the Nasdaq last May. Their stock price grew 25% through its first month, and it just kept on growing thanks to the massive revenues their 4,500 stores produced.   

Or so we thought. 

Last week, you could buy shares of Luckin Coffee for just $4.00. Today, you can’t buy them at all, for any amount of money. This does not mean the shares are priceless — rather, the Nasdaq recently halted trading of $LK after a report convicted Luckin’s C-level officials of artificially inflating sales numbers and essentially making up revenue figures. Apparently, Luckin’s COO gave fabricated revenues to the SEC and shareholders through most of 2019 and attempted to cover up by listing fake sales at their many stores. It’s been estimated that from Q2 2019 to the beginning of Q4 2019, Luckin fabricated over $300 million in earnings by exaggerating prices, duplicating existing sales, and even completely making up new sales. Lying to the public about $300 million worth of fictional profits already sounds bad enough, but it sounds even worse when you consider that Luckin reported a total of $732 million in sales for all of 2019. That means that nearly half of the company’s value just never existed, and that its entire one-year run on Wall Street was built on false narratives. Most of the blame was piled onto Luckin’s COO Jian Liu, who has since been fired along with several of his colleagues. The stock fell about 84% in response to the news and would have continued to fall had the Nasdaq not halted trading. However, a ruined stock listing has been far from the only repercussion. 

In a relatively short span, one of the more popular Wall Street newcomers of 2019 managed to completely disintegrate into a cautionary tale. American news outlets have since labelled Luckin as a scam which will likely never trade on U.S markets again, but the company claims business will continue as usual and that they will maintain their rapid expansion in China. According to Luckin’s CEO, the fraud was an isolated breach of company norms that confined itself to the COO and his associates, and that Luckin has since improved oversight of their divisions. These statements have done little to appease the frustrated investors, financiers, and government officials who all have to deal with the fallout. Goldman Sachs, who have loaned more than $500 million to Luckin in the past, had to seize a large portion of the company’s stock to cover their losses. Investment firms like Citron Research who are large shareholders in Luckin have tried to do damage control by participating in the mass sell-off, but the price had already plummeted and this still surely caused these firms and their partners to lose a whole lot. Although Citron has not yet filed a lawsuit, a number of other investment firms and shareholder groups have, and these lawsuits will add to Luckin’s financial burden. Not only did Luckin lose more than two-thirds of its market cap, but they will have to pay off its tower of lawsuits and soon-to-be-defaulted loans, and will have to deal with the 4,500+ stores they’re operating around China (if all of these stores existed in the first place). On the bright side, around 300,000 people have downloaded the Luckin app over the past two weeks to capitalize on free coffee promotions while they’re still valid.¹⁰ Putting all jokes aside though, there’s pretty much no winners in this situation aside from the few who shorted Luckin or bought Starbucks shares before the investigation. 

The fascinating aspect of the Luckin scandal is the ripple effect that will ensue, as the true scale of Luckin’s deceit combined with the poor timing has the potential to change how Americans accommodate Chinese companies. Oliver Rui, professor at Shanghai’s China Europe International Business School, says the “ongoing accounting probe will have wider impact for other U.S-listed Chinese firms, or Chinese companies that plan to list in the U.S.”¹¹ Right now, auditors in the U.S do not have jurisdiction to investigate Chinese-based companies that trade on the Nasdaq, but analysts like Rui believe the SEC could disbar this rule so that they have more authority over all companies trading in the U.S regardless of where they operate.¹² Even if this law remains unchanged, the SEC and market research groups have already increased scrutiny of other publicly traded Chinese firms. iQIYI, a Baidu-owned movie streaming service similar to Netflix, has been accused of following nearly identical revenue-inflating practices as Luckin, and the investigators say they’ve been fabricating numbers since before their IPO in mid-2018¹³. Andrew Left, founder of the Citron Research hedge fund which held a huge stake in Luckin, summarized the evolving situation in an interview with the Financial Times. According to Left, the Luckin fraud “has shaken investor faith in US-listed Chinese companies” and that “[the fraud] just shows you the lack of controls; you obviously know this wasn’t just done by one person.”¹⁴ In a different Financial Times interview, Chinese industry reporter Fraser Howie said that “it seems crazy to [him] we’re still not asking harder questions about Chinese companies that are promising incredible results,” but that he blames “gullible investors” more than Luckin itself.¹⁴ Finally, this scandal just adds to the IPO troubles we saw in 2019. If it’s true that Luckin, WeWork, and potentially other companies (foreign and local) tend to invent inspiring numbers before their initial public offering (IPO), then this will surely impact how investors trade newly public stocks and could prevent a number of successful startups from getting listed on Wall Street. 

At the end of the day, though, fraud long predates Luckin Coffee, and there have been plenty of outright scams on Wall Street in the past, many of which have nothing to do with China or shady foreign politics. For instance, there was ZZZZ Best in the 1980s, which involved an American businessman named Barry Minkow who forged sales documents for carpet cleaning appliances and then took his company to the NYSE, where his company achieved a market cap of over $200 million. Then in 2001, Enron became a household name for deceitful bookkeeping after they hid huge debts to inflate revenue figures.¹⁵ And who could forget when Bernie Madoff essentially scammed all of lower Manhattan with his $50 billion Nasdaq ponzi scheme (somewhat unrelated, but still timeless and worth mentioning). In all of these and other similar cases, the companies went bust, those responsible received criminal penalties, and everyone kind of brushed them off to the side and continued trading other stocks. The SEC’s go-to response for these incidents has always been along the lines of “there’s thousands of companies trading publicly in the U.S which makes it impossible to completely prevent this type of fraud, so investors should be more cautious about where they’re putting their money.” With the Luckin scandal, however, the response appears to have been less tolerant, but the reason for this tough stance may have less to do with Luckin itself and more to do with the world’s presently evolving political climate. 

Luckin, despite having destroyed their reputation and having potentially ended their relationship with American investors forever, still has many locations around China, a strong coffee-loving customer base who likely won’t forego their espressos because of this scandal, and a popular online promotion system. They could easily continue growing and increasing actual revenues even with all the immediate financial burdens, and if they get delisted from the Nasdaq, they could go public on Chinese markets or even continue to trade publicly in the U.S through other means. As some have pointed out, companies who invent high revenues during their first years of trading often do so because they believe future profits will eventually cover the spread and because they want to keep investors on board in the meantime, and this explanation would make sense in Luckin’s case considering their rapid growth business model. Enron went bankrupt after their revenue scandal went public, but Enron had been mid-collapse for years prior and their accountants falsified numbers to hide their debt, whereas Luckin was actually in the process of scaling when they inflated sales. With that said, the financial reasons for why the Nasdaq and the SEC immediately rushed to end Luckin’s run on Wall Street become less clear. Maybe the U.S and American investors’ actions against Luckin and other similar Chinese companies are truly justified and necessary for protecting economic integrity, or perhaps the enmity has been exacerbated by all the skepticism directed towards China because of the coronavirus pandemic. □


Work Cited

  1. Image source
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