(Yicai Global) April 3 -- The admission by Luckin Coffee, Starbuck's archrival in China, yesterday that its chief operating officer and other employees had faked sales figures by as much as CNY2.2 billion (USD310 million), has seen its stock price melt and many of its key backers distance themselves.

An independent special committee formed to oversee an internal probe on audit issues raised in a January short-selling report found that COO Jian Liu and several staff members fabricated transactions, the Xiamen-based company said.

Luckin's share price [NASDAQ:LK] cratered by as much as 81 percent yesterday. Trading was halted six times during the course of the day as USD5 billion was wiped off its market capitalization. It closed down 75.6 percent at USD6.40 a share.

The stock plunge has seen its two largest stakeholders, Chairman Lu Zhengyao and his wife Guo Lichun with a 23.9 percent stake and Chief Executive Officer Qian Zhiya with a 15.4 percent stake, each lose USD1 billion.

The special committee's report brought up more questions than answers. For one, based on the firm's reported revenue of CNY2.9 billion (USD408.8 million) in the first three quarters of last year, how was Liu able to fake figures that amount to almost the whole year's earnings? How could the COO pull the wool over the eyes of the chief financial officer and CEO on such a scale? How was it possible to fake income, balance sheet and cash flow figures in a financial report?

Investors Withdraw

This sorry state of affairs is a far cry from the fanfare surrounding the Xiamen-based firm's initial public offering on the Nasdaq last year, one of the largest stateside listings by a Chinese firm in 2019.

There were 158 institutional investors in Luckin as of Dec. 31, 64 more than at the end of the third quarter. As of the end of last year, 12 institutions held more than 10 million shares each, including the Bank of America, Switzerland's UBS, US financial services firm Capital Research Global Investors and US private investment capital firm Lone Pine Capital, according to data platform Wind.

This is not going to go down well with Luckin's long term investors, especially those who backed the spinning off of its Luckin Tea line as an independent brand last year, the president of another venture capital firm told Yicai Global.

It will make all investors, especially early-stage backers who have not yet fully exited, question their judgment from all angles. It is likely to affect their further fund-raising abilities, especially in today's bear market, he said.

This incident of financial fraud will have a very negative impact on the Chinese venture capital sector, Wang Jing, founding partner at Shanghai-based investment firm Sky9 Capital, told Yicai Global. It will greatly hurt the future listing of Chinese businesses in the US, as well as damage trust among institutions and shareholders in China's overseas-listed stocks.

Many institutional investors who had backed Luckin's market value and business model during its listing have already begun to distance themselves by resigning or selling stock. Liu Erhai, founder of Chinese venture capital firm Joy Capital which is the sixth largest shareholder in Luckin, is no longer a member of the coffeehouse chain's auditing committee, Luckin said last month.

Private equity firm Centurium Capital has been discreetly shifting shares. The Beijing-based company cashed in USD230 million in January by reducing its stake to 12.15 percent from 14.06 percent and effectively recovered its investment cost. More recently it sold another 44 million shares, bringing its stake in Luckin down to 8.59 percent.

Muddy Waters

In January, Luckin was accused of several instances of fraud by an anonymous report posted online by US short seller Muddy Waters.

"When Luckin Coffee went public in May 2019, it was a fundamentally broken business that was attempting to instill the culture of drinking coffee into Chinese consumers through cut-throat discounts and free giveaway coffee," the report said. "Right after its USD645 million IPO, the company had evolved into a fraud by fabricating financial and operating numbers starting in the third quarter 2019."

Luckin flatly denied the accusations but was forced to appoint a special committee to conduct an internal review to steady investors' nerves.

Unfortunately, the report released yesterday has done little to instill confidence. It was spearheaded by three members of Luckin's board of directors, Sean Shao, Tianruo Pu and Wai Yuen Chong, at least one of whom has a questionable background. Shao, an independent director at Luckin, has been repeatedly named in fraud allegations and short-selling reports.

"He has served as director on some very questionable Chinese companies listed in the US that have incurred significant losses on their public investors," according to the Muddy Waters report.

Four of them, China Medicine, Feihe International, Agria Corporation American Depo and So-Young International, were accused of fraud and five were alleged to be reverse takeovers. These are infamous incidences of skullduggery that took place in Chinese companies between 2011 and 2012, the report said.

Liu, the accused, has also long had a close relationship with Chairman Lu from his decade-long service at the car-hailing app Ucar, which Lu founded.

Inevitable Lawsuits

Luckin blames all its problems on the COO but other executives are also very likely to be pulled into the fray giving investors more grounds to claim compensation, Xu Feng, a senior partner of Shanghai Trend Law Firm, told Yicai Global.

Investors who purchased Luckin stock between Nov. 13 and Jan. 31 can contact legal practitioners to see if they can recover their losses, several US law firms have said.

Financial statement and securities fraud are punishable by a maximum of 25 years' imprisonment, according to US law. Individuals can be fined up to USD5 million and companies up to USD25 million. Auditing agencies can also be implicated and will need to provide strict evidence to the contrary.

Luckin Coffee, its executives and auditors could face huge class action lawsuits, said Xu. The deadline for submission to the chief plaintiff is April 13.

Editor: Chen Juan, Kim Taylor