Luckin Coffee shop in China. Photo: Shutterstock.com

The Nasdaq-listed Chinese coffee chain Luckin Coffee has been in the spotlight since last week when the company admitted that it had fabricated $310 million, or RMB22 billion, worth of sales in 2019.

The revelation followed an announcement by activist firm Muddy Waters Capital that it was short-selling Luckin stock after receiving an anonymous report in January detailing fraudulent behavior at the company.

The incident has many potential ramifications—for banks, lawyers and auditors as well as for investors, who have seen the stock price plummet.

But Luckin Coffee's financial fraud couldn't have come at a worse time. The scandal is occurring as Sino-U.S. relations continue to deteriorate and also comes at the height of a global pandemic, dealing yet another blow to transactions involving Chinese companies, especially U.S. listings.

"The window for Chinese companies to list in the U.S. may be closed for six months," said a Chinese firm partner specializing in listings work who did not wish to be identified. "The long term negative impact could take a year or two to recover from."

Luckin's fraud immediately brought into question the general credibility of U.S.-listed Chinese companies. The coffee chain was a story of Chinese success. Before its downfall, Luckin Coffee was dubbed a capital markets miracle, having successfully raised $651 million from an initial public offering on Nasdaq only 17 months after starting operations. In October 2017, Luckin opened its first coffee shop in Beijing's Galaxy SOHO commercial district. By the time of its initial public offering in May 2019, it had over 2,300 stores nationwide.

And the eye-popping speed of expansion didn't stop after the successful IPO, which was one of the largest U.S. listings from China last year. By the end of the year, Luckin had close to 5,000 stores in China—over 600 stores more than its primary rival Starbucks. Company leadership envisioned more than 10,000 stores all across China by the end of 2021.

This is not the first time Chinese issuers have faced a credibility crisis in overseas markets in the past decade. In 2011, the same short seller, Muddy Waters, said that a Toronto-listed Chinese company, Sino-Forest Corp., was inflating its forest assets and was essentially a fraud. Muddy Waters' report not only triggered a series of investigations of Sino-Forest, which eventually wound up declaring bankruptcy, but it also led to a slew of U.S.-listed Chinese companies being exposed for accounting fraud and were forced to delist.

The bad reputation plagued Chinese issuers for years after the Sino-Forest scandal; it wasn't until 2014 when investors started to rally around blockbuster Chinese listings such as Alibaba's $25 billion IPO on the New York Stock Exchange.

And for lawyers, there's yet another layer of worry. The Sino-Forest debacle did not end with the company's bankruptcy and delisting from the Toronto Stock Exchange in 2012. In 2013, Credit Suisse and Bank of America Merrill Lynch, alongside a group of underwriters, filed a lawsuit against Chinese law firms Jingtian & Gongcheng and Commerce & Finance Law Offices in Canada for a lack of proper due diligence negligence. That lawsuit later triggered Jingtian and Commerce & Finance to file a separate suit in China against fellow Chinese firm JunHe. Both cases settled.

But this time, lawyers may not be liable, sources familiar with the matter say. The investigation into the Luckin case continues, but there is a major difference from the Sino-Forest case. The fraud in Luckin's case occurred in the company's accounting practice, which falls under the responsibilities of the auditor and the underwriters and does not relate to the law firms' legal opinions, according to the sources.

For its IPO, Luckin Coffee was advised by Davis Polk & Wardwell and King & Wood Mallesons on U.S. and Chinese law, respectively. Cleary Gottlieb Steen & Hamilton and Jingtian & Gongcheng represented underwriters, including Credit Suisse and Morgan Stanley. The company admitted that financial fraud occurred during the second, third and fourth quarters of 2019. Its IPO prospectus released only financial statements for the first three months of 2019.

However, in January 2020 the company raised another $363 million in a follow-on share offer, in which it released financial statements for the second and third quarters of 2019. In that deal, the underwriters were advised by Latham & Watkins on U.S. law matters while the rest of the legal advisers remained unchanged from the IPO. EY served as auditors on both deals.

Jingtian & Gongcheng said in a statement that matters related to Luckin's false financial statements do not concern Chinese counsel's due diligence and other legal work.

King & Wood Mallesons declined to comment. Davis Polk, Cleary and Latham did not immediately respond to requests for comment.

Still, lawyers say the Luckin case could have much wider repercussions on deals than they did at the time of the Sino-Forest incident. This case has occurred at a time when Sino-U.S. relations are already strained, said the Chinese firm partner, who did not work on Luckin's deals.

"The United States, no matter who becomes the next president, will likely want to put pressure on China, and this case gives them reasons to do that," he said.

In fact, before Luckin's fraud was exposed, lawmakers in the U.S. were already pushing for more accounting oversight of Chinese companies. Currently, the Public Company Accounting Oversight Board, which oversees audits of all public companies in the U.S., does not have full access to accounting information of U.S.-listed Chinese companies due to restrictions of Chinese law that prevent business records of domestic companies from leaving the country. Last year, during the two countries' trade negotiations, the Trump administration was reported to have considered delisting Chinese companies from U.S. exchanges due to noncompliance with the oversight rules.

And this is all happening as the coronavirus pandemic is plunging global markets into a deep recession. The Dow Jones Industrial Average has dropped by more than 20% from an all-time high in February. The quarantine and social distancing measures implemented by governments around the globe have already slowed business operations and deal-making.

Luckin, which is facing a series of class actions in the U.S., is unlikely to have 10,000 stores anytime soon. Last week, the Chinese company announced that the board has formed a special committee and has hired Kirkland & Ellis as outside counsel to investigate the fraud. The company's shares closed at $4.39 Monday—a fraction of the initial offer price last year and a drop of more than 91% from its share price in January, when it rose to a high of $50 before the coronavirus knocked it down.

Last Friday, the China Securities Regulatory Commission made a rare statement denouncing Luckin's fraudulent behavior. The statement, which could indicate a possible domestic investigation into Luckin Coffee in China, also signals the seriousness and scope of the case's impact.

The ripple effect has already begun. On Tuesday, due diligence firm Wolfpack Research and Muddy Waters both announced that they were shorting iQiyi, a Chinese video streaming company, accusing it of inflating its 2019 revenue. IQiyi, which listed on Nasdaq in 2018, has denied the allegations.

Meanwhile, more than a dozen U.S.-listed Chinese companies, including Alibaba's top domestic rival JD.com, are reportedly looking into a possible secondary Hong Kong listing—a move made possible following a 2018 rule change and last year's successful listing of Alibaba. The Luckin case might prompt more to consider that option over listing in the U.S.

Longer term, lawyers say the U.S. market will still see Chinese listings.

"But it will be complementary to Hong Kong," the Chinese firm partner said.

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