If It Sounds Too Good to Be True, It Is - Lessons from the Luckin Coffee Scandal

If It Sounds Too Good to Be True, It Is

Lessons from the Luckin Coffee Scandal

One of life’s lessons that most of us learn the hard way: If something seems too good to be true, it probably is. In business, this lesson often ends up costing companies a lot of money.

In the case of Luckin Coffee, numbers that seemed too good to be true were exactly that – fraudulent. While the company did not necessarily start out intending to con investors, that’s what happened.

The Backstory

Luckin Coffee, headed by Lu Zhengyao, started with big goals. The Chinese-owned company had grand, sweeping aspirations in 2017. Zhengyao said that Luckin would sell more coffee in China, a nation of voracious tea-drinkers, even beating Starbucks. It would do so by selling lower-priced coffee via a takeaway app, eliminating the cost of a large sitting area. 

Joy Capital, one of the largest VC firms in China, and the Singaporean sovereign wealth fund, GIC, invested and the company quickly achieved unicorn status. Luckin opened 5,000 locations across China (more than Starbucks’ 4,000) and attracted more investors. It went public in the United States in May 2019 and reported sales of $200 million in one quarter.

Suspicious Growth

In the last quarter of 2019, Luckin reported a six-fold increase. The scale of the jump, however, seemed suspicious and caught the attention of Carson Block, a short seller for the firm Muddy Waters Research. Block, however, did not move forward with an investigation because of the cost.

Fortuitously, Block was contacted by a fund manager who had already prepared a research report about Luckin and wanted Muddy Waters to publish it. The document included the work of more than 1,000 investigators who monitored sales and foot traffic in Luckin locations and claimed that Luckin was inflating the numbers by 69% in the third quarter of 2019 and 88% in the fourth.

Auditors were immediately brought it and, after several months, stated that Luckin had faked more than $300 million in sales. They started cooking the books in April 2019, before the company debuted on Nasdaq. As a result, the U.S. Securities and Exchange Commission fined Luckin $180 million in December. Luckin declared bankruptcy in the U.S. in February 2021. 

The Luckin Aftermath

The sad Luckin story brings several issues to the forefront, including the importance of due diligence and monitoring for fraud. While individual investors would have been hard-pressed to discern fraud, VC firms and banks have the funds for investigations. This should have been done as soon as there was a suspicion (Block has not revealed the name of the person or company that conducted the original report.)

When Luckin filed for bankruptcy in the U.S., it protected itself from lawsuits from U.S. creditors. The company owes bondholders and shareholders nearly half a billion dollars. While this is a fine way to protect itself, it is investors who need protection.

Interfor has a team of highly experienced financial investigators who conduct inquiries with discretion and confidentiality. In the future, if you suspect a company is committing fraud or not being straightforward about its finances, we can help.

Carson Block did not want to launch an investigation because of the high cost he anticipated. But a preliminary investigation could have saved investors millions of dollars. That is why we always recommend putting money forward for an investigation, as it is very likely it will save much more in the long run.