Author: Ektha Vivekanand, a student at School of Excellence in Law, The Tamil Nadu Dr Ambedkar Law University
Abstract:
Accounting Fraud has become a white-collar crime of common parlance. While Indian scams carried out by people like Harshad Mehta and Nirav Modi are referred to regularly, these crimes occur periodically on an international scale as well and one prime example of this is the Luckin Coffee scandal from 2019. This article highlights the features of Luckin Coffee as a company, how the scandal unfolded, how the authorities such as the Securities and Exchange Commission reacted to it and lastly, the aftermath of the scam while also highlighting the present position occupied by the company in the world of coffee retail.
Introduction:
Luckin Coffee is China’s beverage retailer that serves caffeinated beverages and grew so large that it gained recognition as Starbucks’ competing coffee chain. In 2018, Charles Zhengyao Lu and Jenny Qian Zhiya launched the Luckin brand by opening their first outlet after incorporating the company in the Cayman Islands. The founders were however not strangers to success since they each made huge profits at their previous business ventures as well before becoming the Chairman and CEO of Luckin Coffee, respectively. The success seen by Luckin in its initial years was completely owing to the copious amount of funding that the founders were able to attract to the company by way of venture capital financing.
It expanded on a grand scale by establishing 4507 stores in the span of two years between 2018 and 2020. In 2019, based on the number of consumers served, the company even overshadowed Starbucks in the coffee race in China. Luckin was known for its unique selling point of offering its products at highly discounted rates and also operating on a coupon system which enabled consumers to claim greater price benefits by way of obtaining a coupon through the Luckin app and producing it at any retail outlet. On the accounting side, the revenue generated from the coupon system as depicted by Luckin was calculated on the basis of the number of coupons redeemed and not the number of coupons actually sold to consumers. Another contributing factor to Luckin’s growth is the fact that they targeted their focus on smaller outlets with unique aspects in comparison to larger, more mainstream outlets.
Luckin is known for being tech-savvy by making most of its operations computer-based like enabling consumers to order coffee through the app or making its kiosks cashier-less. Within 18 months of its incorporation, Luckin managed to launch its IPO and get listed on NASDAQ in the United States of America in March 2019. Being the first China-based coffee retailer listed on an American stock exchange, it attracted approximately 600 million USD initially. Luckin additionally reported a sharp spike in its generated revenue at 1.73 million USD in the first quarter of 2019 which was equivalent to more than half of the total revenue generated by the company in 2018, as a whole. Luckin attributed its growth to factors like quality improvements, an increase in consumer base, the number of stores etc. The estimated market value of the company also saw a sharp spike and came up to 3.9 billion USD in 2019. A public report that highlighted its growth structure resulted in a further increase of its market value up to 5 billion USD.
The Traces of the Scandal:
A month after Luckin went public through the listing on NASDAQ, TechNode published an article that detailed one of Luckin’s senior executives’ profile – Yang Fei, the Chief Marketing Officer. Suspicions arose about the activities happening behind closed doors when Yang Fei abruptly chose to resign from his position a month before the listing of the company. Most of China’s consumers simply believed that the reason behind his resignation was to prevent any hiccups in the IPO’s listing since Yang Fei had a prior arrest record wherein, he had served time of 2 years for violating China’s advertising law. Post its IPO, the company continued its growth-oriented strategy by introducing merchandise, launching its own tea and juice line etc. Any losses were compensated for by the additional fundraising effort made by the company to raise 865 million dollars by way of the issuance of convertible bonds and follow-on shares.
The whole question of a scandal having taken place within the closed walls of Luckin Coffee arose due to a tweet by Muddy Waters Research on 31st January 2020. Via the tweet, they shared a link to a report detailing the fraud taking place within the company which they had received on an anonymous tip. The report documented around 11,260 hours of store footage videos to establish and prove the fact that Luckin was fabricating its sales numbers. It was found that the company had already inflated sales by around 88%.
This report’s release coincided with the coronavirus pandemic wreaking havoc worldwide and led to Luckin temporarily closing down operations in most of its retail outlets. The natural step taken by Luckin in response to the claims laid by the report was to vehemently deny all the allegations put forth and counterclaim that the claims made were not substantiated by appropriate supporting evidence.
The SEC Filing and Findings:
On April 2nd, 2020, Luckin Coffee, on its own volition, submitted a filing to the Securities and Exchange Commission (SEC) in the United States, stating that it is carrying out an internal investigation regarding the actions of its former COO Jian Liu. As per the filing, he had reportedly fabricated and inflated sales numbers of FY2019 by over 300 million USD. It was additionally claimed that this alleged fudging of numbers took place in the second quarter of 2019 which was around the time Luckin was listed.
The Chairman and Co-Founder, Charles Zhengyao Lu, reportedly defaulted on a loan he took that had a margin of around 518 million USD as issued by Goldman Sachs, and it was additionally reported that he used Luckin Coffee stock as collateral although the stock value had suffered a drop of around 80%. Another significant setback for Luckin’s case was that NASDAQ decided to not permit any trading of their stock till all these matters reached a resolution stage.
Investors, being agitated by the possible losses they were facing, began suing Luckin for damages all around the world. The company’s offices in China were also raided for want of additional evidence. Due to the immense financial pressure being imposed, Charles Zhengyao Lu was compelled to dispose of his shares in his previous business venture in order to repay his debts.
Luckin’s board ended up removing the CEO and founder, Jenny Qian Zhiya as well as the COO, Jian Liu in May 2020, in response to the severe allegations however Charles Zhengyao Lu managed to overcome the vote of no confidence by the board and continued in in his position at that juncture. American investors gradually began questioning the legitimacy of the listing of Chinese companies on American Stock Exchanges, in response to which NASDAQ released stricter standards without explicitly mentioning Chinese firms.
Details of the Scandal:
The ultimate findings helped determine that the scandal was in fact a three-fold mechanism. A large part of the fabricated sales of Luckin was attributed to the coupon sales being fabricated. Coupon sales made to three different categories of consumers were targeted, namely, individual consumers, corporate consumers and sales made to third-party shell companies. These third-party shell companies played the role of intermediaries who further sold the coupons to individual consumers.
The first fraudulent ploy, in April 2019, involving Luckin employees was to make the employees, their families and friends transfer money from their private bank accounts to their WeChat or AliPay accounts (these were the platforms recognised by Luckin for the purpose of purchasing coupons) and buy coupons on the Luckin app. They were then made to redeem these coupons and the company in turn, created fake orders and falsified the sales figures. This scheme was utilised by Luckin to fabricate around 1 million USD of sales. It is yet to be determined whether the money earned through this scheme was recycled back to employees to further their purchase of coupons or not.
The second scheme adopted by Luckin in May 2019, involved the sale of coupons by Luckin employees to fake corporate consumers. These consumers were actually related to the employees themselves and it resulted in the fabrication of around 10 million USD of sales revenue. Much like the first scheme, in this scheme as well, it is uncertain as to whether this money was recycled to the employees or not.
The third ploy, that was brought into action, from the onset of May 2019, was the fabrication of a number of coupons sold to third-party shell companies. The individual consumers who were supposedly purchasing the coupons from these third-party companies, did not actually place these orders or redeem these coupons. These shell companies were being controlled by Luckin employees or their relatives, who directed the funding towards Luckin and they would later alter the name of the sender of the money from the actual funding company to the name of the shell company, in the Luckin’s bank statements. Hence, the employees were involved in the purchasing of coupons, their redemption as well as the fabrication of coupon sales and revenue.
This comprised the biggest share of false revenue, around 90% of the overall 311 million USD. Certain employees at Luckin altered the source data from the genuine business operations database to the counterfeit one. Source data encompasses the reports required for creating financial statements and maintaining accounts. The finance department at Luckin was only able to access the falsified database, which led to a failure in detecting irregular transactions. Hence, the coupon sales being characterised as the unique selling point of Luckin Coffee ended up being the prime contributing factor to their fraudulent activities.
Luckin issued misleading statements and distorted its financial results to attract investors. The company did not provide accurate information regarding revenue and expenses and also raised funds using fabricated bank statements. Additionally, Luckin did not have sufficient internal accounting measures in place or maintain precise financial documentation. The organization was aware that its financial statements and records were inaccurate and deceptive. Luckin colluded with financing firms, suppliers, and third-party shell companies to create false expenses and costs.
The Aftermath:
All of these factors ultimately culminated in the delisting of Luckin Coffee from NASDAQ on June 23rd 2020. The board of directors filed before the SEC to oust the Chairman from his position of power, however, he survived the vote of no confidence yet again. The entire scandal resulted in a report encapsulating the results of the internal investigation conducted by the company’s Special Committee. Statistically, 550,000 documents were reviewed, over 60 witnesses were examined and extensive forensic accounting and testing of data analytics was done.
As per this report, revenues were overstated by a sum of 35 million USD in the second quarter of 2019, 99 million USD in the third quarter and around 66 million USD in the fourth quarter, thereby adding up to a sum total of 300 million USD of overstated revenues that had not actually been earned by Luckin Coffee.
The Chairman was finally removed after two unsuccessful votes, on 15th July 2020. Twelve employees who had reportedly worked alongside the COO and CEO in the three schemes that had occurred, were terminated.
The SEC charged Luckin Coffee with the fabrication of financial statements between April 2019 and June 2020 in matters pertaining to revenue generated, expenses incurred and net loss suffered in order to deceive investors by presenting an altogether different picture than the existing financial situation of the company. A fine of 9 million dollars had been imposed by Chinese regulators in September 2020. Additionally, a penalty against Luckin Coffee was announced by the SEC in December 2020 which in turn resulted in Luckin reaching a settlement agreement with the SEC, which included a few permanent injunctions on its operations as well as a payment of a penalty of 180 million USD by the company. However, it is to be noted that, Luckin neither admitted nor denied any of the allegations put forth against it by way of this settlement agreement.
Luckin Coffee ultimately filed for bankruptcy in January 2021 owing to the unpaid debts pending its attention.
Conclusion:
In order to address its debt obligations, Luckin Coffee raised around 261 million dollars from two Chinese private equity firms – Centurium Capital and Joy Capital. More than 600 of Luckins stores were permanently shut down and a lot of the staff and employees were laid off. A franchise model was introduced in January 2021 to commence the shifting of set-up costs. The use of heavily discounted offers was completely halted and the focus shifted to extracting more value from existing users.
In September 2021, a settlement of 187.5 million dollars was reached with all its shareholders spread over the globe. Post this settlement, Centurion Capital, which previously aided Luckin Coffee made a public announcement that it was acquiring the remainder shares of the company and taking control of it.
The current picture of Luckin is such that the CEO Guo Jinyi completely changed the way the company operates and it surpassed Starbucks in terms of store count in China, again in March 2022. The next month saw Luckin Coffee emerging from bankruptcy and seeing its first profitable quarter a few weeks later.
Alleged reports suggest that Luckin Coffee is looking to relist on NASDAQ over the next few years highlighting the fact that the company has gone full circle over 6 years.
References:
- Xiaoshuai Li, Daeyoung Ko, Financial Fraud of Listed Companies: The Case of Luckin Coffee Incident, Academic Journal of Business and Management
- Seven Pillars Institute, Case Study: Luckin Coffee Accounting Fraud
FAQs:
Q. Does Luckin Coffee still exist in the Chinese markets?
A. Yes, after the acquisition of the company by Centurion Capital in 2021, the company began to not only exist, but thrive again, while even generating profits in the subsequent months.
Q. Did the coupons issued by Luckin Coffee play a role in their fraudulent activities?
A. Yes, the coupon system was the primary contributing factor to Luckin’s fabrication of sales revenues.
