While accounting fraud by Chinese companies is far from rare, two significant cases in the past year have especially unnerved the market. Fraudulent activity by Luckin Coffee and Joyy Inc. erased billions of dollars of market capitalization and led the United States to call for better accounting transparency from Chinese companies.
Past fraudulent activity undertaken by firms such as Sino Forest Corp, China MediaExpress, and Longwei Petroleum have roiled the international markets. Many of these cases of fraud were exposed by small short selling hedge funds such as Kynikos Associates, Citron Research, and more importantly, Muddy Waters Research. As the whistleblower of Luckin Coffee and Joyy Inc.’s fraud, Muddy Waters first gained prominence after uncovering irregular accounting at Sino Forest in 2011. Their track record was solidified later when they correctly accused China Zhongwang, an aluminum producer, of secretly shipping aluminum overseas and stockpiling it in the Mexican desert to falsify revenue data. Given their past success in identifying underhanded dealings, many investors took heed of their warnings when they brought the two most recent cases to the media’s attention.
No Joyy Nor Luck in Markets
The Luckin and Joyy incidents have brought much deeper and widespread impact on the markets when compared to cases of accounting fraud in the past. Luckin Coffee was seen as China’s answer to Starbucks and was quickly outpacing the Seattle-based coffee giant’s expansion in China. Company fortunes quickly soured after Muddy Waters published damning information from a Chinese hedge fund, which led to Luckin subsequently admitting that their 2019 growth figures were fabricated through a complex scheme to boost revenue. In November 2020, Muddy Waters also published a report on Joyy Inc., which was in the process of selling its live streaming division to Baidu at the time.
These two incidences of fraud will exert more pressure on US-listed Chinese firms and potentially discourage others from listing unless they go through thorough — and expensive — audits and compliance checks. The impact of slower listings will be felt by US exchanges like the NYSE and the Nasdaq as well as the Chinese companies that would otherwise have had access to US capital markets.
These discoveries occurred at a particularly bad time for US-listed Chinese firms as Congress was already deliberating over a bill which would require exchanges to delist Chinese firms that did not meet particular accounting standards. The bill passed easily just days after these cases of fraud were exposed.
Out of Luck[in’]
In April 2020, Luckin Coffee’s stock plunged 75% after the company announced that a large portion of its reported sales were fabricated. Prior to this revelation, Luckin had been one of the fastest growing companies in China and a darling of large US investors. The admission of guilt had immediate consequences, prompting the ousting of its CEO, Jenny Qian, a massive internal review, an SEC investigation, and Nasdaq’s delisting of its stock on June 29, 2020.
Founded in mid-2017, Luckin’s rise was dizzying. After opening its first location in late 2017, Luckin opened over 500 more stores within the next year. Soon enough, the company was on its way to overtaking Starbucks and becoming a home-grown success story.
After going public in May 2019, Luckin raised US$651 million, which were earmarked for advancing the company’s goal of opening more than 10,000 stores in China by the end of 2021. After reporting 558% year-over-year sales growth, Luckin stock spiked in reciprocity, doubling in just two months. Big name US institutional investors like Lone Pine Capital, Point72 Asset Management, and Louis Dreyfus held large investments in Luckin, which to that point, were paying off handsomely.
2020: a Year of Bad Fortune for Luckin Stock
The house of cards began to shake on January 31, 2020, when an anonymous email—later attributed to Chinese hedge fund Snow Lake Capital—was sent to multiple short sellers, including Muddy Waters. The report was met with skepticism by many investors that had already heavily scrutinized their China positions after several instances of Chinese company fraud had been exposed in the past. In fact, Luckin’s stock hardly dropped after the report came out, and once the company denied the claims on February 3, the stock price continued to rise by upwards of 30% over the following weeks. Luckin’s auditor, Ernst & Young Hua Ming LLP, was set to review the company’s 2019 earnings results when, on April 2, Luckin revealed that US$310 million out of its reported US$732 million revenues in 2019 had been fabricated.
The undoing of Luckin was largely due to smaller hedge funds like Snow Lake Capital and Muddy Waters. While E&Y Hua Ming did uncover fraud in their follow up investigation, an earlier report from January failed to uncover fraudulent activity over the same period. Furthermore, the bulge bracket investment bank that conducted Luckin’s IPO, Credit Suisse, conducted the required due diligence in the lead up to Luckin’s offering, but also failed to uncover any deceitful activity, even going as far as to issue a report just months before the whistles were blown on Luckin refuting claims of fraud. Following suit, five other big name brokerages maintained their ‘buy’ recommendations for Luckin.
On December 16, 2020, Luckin Coffee announced it had settled with the SEC to the tune of a US$180 million fine. Luckin’s current CEO, Jinyi Guo, asserts that this settlement illustrates Luckin’s cooperation and dedication to improve.
No Joyy For Baidu
Joyy Inc., by contrast, is a Nasdaq-listed leader in the live-streaming industry, claiming over 390 million global users. China’s live streaming industry is sized at nearly US$66 billion and is projected to double by the end of the year due to the COVID-19 pandemic. In its most recent earnings report, JOYY announced that the Chinese internet giant Baidu would be acquiring their live streaming business, YY Live, in an all-cash US$3.6 billion deal.
The acquisition was set to shore up the struggling streaming platform’s missteps while also diversifying Baidu’s revenues beyond its search business. Baidu’s revenue growth has dropped over the past year, especially within its content streaming division, iQiyi. The recent ban on over 200 Chinese apps by the Indian government, coupled with stiff competition from rival ByteDance, have also eaten into Baidu’s revenues. Robin Li, co-founder and CEO of Baidu announced, “This transaction will catapult Baidu into a leading platform for live streaming,” demonstrating the importance of the acquisition to the internet giant.
Joyy Inc. Stock Plunges on Muddy Waters’ Claims
Just two days later, on November 18, Muddy Waters published a report alleging massive fraudulent activity by YY Live, claiming that YY Live activity was misstated by up to 90%, with almost all users being computer-generated bots operated by YY Live itself. The short seller reached this conclusion after identifying that the majority of the bots’ mobile device IDs (IMEIs) linked back to YY servers and that a significant number of the IMEIs in Wuhan “displayed IP addresses that inexplicably jumped from city to city amid the lockdown.” The tip system that allowed users to contribute to content creators was also more aptly described as a tip recycling system, wherein creators gifted money to themselves again and again to boost their stats.
The report culminated in a 26% plunge in Joyy’s stock on the day that it emerged. While Baidu and Joyy did not immediately respond, Joyy released a statement condemning the report, stating, “Muddy Water’s report is full of ignorance about the live-streaming industry…The report contains a large number of errors with unclear logic, confusing data, and hasty generalizations.” Regardless, a class action lawsuit has been filed for securities fraud due to overstated revenue, growth, and user data.
2020: A Year with Lasting Implications for Chinese Firms
There are broad implications for all US-listed Chinese firms after uncovering multiple instances of fraud at Chinese companies in 2020. In May, 2020, the US Senate passed a bill that would delist Chinese firms that failed to meet the regulations outlined within the Sarbanes Oxley Act. This Act, passed in 2020 following multiple cases of highly visible corporate accounting fraud such as Enron and Worldcom, requires that the Public Company Accounting Oversight Board (PCAOB) reviews all audits for US-listed companies. On December 2, 2020, the same bill passed through the House and is currently waiting for President Trump’s signature. The bill stipulates that Chinese firms listed in the US must allow the PCAOB, or any PCAOB-approved organizations abroad, to inspect their audits. Current US-listed Chinese companies would have three years to comply with the newly required audit inspections before delisting would occur.
More than 250 companies across China and Hong Kong are listed on US exchanges, bringing along with them over US$2 trillion in market capitalization. At a time when the IPO market in China faces skepticism, as demonstrated by Ant Financial’s failed IPO, this bill has upped the ante for Chinese firms looking to raise funds in capital markets that do not comply with US accounting standards. Large companies like Alibaba, JD.com, and NetEase have already begun dual listing shares on the Hong Kong Stock exchange as a precaution against potential US delistings.
While the bill is designed to maintain standardized reporting requirements for US-listed stocks, the implications of a mass delisting event would also adversely impact US companies and investors. The NYSE and Nasdaq both receive significant listing fees from Chinese companies and earn money from investors trading Chinese stocks. Additionally, any delisting would result in massive shareholder value loss for any American investors invested in these stocks due to decreased liquidity. Companies and individuals alike would also be significantly more limited in their ability to geographically diversify investment portfolios, of which the opportunity cost would be evident as the Shanghai Stock Exchange has outperformed the NYSE by 11% through mid-November, 2020.
However, the Sarbanes Oxley Act also places Chinese companies in a difficult situation due to the very nature of the political economy in which they operate. In many cases, Beijing cites national security secrecy laws to prevent the PCAOB from fully reviewing audit reports, leaving many Chinese firms stuck between a rock and a hard place. Should they comply with US regulation, they would be breaking Chinese law, but if they fail to comply, they would then be breaking US law.
As seen by the case studies of Luckin and Joyy, fraud committed by quickly growing, emerging companies has the capacity to rattle global markets and even drive policy. While incidents like these can spook investors over the short-term, the growing demand for Chinese companies in US markets is too strong to overlook. While US policymakers have begun taking steps to tackle the issue of standardized reporting requirements for US-listed firms, the next step will be to collaborate with Chinese regulators to identify a path forward for Chinese firms to maintain the symbiotic relationship between Chinese firms and US exchanges, responsibly.