Luckin Coffee scandal

US authorities are placing greater scrutiny on Chinese companies and other emerging markets listed in the US following the fallout from the Luckin Coffee fraud scandal.

A recent success story among investors, having raced to a Nasdaq listing within 18 months of its foundation, and challenging coffee giant Starbucks in the Chinese market, Luckin Coffee’s reputation now lies in tatters.

This month, allegations of a $300m fraud linked to a former board member were followed by reports that the company had suspended several staffers and launched an internal investigation.

However, Luckin’s problems did not stop there: the US Securities and Exchange Commission (SEC) has now stepped in and issued a lengthy statement on the risks of investing in emerging market companies.

The SEC, and US investors in general, have had a difficult relationship with Chinese companies ever since the Sino-Forest scandal in 2011 when allegations of fraudulent accounting surfaced.

In this case, when auditors refused to submit key documents – citing Chinese law, which bans sensitive information from being sent outside of the country – the SEC sued the Chinese units of the ‘big four’ accountancy firms. Tensions did not ease and in 2014 the SEC barred these Chinese units from auditing US-listed entities for six months.

The Luckin Coffee scandal could bring this issue back to the surface and attract fresh scepticism from US investors.

Nearly 200 Chinese companies are currently listed on the New York Stock Exchange and the Nasdaq stock market.

Many of these have been audited by ‘Big Four’ firms, including Luckin Coffee, which was audited by EY before the scandal broke.

The news of the alleged fraud emerged when, in a filing to the SEC, Luckin’s board revealed it was initiating an investigation into its former chief operating offer Jian Liu who, it said, might have inflated revenues of the company.

Liu is accused of inflating revenues by $300m from as far back as the second quarter of 2019. Board expenses may also have been inflated, the firm admitted, meaning the company had to acknowledge to investors that they could not rely upon its most recent financial results.

In response, the SEC has stressed to investors the “substantially greater risk” of incomplete or misleading disclosures from companies in China and other emerging markets.

The commission reminded investors that the Public Company Accounting and Oversight Board (PCAOB) was still unable to properly inspect audit papers in China and enforcement by the SEC, the Department of Justice and other US authorities was limited.

The SEC has also warned that US investors have limited recourse in these matters and urged investment advisers and fund managers to properly disclose such risks to their clients.

While more Chinese companies brace themselves for fresh scrutiny from US authorities and investors alike, Luckin’s problems are far from over.

After Luckin’s shares plummeted 80% on the news, its market cap has been reduced from around $4bn to just over $1bn.

This massive decline has since put pressure on banks that extended loans to buy Luckin stock on margin, with these institutions seemingly blindsided by the revelations.

According to reports in The Wall Street Journal, banks stand to lose over $100m on a structured loan made to the coffee chain.

Goldman Sachs, acting as a disposal agent for lenders, has revealed that an entity controlled by Luckin chairman Charles Zhengyao Lu defaulted on a $518m margin loan facility. The shares posted as the collateral for the loan have plummeted in value, thus undermining the arrangement.

Last Updated: 23 April 2020
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