Luckin Coffee, iQIYI fraud allegations point to wider China problem

“When Luckin Coffee went public in May 2019, it was a fundamentally broken business that was attempting to instill the culture of drinking coffee into Chinese consumers through cut-throat discounts and free giveaway coffee,” begins an 89-page anonymous report shared by short-seller firm Muddy Waters. Right after its $645 million IPO, the company had “evolved into a fraud by fabricating financial and operating numbers” starting in the third quarter of 2019.

“Luckin Coffee delivered a set of results that showcased a dramatic business inflection point and sent its stock price up over 160 percent in a little over two months,” the anonymous executive summary continued. “Luckin knows exactly what investors are looking for, how to position itself as a growth stock with a fantastic story, and what key metrics to manipulate to maximize investor confidence.”

Specifically, the report alleged that:

• The number of items per store per day was inflated in the third and fourth quarters of 2019;
• Items per order had declined from the second quarter to the fourth quarter 2019, and the effective selling price was inflated in the third quarter of 2019;
• Luckin Coffee overstated advertising expenses and may recycle overstated advertising expenses to inflate revenue in the third quarter of 2019; and that
• Net revenues from other products were inflated in the third quarter of 2019.

In a response statement issued in February, Luckin Coffee, at first, “categorically denie[d]” all allegations in the report, calling them “misleading and false.” The company claimed the report’s methodology was “flawed, the evidence is unsubstantiated, and the allegations are unsupported speculations and malicious interpretations of events.”

Special committee formed

As of April, however, Luckin Coffee has changed its tune. In its latest statement on the matter, the company announced its board of directors has formed a special committee to oversee an internal investigation into these matters. The special committee is comprised of three independent directors: Sean Shao, Tianruo Pu, and Wai Yuen Chong, with Shao serving as chairman. Additionally, the special committee retained Kirkland & Ellis as its independent outside counsel and FTI Consulting, an independent forensic accounting expert.

According to Luckin Coffee, the special committee on April 2 brought to the attention of the board information indicating that, beginning in the second quarter of 2019, Chief Operating Officer Jian Liu and several employees reporting to him “engaged in certain misconduct, including fabricating certain transactions.” In response, the special committee recommended suspending employees implicated in the misconduct, as well as suspending and terminating contracts and dealings with the parties involved in the identified fabricated transactions.

“The board accepted the special committee’s recommendations and implemented them with respect to the currently identified individuals and parties involved in the fabricated transactions,” Luckin Coffee stated. “The company will take all appropriate actions, including legal actions, against the individuals responsible for the misconduct.”

Inflated costs and expenses

The information identified at this preliminary stage of the internal investigation indicates the aggregate sales amount associated with the fabricated transactions from the second quarter of 2019 to the fourth quarter of 2019 amount to around RMB2.2 billion (U.S. $310 million). Certain costs and expenses were also substantially inflated by fabricated transactions during this period, the company stated.

As a result, investors should no longer rely upon the company’s previous financial statements and earning releases for the nine months ended Sept. 30, 2019, and the two quarters starting April 1, 2019, and ended Sept. 30, 2019, including the prior guidance on net revenues from products for the fourth quarter of 2019, and other communications relating to these consolidated financial statements. The investigation is ongoing, and the company said it will continue to assess its previously published financials and other potential adjustments.

Luckin Coffee said it will release additional information concerning the internal investigation “in due course and is committed to taking appropriate measures to improve its internal controls.” On April 7, NASDAQ halted trading of Luckin Coffee pending additional news updates.

Wider China problem

The apparent scam that is Luckin Coffee, however, is just one example of a much broader, disturbing problem in the United States, in which China-based firms listed on U.S. stock exchanges con U.S. investors out of billions of dollars. In fact, the problem is so widespread that it was the focus of a 2017 documentary, called “The China Hustle.”

Such scams continue to generate significant issues for the U.S. accounting and auditing community, as well, since U.S. auditors don’t have jurisdiction over companies listed on the NASDAQ that are based in China. In November 2019, the Securities and Exchange Commission and the Public Company Accounting Oversight Board (PCAOB) met with the Big Four “to discuss audit quality across their global networks and certain of the challenges faced in auditing public companies with operations in emerging markets, including China.”

Among the issues discussed was that the PCAOB “continues to be prevented from inspecting the audit work and practices of PCAOB-registered audit firms in China on a comparable basis to other non-U.S. jurisdictions.” During the November 2019 meeting, the SEC said it made clear that with the PCAOB restricted in its inspection efforts in China, it “expect[s] U.S. audit firms to bring appropriate increased attention and resources to their internal and cross-network quality control processes.”

Floodgates opening?

On April 7, a second report emerged against another Chinese company by another investor activist firm, this one published by Wolfpack Research (with assistance from Muddy Waters) regarding China-based video-streaming company iQIYI. That report alleges iQIYI overstated its revenues and subscriber numbers.

According to the report, iQIYI “was committing fraud well before its IPO in 2018 and has continued to do so ever since. Like so many other China-based companies who IPO with inflated numbers, IQ is unable to legitimately grow their business enough to true up their financial statements.”

Wolfpack Research estimates that iQIYI inflated its 2019 revenue by approximately RMB8 billion (U.S. $1.13 billion) to RMB13 billion (U.S. $1.84 billion), or up to 44 percent. It does this by overstating its user numbers by approximately 42 percent to 60 percent and then inflates its expenses, “the prices it pays for content, other assets, and acquisitions in order to burn off fake cash to hide the fraud from its auditor and investors,” the report states.

Like Luckin Coffee, iQIYI is denying the allegations. “The company believes that the report contains numerous errors, unsubstantiated statements, and misleading conclusions and interpretations regarding information relating to the company,” iQIYI stated.