China fakes

In May 2019, Luckin Coffee began trading publicly on NASDAQ at $17 a share. The Chinese coffee company raised $561 million in its IPO and in less than a year, its stock value had tripled to $51 a share. Started in Beijing in 2017, but headquartered in Xiamen, this Chinese company established thousands of locations in the span of two years. Luckin Coffee shops are designed to favor convenience and speed, as opposed to Starbucks’ more leisurely atmosphere. Luckin proclaimed itself as the greatest threat to Starbucks’ growth in China and in January 2020 Luckin Coffee had 4,500 operating coffee shops. Luckin offered heavily discounted prices, which increased its popularity and its ability to expand. At a glance, Luckin Coffee’s rapid and sustainable growth made the company seem like a foreign investor’s dream.

However, on January 30, 2020, an anonymous report on Luckin Coffee was released in the United States, claiming several cases of fraud. On January 31st, Carson Block of Muddy Waters LLC (which has a long history of spotting Chinese stock fraud) posted the 89-page report on Twitter. The claims in this report are not pretty: from April 2019 through the fourth quarter, Luckin Coffee inflated sales by $310 million and falsely increased expenses by $190 million. The first line of the report states: “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.”

Though executives at Luckin initially denied the validity of the report, an internal investigation began in April 2020 and it essentially reached the same conclusion as the anonymous report: Luckin had grossly exaggerated (a/k/a flat out lied about) its sales figures to inflate the company’s value for the IPO. The investigation found Jian Liu, Luckin’s chief operating officer, as the primary culprit of the misconduct, though it is likely that the company’s chairman, Charles Lu, was aware of these misdeeds. The internal report also said that the accounting fraud was accomplished by funneling funds to the company from several third-party companies, most of which had ties to Luckin executives. Additionally, Luckin employees created false sales transactions to increase the company’s perceived value before going public.

Luckin Coffee’s market value, which was listed at $12 billion earlier this year, has now fallen to $1 billion. Luckin’s stock has lost 94% of its value and was most recently listed at $2.50 per share. On June 26, NASDAQ delisted Luckin shares and no longer allows them to be publicly traded.

Luckin’s swift demise is yet another warning to investors to be wary of Chinese companies. This may be easier said than done. The anonymous report from January that first revealed the controversy states “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.” Mark Williams, a professor at Boston University and a former U.S. Federal Reserve bank examiner, said “Luckin is a microcosm of what can happen when weak underwriting standards are allowed to persist in the pursuit of rapid growth.”

Even more recent on the list of scandals involving fraudulent Chinese companies on NASDAQ is the Kingold Jewelry controversy. Kingold Jewerly is a Wuhan-based corporation that in the last five years took out $2.8 billion dollars in loans from Chinese financial institutions, using gold bars for collateral. On May 22, a Chinese court examined the gold bars and discovered they were gilded copper. Once this story came out, Kingold stock value fell 57%. The once-billion-dollar company now has a market capitalization of only $5.3 million. These scandals have not gone unnoticed by Wall Street and Washington, who are working together to pass bills that require fundraising applicants to prove they are not owned or controlled by a foreign government. NASDAQ is also hoping to create higher standards for applicants of initial public offerings and increase the minimum fundraising to $25 million.

Bob Pisani of CNBC has a July 9, 2020 article setting out other possible measures that might convince China to comply with US securities regulations. The issue at hand is that, just as fraudulent Chinese companies hurt Wall Street, so too does increased regulation and sanctions. The issue for Wall Street is striking a balance between enforcing stricter regulations while still allowing investors to profit from Chinese stocks. As accounting professor Roger Silvers puts it, “they have to be careful not to cut off their nose to spite their face.”

In the meantime, Luckin and Kingold stand as testaments to the risks of investing in Chinese companies. What appeared to be a foreign investor’s wildest dream soon became their darkest nightmare. The core of Luckin and Kingold and similar Chinese investment disasters  is that their stories were not plausible. No discounter opens 4500 retail outlets in two years and is also profitable. No jewelry company keeps massive amounts of gold in a warehouse to use as collateral for loans. More importantly, no lender takes gold as collateral without doing an inspection. This is particularly true in China, in light of the 2014 Qingdao copper scandal, where non-existent copper was used for the same illicit purpose. See Qingdao scandal casts a long shadow over metal markets.

It is time for U.S. investors to quit pretending China is somehow different from the rest of the world. It is not. If the deal looks or even smells bad, it almost certainly is bad.