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Liza Ayres
Contributing Writer

In early April, China-based Luckin Coffee shocked investors and consumers worldwide when its board revealed in an SEC filing that it has initiated an internal investigation into the activities of its former Chief Operating Officer (COO), which are linked to an alleged $300 million fraud.

The Beijing-based company opened its first location in 2017 and has expanded from a few stores and delivery kiosks to tens of thousands in the past few years. In its Initial Public Offering (IPO), Luckin Coffee raised more than $570 million on NASDAQ when it debuted on NASDAQ in May 2019. The company impressed venture capitalists, rival companies and wealth advisors by showing such rapid growth that it outpaced Starbucks’ presence in China in 2019, having pledged to open nine stores per day of that year. Luckin Coffee finished 2019 with 4,500 locations, while Starbucks has 4,300 locations.

Luckin Coffee was lauded as ushering in the future of not only the coffee business in China, but also a new wave of tech-heavy restaurant concepts. Investors noted that the coffee business in China is much smaller than it is in the U.S., but Luckin Coffee tried to create demand for its product by increasing its presence, which resulted in net losses with hopes for an eventual profit. Additionally, Luckin Coffee implemented swiftly changing technology to make a name for itself as a model of an ultra-convenient coffee shop. It created engaging user experiences by using coffee vending machines and kiosks, and it used data analytics and artificial intelligence to improve its operations.

As striking as Luckin Coffee’s growth appeared, even more surprising was the announcement of the current investigation into the massive fraud behind its revenues.

Jian Liu, former COO of Luckin Coffee, is suspected of having inflated revenues by an early estimate of $300 million, and the company’s board believes Luckin Coffee expenses have been similarly inflated. If that number is accurate, the fabricated sales would amount to about 41% of their total estimated sales in the past year. This alleged fraud is thought to have begun in the second quarter of 2019, and the company told investors that they shouldn’t rely on the company’s recent financial statements, which might be highly inaccurate now.

The announcement of the internal audit came a few days after the company appointed two new independent directors to its board. Tianruo Pu, an accounting executive who was Chief Financial Officer (CFO) of Zhaopin and UTStarcom, and Wai Yuen Chong, a supply chain executive who worked at Charoen Pokphand Group and Starbucks — Luckin Coffee’s main competitor. Both joined the company’s audit committee tasked with taking on this investigation. The special committee was formed after an audit of the past year discovered financial discrepancies.

As of April 6, Luckin Coffee shares were down 80% from normal, and the company’s market cap is now just above $1 billion, a decline from its near $4 billion valuation immediately post-IPO. The extreme decline puts pressure on banks that extended loans to buy stock, and some of the company’s executives might experience losses of above $100 million.

Since the company announced the internal audit, Luckin Coffee’s smartphone app has, interestingly, experienced a surge of downloads, according to mobile intelligence service Apptopia. The increase has been explained by two competing forces: Chinese consumers rallying around the company as a form of Chinese nationalism against the American coffee chain Starbucks and the desire to use coupons and pre-paid drink specials, which played a large role in Luckin Coffee’s marketing strategy. Heavy discounting and coupons were offered frequently, and customers might be worrying that those deals might not be available in the future because of the company’s financial loss due to the fraud.

The special committee recommended suspending Liu and the employees implicated in the misconduct, but as of now, much of the company’s internal workings remain private and uncertain. This discovery and investigation have investors contemplating key details of the international stock market and internal business fraud. The massive scale of the fraud is concerning, especially given that the company was credible enough to be listed on NASDAQ, and considering Luckin Coffee had followed American accounting rules as a publicly traded company.

Furthermore, the alleged fraud has already brought up some big questions concerning the auditing process and how investors can trust the foundation of a company. How could such a major fraud not have been caught by auditors until so far down the line? And how could a stock so popular among retail investors and day traders have been built on a deceitful and unstable structure?

The investigation will hopefully help to answer some of these questions, as well as reveal significant findings that can serve as guidelines and precautions when other rapidly successful businesses start to make waves on the international finance scene.

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