Chinese frauds: A lesson from Sino-Forest (TSX: “TRE”)

CHOY TUNG WAH (DONALD) 1155008610YOYO YANG 1155018831IFY ONWUDINJO 1155026292SIMON TSUI 1155035339TSO LAM KWAN 1155011295

FIN6225W China Finance

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Agenda

Company background

Listing in Canada

Complex Structure

Listing via RTO

Conclusion

Muddy Water’s report

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Company background

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• A Commercial Forest plantation operator in PRC

From 2001~2010 Quadruple increased in Revenue EPS increased by 8 times Net CF in operation increased by 65 times

As of May 2011 1955th on “Forbes global 2000 leading

company” with 5.22 B market cap 1,204th in profit 1,656th in market value

• Co-founded by Allen Chan （陈德源） and K K Poon in 1992

• Listed on TSX since 1995 via RTO (code: TRE)

• Holding a majority interest in Greenheart Group Limited (HKSE:00094)

Company background

• lease land for 30 to 50 years• Continuously plant advanced

seedlings• apply best plantation management

practices

• Acquire mature trees

• Sell as standing timber/logs, or use fibre at manufacturing facilities

• After harvesting, have the right to lease land and replant with superior seedlings

• Plantation then be classified as Planted Plantations

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Purchased PlantationsPlanted Plantations

A. Wood Fibre Operations – Core business (Business adjustment since 2003)

Company background-Business

• Engineered-wood flooring produced in Jiangsu Province and distributed through more than 300 outlets

• Sawn timber produced in Yunnan Province and Heilongjiang Province

• Finger-joint board and blockboard produced in Hunan Province

• Plywood and veneer products produced in Guangxi Province

• Greenery and nursery operations based in Jiangsu Province

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Company background-Business

B. Manufacturing and Other Operations (nationwide in the PRC)

Company background-Business

Authorized intermediary “AI”

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Core Business

Company background-Business

Plantations shares: Plantation Fibre Trading of Wood LogsManufacturing & Other Operations

48.8%

2005

77.1%

2009

72.8%

2010

Land area:62M Cube/ 1st in China

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Listing in Canada

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Listing in Canada

1994

1995

2010

2011 Paulson & Co. Inc. ： 34.71 M shares / 14.1% voting rights

Davis Selected Advisers L.P. :30.91 M shares /12.6% voting rights

Fund raising & market capitalization : USD 3billion (31 December 2010 Muddy Waters.LLC’s research report).

Bonds outstanding: USD1.9 billion (63%) Bank borrowing: USD0.2 billion (7%) Equity financing: USD0.9 billion (30%)

Toronto Stock Exchange (TSX) (“TRE”), market capitalization: CAD 21M

Listing in Canada through RTO: two shell companies (Mt. Kearsarge Minerals Inc. & 1028412 Ontario Inc)

Traded on certain exchanges in Germany and United States, e.g. “SFJ GR” on Berlin exchange, “SFJ TH” on the Tradegate market and “SNOFF” on the US’s over-the-counter (OTC) market

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Listing in Canada – Motivation

• Desires to improve the quality of Chinese enterprises• “Let the most beautiful daughter marry first”

• “Leizhou Forestry Bureau” : formed an equity joint venture and partnered on the deal with Sino-Forest in 1994

• Overseas capital markets: well-established, more stringent listing requirements, accounting standards strengthen corporate governance and operating performance

Chinese Government

• Privatization limited to SOE in China’s capital market

• Listing onshore market, the process is long and cumbersome

• Political issue is another constraint

China Capital Market

Listing in Canada – Motivation

OverseasAdvantage

Significantly increases liquidity and lowers the leverage

DomesticDisadvantage

Dominated by retail investors rather than institutional investors

Volatile, sensitive to rumors and inside information and strong intervention by the government

Market performance cannot be truly reflected driven by unstable supplies of capital and long-run uncertainties

DomesticDisadvantage

DomesticDisadvantage 12

TRE’s Institution Investors in TSX:

Paulson & Co.(14.13%)Davis Selected Advisers LP(13%)

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Complex Structure

1. Company Structure

2. Business model – WFOE

3. Business model - VIE

4. Business model - BVI

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Company Structure-Complex structure

In total 97 related parties/subsidiaries:

Sino-Forest Corporate Org Chart

Location of the registered office

Number of the companies

Barbados 1

Canada 1

Suriname 1

Cayman Island 2

New Zealand 2

Hong Kong 8

China 17

China, WFOE 23

British Virgin Islands (BVI) 37

Total 97

Sino-Forest Corporation (Canada)

Sino-Panel Holding Ltd

(BVI)

Sino-Global Holdings Inc.

(BVI)

Sino Panel Corporation

(Canada)

Sino-Wood Partners Ltd.

(HK)

Sino-Capital Global Inc.

(BVI)

Sino-Forest Int’l Corporation (Barbados)

??

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WFOE

• For mainland business owned by FEs, given that Sino-Forest has started its tree-planting operation in China since 1996

Wholly Foreign-Owned Enterprise (WFOE): 23 companies

Common investment vehicle

lawful rights and interests

Investment Others

• Protected in accordance with the Law of the People's Republic of China

• No requirement of the involvement of a mainland Chinese investor

• Less conflict to deal with domestic partners

• No foreign currency control

Sino-Forest

Company Structure - WOFE

Greater efficiency 2

Greater efficiency in term of the operation, management and future development and better control of its plantation business

Company Structure - WOFE

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Sino-Forest’s WFOE Model:

Plantation rights holders

Sino-Forest

in return of leased land

pay the land lease rent

1Long term Lease

Terms of land leases are between 30 and 50 years, depending on the province and region

Variable interest entity (VIE) used in RTO• when overseas listed Chinese company is engaged in foreign

direct investment in some restricted areas and licensed business, such as internet services provider, media and education, also the same case in TRE

VIE

Chin

ese

dom

estic W

FO

E

SPV

Whole Foreign owned Enterprises, setting up for controlling PRC individual through a series of service agreements

Chinese company, seeking offshore listing, wholly foreign-owned enterprises

Special Purpose Vehicles, registered in certain countries, such as Cayman Islands or BVI, those in tax heaven countries

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Company Structure – VIE (with BVI)

18The financial results of domestic company can be consolidated with SPV1 into the group’s overall financial statements, according to US (GAAP)

Foreign investors/ PRC individuals establish SPV1 in Cayman Island or BVI

SPV1 sets up a wholly-owned SPV2 in Hong Kong; and then SPV2 establishes the "WFOE" in the PRC

Through a set of contractual arrangements, WFOE gains an authority to actually control the domestic company

Company Structure - VIE

And Tax benefits as well…

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Company Structure – BVIA new business model through establishing those related companies registered in British Virgin Island (BVI) for trading of standing timber since 2003

Purchasing Agents in PRC

BVIEnd

Customers

Authorized Intermediaries

(AI) in PRC

Sino-Forest

Business Model with BVI

Direct Sales Model

End Customers

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Company Structure – BVI

Dramatic increase in overall net profit :2003: USD0.3 M 2010: nearly USD4 M

Average annual compounded yield : 45%

Share price outperformance:Sino-Forest increased more than 400% - Dow Jones Indices increased less than 250%- SSE Index, HSI, TSX Composite increased less than 200%

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Company Structure – BVI

Purchasing Agents in PRC

BVIEnd

Customers

Authorized Intermediaries

(AI) in PRC

Main incentives: 1. Lack of AI disclosure

Very hard to collect any sales evidences between BVI and AINo requirement of audit and financial statements filing for BVIFraudulent financial reportingChallenged by Muddy Water

2. Tax Benefit from China Enterprise income taxPurchase agents can sell lower prices to BVI which then sell higher price to AISubstantial profit can be recorded in BVI BVI tax haven has no taxes in place and completely out of the scope of China Enterprise income tax

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Muddy Water’s report

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Muddy Water’s report

Has always been fraud

Claims to possess more

timber than existing ones

Exaggerates Assets

Manipulates Valuation reports

(Poyry) by providing fraud dataMuddy Waters:Utilized 10 people with disciplinesof accounting, law, finance andmanufacturing to write a report toexpose Sino-Forest’s (TRE) fraud

Believes that…

Thursday 2 June 2011:

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Muddy Water’s report

Misrepresenting rights to timber acreage

MASSIVELY OVERSTATING REVENUES ??

Muddy’s charge: “AI” with Ponzi Scheme

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Muddy Water’s report

MASSIVELY OVERSTATING REVENUES ??

Muddy’s charge: Doggy Suppliers

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Muddy Water’s report

Bo Hu ( 博 虎 ）

Fujian Lusheng( 绿 盛 ）

“How many $200 millionCompanies are in thisApartment complex?”

“…operates at the address on the 5thFloor….four desks,180m2 with 5-6 employees in the office at the time of visit. This implies that Lusheng has an extremely efficient computer system (given that it possesses so much money and so many payments with a small staff).”

• Stock is down nearly 93% from mid-April, when rumors of financial fraud started to circle the company

• Last active trading day was August 2011 at $4.81/share.

• Delisted May 9 2012 after failing to meet listing requirements and producing necessary financial statements

Muddy Water’s report

Collapse of stock price:

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A. Denied the allegations of MW

Public statements made by Muddy Waters and Carson Block were defamatory

The report was not designed to inform the investing public, but rather, to scare invertors——Sino-Forest ： a criminal and fraudulent enterprise

Misrepresenting facts to benefit its short position- Has taken out a major short position in Sino Forest’s shares

─ 11 August 2011 – 1st Interim Report─ 10 January 2012 – 2nd Interim Report─ 31 January 2012 – Final Report

Muddy Water’s report-Sino-Forest’s response

B. Appointed independent directors (the "IC")

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C. Terminology Clarification

Source: http://www.metalaugmentor.com

Muddy Water’s report-Sino-Forest’s response

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Muddy Water’s report-Sino-Forest’s response

Going after the ‘gatekeepers’

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Muddy Water’s report-Sino-Forest’s response

Sino-Forest IC report:

On-going Court Case(USD 4B)

30 March 2012 Sino-Forest commenced an action in the Court

against Muddy Waters, Carson Block, and others

Charging:• Damages amounting at USD 4B • Recovery of profits made by Muddy Waters and others in connection

with the Muddy Waters report

31 Jan 2012• Assessed forest assets by third parties —(Indufor & Stewart Murray) only decreased by 5%, 6.9 hectare differ• Subsidiary Greenheart’s Stock price recover for

93%

Q:What is Reverse Mergers (RTOs) “A reverse merger (RTO) is a transaction in which an unlisted private operating company becomes public via a merger with a publicly traded shell company, which is generally a company with no material business operations.” (SEC)

Q:Current situationBeginning in 2007 and continuing into the present, more than 150 Chinese companies have obtained listings on both U.S. and foreign stock exchanges via reverse mergers (RTOs).

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Listing via RTO

Take a US exchange as sample:

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Listing via RTO

LISTING VIA RTO

Q:Why a reverse merger rather than an IPO?

Reduce time and cost

Less legal groundwork needed

No need to time the market

A firm can avoid having to go through the lengthy SEC review process. This can save the firm anywhere from 2-12 months

A RM typically costs $200,000~300,000 less than an IPO, and this does not include indirect IPO costs such as underpricing.

Many IPOs are withdrawn at the last minute due to a perceived lack of interest among investors. 34

LISTING VIA RTO

Chinese Corporate Fraud ContagionAn unprecedented wave of alleged frauds pertaining to governance and accounting “irregularities” involving many of China RTO companies occurred……

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LISTING VIA RTO

Influence of Alleged and confirmed Chinese frauds

Bankruptcy Debt rating down/withdraw

Sino-Forest:

• Standard & Poor’s Ratings Services withdrew Sino-Forest debt rating

• Moody’s Investors Service placed the company’s credit rating on review

Stock price down

Sino-Forest:

On April 10, 2012, the ISDA Determinations Committee issued a formal decision that a Sino-Forest bankruptcy credit event had occurred…

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LISTING VIA RTO

Other interes

t groupsShort-

sellers

Private

investor

Sino-Forest’s loss: • Estimated loss of $500 M to

$750 M to the Paulson & Co. hedge fund;

• Resulting in $1.5B in subsequent fund redemptions thus far by investors according to Institutional Investor (October 31, 2011).

So-called “Chinese ‘fraud cap’ space”: Absaroka Capital Management; Alfred Little; Bronte Capital; Buyersstrike: Citron Research; Glaucus Research; Kerrisdale Capital; and Muddy Waters.

Have lost over $7 billion in 2011 alone from numerous frauds involving Chinese companies listed on U.S. exchanges, accounting for over 80% of Nasdaq permanent trading halts.

Institution investor

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LISTING VIA RTO

A or B??A: Profit by making wild claims that put honest companies under a cloud?ORB: The healthy egg doesn’t attract flies?

---Kai-Fu Lee, the former boss of Google’s China arm. Angered by what he sees as egregious mistakes in a recent report by Citron on Qihoo 360 Technology, a Chinese internet firm listed in New York, he marshalled five dozen Chinese technology investors and entrepreneurs to denounce Citron’s “lies”.

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LISTING VIA RTO

Why Chinese RTOs caused problems?

Auditing

failure

Complicity of Chinese Banks

Small auditing firms

Deloitte revealed that the Longtop’s reported cash balances did not exist and that there were “significant bank borrowings” which were unrecorded in the company’s books

not have the resources to meet auditing obligations

all of the private company’s operations are in another country

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Other reasons Explanation

VIE structure: Outside the reach of Chinese law

• Registered in such places as the Cayman Islands, BVI; outside the reach of Chinese law.

• The loophole that allowed them to list in America via reverse takeovers is an American loophole.

“Guanxi” / Endemic Nepotism of Chinese Companies: Magnification of Risk Exposure of Fraud

• The risk of failure is exacerbated by the fact that Asian values differ markedly from those of the West.

Corporate-governance: China’s resistance to foreign inspection of Chinese audits

• The Chinese government refuses to allow inspections by the Public Company Accounting Oversight Board of 110 Chinese audit firms affiliated with major international audit networks.— Deloitte-Longtop case

Other factors are language and distance… 40

LISTING VIA RTO

LISTING VIA RTO

How to solve the problem?

—Investigating microcap fraud in general (foreign exchange side)

Exchange regulator (e.g. SEC)

to issue a recent "investor bulletin" on the risks of reverse mergers

Accounting regulator

(e.g. PCAOB) to issued

warnings to accountants about reverse mergers

The Justice Department

involved in the

investigation

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Why China company again???

2. Lesson from Sino-Forest

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Conclusion

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Investors: Everybody wants a piece of China

Conclusion-Why China company again:

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Normal investors:• China, as Wheatley points

out, is “the new dot-com”

• Neglect fraud prevention and detection

Short-sellers:• Full of loopholes within

private enterprises

• Calculated accuse

A old joke:Keep three accounting books: • One for the public• One for the tax authority• One is the real one

B. Fraud, is it national culture?—“No credibility”

Difficult to build a private business like Sino-Forest in the state-dominated Chinese economy without:• Committing financial crimes • Misdemeanors

A. State-dominated Chinese economy

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Conclusion-Why China company again:The foundation of China Finance:

How to solve the problem?

CONCLUSION:

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Q & A FIN6225W China Finance

Chinese fraud, RTO Risk, etc

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As investors, how many of you are still willing to invest in offshore listed China private enterprises after learning Sino-Forest Case?Any reasons?