Bad coffee

Luckin Coffee fraud has big implications for Chinese issuers

A stricter review process and waning investor interests are the new realities Chinese companies confront when listing in New York. Improvements in the methods of conducting due diligence and enhanced safeguards for investors are sorely required.

Luckin Coffee’s share price dropped more than 80% at the beginning of April 2020 after the company issued findings from an internal investigation uncovering Rmb2.2 billion $311 million) in fabricated sales from the second to the final quarter last year.

The spectacular fallout of a Chinese company that had recently been valued at $4billion will have wider and long-term ramifications, experts claim.

“One rotten apple is ruining a whole barrel,” Haitong’s analyst wrote in a briefing to investors. “All the Chinese companies listed in the US will likely suffer collateral damage.” As one of Luckin Coffee’s four IPO underwriters, Haitong initiated an internal investigation into the matter, according to an executive at the bank speaking on grounds of anonymity to FinanceAsia.

The analyst was referring to Chinese American depositary receipt (ADRs), certificates issued by a US bank that represents shares in foreign companies. Chinese ADRs were already facing weak investor demand, with only six out of 34 companies listed in 2019 still above their IPO price, according to Bloomberg data.

“There is not much room to take a long position on the market,” one Nomura analyst told FinanceAsia. “It is another reason for so much short-selling at the moment.”

The Luckin Coffee news has also exposed more rotten eggs. TAL Education, an education service provided, subsequently admitted it had previously fabricated sales while China streaming platform iQiyi has also been accused of fraud.

Due Diligence Demand

At the heart of the issue is the capacity for investors, and the infrastructure that supports them, to do their homework. Better rules that allow more independent auditors to operate freely in China is necessary, particularly if the capital markets are to further open and win international investor trust.

“Sometimes it is hard to verify authenticity only by reviewing documentation,” Keith Williamson, managing director of Alvarez & Marsal told FinanceAsia. “Especially under the current situation when everyone is working from home. Investors should be wary, thinking about the best way to check due diligence. It is always better to get full access to all the records.”

Luckin Coffee’s behavior only goes to back up the growing bipartisan support for nations to “strengthen regulation on Chinese companies”, said Chesley Tam, a Morningstar analyst speaking on a conference call when responding to question about Luckin Coffee.

Particularly as market valuations are coming down, “we have seen increasing concerns about corporate governance in China,” Tam continued.

Muddying The Waters

Sales accountability at Luckin Coffee surfaced back in January 2020 when Muddy Waters, a due Chinese company diligence research house and short seller, cited a third-party report highlighting operational irregularities in the business. At the time of the announcement, management at Luckin Coffee brushed off the report and although its stock price fell in late January, with the price rallying in February, investors didn’t appear immediately bothered.

Muddy Waters founder Carson Block said on CNBC that “this is again a wake-up call for US policymakers, regulators, and investors about the extreme fraud risk China-based companies pose to our markets”.

China’s regulators are also unhappy. The China Securities Regulatory Commission issued a rare notice on April 3 condemning the Luckin Coffee fraud. A month prior it updated its securities law, under which Luckin Coffee could face lawsuits from Chinese investors to compensate for the loss after the short report was published.

“For those bookrunners, auditors and lawyers [working for a fraudulent company], the reputational damage can [be more painful] than a penalty from the regulators,” one Beijing-based compliance lawyer told FinanceAsia.

Hong Kong Bound?

With many legitimate companies hoping to distance themselves from questionable operators, the appeal to list closer to home only increases. Now that China has been included into the MSCI EM Index, there is less need to list in New York, while Hong Kong offers a US-dollar pegged currency and deep capital markets.

Since 2018, the Hong Kong Exchange has reformed listing rules to become more competitive to New York, shortening the IPO reviewing process and expediting the turnaround process, Paul Go, IPO leader at EY, told FinanceAsia.

Following Alibaba, other US-listed Chinese companies such as JD.com, Ctrip and Baidu were expected to ‘come back’ to China and list in Hong Kong. Baidu had already hired its investor relations manager in Hong Kong, while JD.com was penciled to IPO this year. However, due to the outbreak of COVID-19, these plans are postponed.

With many stocks rallying as investors were giving companies the benefit of the doubt, trust has been eroded and amplified as risk-averse sentiment remain high. Given the momentum of distrust, expect more pressure on Chinese ADRs in the upcoming quarters or until better oversight is put in place.

It is not only international investors, but also domestic Chinse asset managers hoping that better regulatory oversight improves the market.

¬ Haymarket Media Limited. All rights reserved.

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