Luckin Coffee Settles Financial Fraud Action

When the sales pitch is “to good to be true” it usually is. This is the repeated theme of the offering fraud actions filed week after week by the Commission where much is promised and nothing is delivered.

Should the same principle apply to the financial results of an issuer? Apparently not. Those type of results generally cause the stock price to surge and the capitalization of the firm to climb; everyone makes money, at least for a while.

Perhaps it should. Consider the financial results of an off-shore coffee company with ADS traded in the U.S. The company sought to become China’s largest coffee firm almost overnight. Its revenues, stock price and capitalization skyrocketed in a handful of months. No questions were asked. After all, the Sarbanes-Oxley Act imposed stringent protections. In fact, the reported results were to good to be true – they were fraudulent. SEC v. Luckin Coffee, Inc., Civil Action No. 1:20-cv-10631 (S.D.N.Y. Filed December 16, 2020).

Luckin is a retail coffee provider, formed in the Cayman Islands and based in Fuijian, China. The firm’s business model is premised on the assumption that there is a large, unmet demand for coffee in China. The company believed that it could stimulate mass market consumption through aggressive price discounting and offering customers free or reduced-price products through the use of coupons. Customers purchased coffee through a phone-based app. Coupons for the products were redeemed through apps. Payment for a purchase was made with funds on deposit with the customer’s Alipay or WeChat account.

In May 2019 Luckin made an IPO of ADS in the U.S., raising about $600 million. The materials reported that the company was formed in October 2017. By March 31, 2019 it was operating 2,370 stores in 28 cities across China. The company reported 16.8 million transacting customers. It had become China’s second larges coffee store; it was the fastest growing coffee network. Luckin’s goal was to be the largest coffee network.

The prospectus acknowledged early losses. The same document reported that at year end 2018 Luckin had total revenue of USD $125 million. At the end of the first quarter of 2019 Luckin reported revenue of USD $71.3 million keyed to what was described as “strong growth.” Luckin repeated its ambition to be the largest coffee network in China.

In the months before the IPO kicked off news reports talked about the “meteoric expansion” of the firm, its “stunning” and “super-charged” growth pattern at “break-neck speed.” Luckin’s initial pre-IPO valuation of USD $1 million in July 2018 was recalibrated to USD $2.2 billion by November 2018 to USD $2.9 billion in April 2019. In May 2019 the IPO price of USD $17 per share valued the company at USD $3.9 billion.

The super-charged growth and staggering valuation increases over a handful of months were the product of three fraudulent schemes tied to coupons that were controlled by insiders. Revenue for coupons was recognized when it was used by the customer. The first scheme began in April 2019. Luckin employees and others transferred money from controlled individual bank accounts to certain WeChat and Alipay accounts used to create fake customer orders. Although the orders were fake, and the coupons not redeemed, the revenue was recognized. Millions of dollars in revenue were created.

Second, certain company employees fabricated coupon sales tied to four purported corporate customers beginning in May 2019. Each entity was controlled by employees and/or the other two entities used to facilitate scheme one above. Again, fake customer orders were created to redeem the coupons. Nearly triple the amount of revenue was recognized compared to the first scheme.

The third scheme was similar. Here additional entities were combined with the two used in scheme one and scheme two and tied to fake coupons. In this instance funds were transferred into Luckin’s bank accounts. Bank statements were altered so it appeared that the money originated from agents rather than the companies used to make the payments. The money was tied to fake coupons, fictitious customer orders and fake redemptions. This scheme generated about 90% of the USD $311 million in total fabricated revenue. All of this revenue was carefully tracked on a parallel set of firm books. The finance department of Luckin only had access to the fake revenue books, not the real corporate books.

The fraud emerged during an annual external audit for the Luckin’s financial statements. Luckin then announced that over USD $300 million in sales transactions in the last three quarters of 2019 were fabricated. The share price dropped from USD $27.19 on March 31, 2020 to USD $3.39 per ADS on April 6, 2020. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B).

Luckin took remedial acts and cooperated with the Commission. It resolved the case by consenting to the entry of permanent injunctions based on the Sections cited in the complaint. In addition, the company will pay a penalty of $180 million which may be offset by payments made to shareholder in the provisional liquidation in the Cayman Islands.

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