Luckin Coffee Scandal Explained: What Actually Happened

Executive Summary:

Luckin Coffee is a Chinese coffeehouse chain selling not only coffee but other beverages like tea and juices as well as food.

The firm’s executives inflated 2019 sales numbers by more than $300 million, which caused a delisting of its stock and led to Luckin going bankrupt.

What Is Luckin Coffee?

Luckin Coffee, or ruixing in Chinese, which means ‘happiness’ and ‘luck’, is a coffeehouse chain that sells all kinds of beverages.

It is commonly referred to as China’s answer to Starbucks, selling coffee, tea, and food across thousands of kiosks and shops.

The company made a name for itself thanks to its online-offline model, which enables customers to purchase coffee and other products through its dedicated app and on other popular platforms.

That purchase can then be picked up directly within the store or delivered straight to the customer’s doorstep.

Many of its stores are also fully cashier-less, meaning you only interact with a machine and not with a real human being. As such, technology remains at the core of its business.

Another reason for the firm’s rapid ascend is the hefty discounts it provides (vis-à-vis coupons), especially in comparison to Starbucks. Customers are then upsold on other items, like Apple products, where Luckin makes its margin.

Luckin Coffee went public on the Nasdaq stock exchange back in May 2019 but was soon rocked by an accounting scandal that almost evaporated the company.

What exactly went down and what ultimately happened to the company will all be covered in the coming chapters.

Detailing Luckin’s Founding Story

If you’re hoping to read a true rags-to-riches story, then I’ll have to disappoint you right here and there.

By the time (January 2018) Luckin’s founders Charles Zhengyao Lu and Jenny Qian Zhiya opened their first store, they already experienced some level of success.

CEO Zhiya previously led the Chinese ride-hailing platform UCAR as COO where she oversaw billions of dollars in funding being raised.

UCAR itself was led by Charles Zhengyao Lu who had previously made it big as the founder of CAR Inc., one of China’s largest car rental companies.

Together, the two used their access to capital to form a viable competitor to Starbucks, which had become the largest coffee chain in China.

And China certainly welcomed the opportunity to push out Western companies in favor of its local champions (see Google, Facebook, and others).

By October 2018, a year into the business, Luckin had already managed to become the second-largest coffee chain in the country after opening 1,000+ stores.

Its growth was largely funded by the hundreds of million in venture capital the founders managed to attract. This, in turn, enabled Luckin to hand out generous discounts and thus heavily undercut Starbucks on price.

Another reason why Luckin Coffee was able to grow that quickly was its focus on smaller stores over larger ones that offered some sort of unique experience.

The eye-watering growth ultimately culminated in the firm’s IPO on the Nasdaq stock exchange in May 2019. At the time, Luckin reported a net loss of $241.3 million for 2018 on sales of just $125.3 million. Meanwhile, the IPO netted the firm another $561 million.

However, questions were already being raised back then. TechNode, a month after Luckin Coffee’s public market debut, published a piece profiling one of its leaders.

Yang Fei, its Chief Marketing Officer, had previously been imprisoned for 2+ years for violating China’s advertising law. He then went on to join UCAR where invented a set of growth hacking techniques that helped propel the firm’s valuation to $5.5 billion.

Fei stepped down a month prior to the IPO, leading Chinese media to speculate if something foul was going on. Others just assumed that Luckin Coffee simply wanted to avoid any controversy to prop up its share price.

Post-IPO, Luckin Coffee continued to double down on its growth-at-all-cost strategy. For example, the firm introduced merchandise, spun off its own tea line called Xiaolu Te, and launched a juice line, all while continuing to burn through cash.

Portions of those losses were offset by another fundraise of $865 million through a follow-on share sale and issuance of convertible bonds.

Some even began to speculate if Luckin Coffee had already surpassed Starbucks when it came to store count. Unfortunately, this was the last bit of positive news we would hear for a long while.

Explaining the Luckin Coffee Scandal

How does a corporate scandal that spreads across continents begin? With a tweet. On January 31st, 2020, short seller Muddy Waters Research shared a link to an anonymous report that was sent to the company.  

The author of said report allegedly documented 11,260 hours of store traffic surveillance video, which suggested that Luckin Coffee heavily inflated its sales numbers. The coffee maker had apparently inflated numbers by as much as 88 percent.

Keep in mind that the issuance of the report came just as the coronavirus began to wreak havoc across China and later the world, forcing Luckin to temporarily shut down most of its stores.

Luckin Coffee, as expected, swiftly and vehemently denied those allegations, stating that the “methodology of the report is flawed” and that the “evidence is unsubstantiated.”

So, over the next two months, nothing really happened. The report remained out in the wild, with some shareholders claiming that they planned to sue the company. But then, on April 2nd, 2020, a literal bombshell dropped.

That day, Luckin Coffee filed with the Securities and Exchange Commission (SEC) where it disclosed that its board had initiated an internal investigation into the activities of its former COO Jian Liu. The filing stated that he was suspected to have inflated FY 2019 sales numbers by over $300 million.

Furthermore, the alleged fraud began in Q2 2019, right around the time when Luckin went public. Over the course of the coming days, the negative news just kept piling on.

First, it was reported that chairman and co-founder Charles Lu defaulted on a $518 million margin loan issued by Goldman Sachs (the money itself actually came from Morgan Stanley, Credit Suisse, Haitong, CICC, and Barclays). He had previously used Luckin stock, which dropped by more than 80 percent, as collateral for the loan.

Nasdaq also halted all trading of Luckin Coffee’s shares until the matter was fully resolved. In the meantime, dozens of lawsuits from disgruntled investors were filed all across the globe. Chinese officials even raided the firm’s offices to find any additional evidence.

Charles Lu, as a result of the financial turmoil, was forced to sell portions of his equity holdings in CAR Inc to satisfy lender demands. With billions of dollars in shareholder losses, something or rather someone ultimately had to give.

Those people ultimately ended up being CEO and founder Jenny Zhiya Qian as well as COO Jian Liu, both of whom were terminated by Luckin’s board on May 12th, 2020. Chairman Lu Zhengyao ended up surviving the vote of confidence and retained his position – for the time being.

Interestingly, American lawmakers, fueled by Trump’s trade war, soon started to question the legitimacy of Chinese businesses listed on American exchanges. Those worries were amplified by another sales inflation scandal of TAL Education, which was coincidentally listed on the Nasdaq, too.

The Nasdaq, without explicitly mentioning Luckin or any other Chinese company, introduced tighter listing standards for firms in jurisdictions that have “secrecy laws, blocking statutes, national security laws, or other laws or regulations restricting access to information by regulators of U.S. listed companies.”

On June 23rd, 2020, the scandal ultimately culminated in the delisting of Luckin Coffee from the Nasdaq. That same day, its board filed with the SEC, requiring its chairman, Lu Zhengyao, to resign. However, Lu survived the vote of no confidence once again.

Meanwhile, the whole saga ended somewhat unspectacularly when the company’s Special Committee, which investigated the scandal, shared its results.

“In the course of the Internal Investigation, the Special Committee and its advisors reviewed over 550,000 documents collected from over 60 custodians, interviewed over 60 witnesses and performed extensive forensic accounting and data analytics testing,” the filing stated.

According to the committee’s analysis, Luckin Coffee overstated revenues by $35 million in Q2 2019, $99 million in Q3, and almost $166 million in Q4 (present dollar terms) for a total of $300 million.

The last nail into Luckin’s proverbial coffin was the final ousting of chairman Charles Lu who was removed from his position on July 15th, 2020. With Lu and the rest of the involved parties out of the way, it was time to write the company’s next chapter.

The Aftermath

Many, whether correct or not, speculated that the ousting of its founders and delisting of its shares would lead to Luckin’s demise.

There was simply no way to tap the capital markets or institutional investors for additional funding given the distrust around Luckin’s financial filings and the fact that it remained a loss-making operation. Covid-related closure only added fuel to the already ravaging fire.

Another issue was the potential fines that loomed over the firm’s head. The $9 million fine Chinese regulators imposed on the firm in September 2020 became the first sign of what was to come.

Three months later, in December, the SEC fined Luckin Coffee $180 million, with the latter not admitting or denying the allegations brought on by its investors.

The mounting debt load ultimately culminated in Chapter 15 bankruptcy, which Luckin Coffee filed back in February 2021. Chapter 15 protection is commonly used by foreign entities seeking to restructure debts from U.S. operations.

As such, Luckin’s stores remained open and its operation thus intact. Luckin Coffee, to satisfy its debt obligations with the SEC, raised $260 million from two Chinese private-equity firms, namely Centurium Capital (which contributed $240 million in senior convertible preferred shares) and Joy Capital.

Furthermore, Luckin closed down more than 600 stores (from around 4,500 down to 3,900) while laying off staff as well. The firm also introduced a franchise model in January 2021, thus shifting the set-up cost to the franchisee.

Lastly, Luckin halted its heavy discounted offers and instead focused on extracting more value from existing users, for example by funneling them to other and more lucrative offers.  

The last bit of its legal troubles would finally be resolved in September 2021. That same month, Luckin Coffee reached a global settlement of $187.5 million with its shareholders.

With most of the financial uncertainty out of the way, it was time to get back on track. Previous backer Centurium Capital, to usher in the firm’s new timeline, announced that it acquired the remainder of its shares and thus take control of Luckin Coffee.  

Its new chairman and CEO Guo Jinyi successfully managed to turn around the ship, which culminated in the surpassing of Starbucks in China (store count) back in March 2022. A month later, Luckin Coffee successfully emerged from bankruptcy only to hit its first profitable quarter weeks later.

Luckin Coffee is now actively working on expanding the brand into other countries, namely in Southeast Asia, for 2023 and beyond.

And the firm’s executives certainly haven’t lost their humor, either. Why? Because Luckin Coffee is allegedly working on being relisted on Nasdaq within the next few years.

Hi folks, Viktor checking in! Years of experience in various tech-related roles have led me to start this blog, which I hope provides you with as much enjoyment to read as I have writing the content.