By Paul Hodgson – CCO and Senior Research Associate
[This blog first appeared on Forbes.com]
In September 2009, GMI Ratings’ AGR (accounting governance risk) rating for Sino-Forest Corporation, which filed for bankruptcy protection on March 30th 2012, moved into the Aggressive range, indicating that it was more likely to be sued, and/or underperform the market, than two thirds of the 18,000 companies with an AGR rating. In fact, apart from a single quarter ending June 30, 2009, Sino-Forest had been rated Aggressive since the quarter ending September 30, 2008. In December2010, the company plummeted into the Very Aggressive range, in the lowest percentile compared to its peers and the 13th percentile compared to all companies. It never veered from this Very Aggressive rating until, well, until the rest of the world caught up with our concerns in early June 2011, Canadian regulators opened an investigation into accusations by Muddy Waters, a short seller that published a report alleging that Sino-Forest’s business model was a “Ponzi scheme” and that Sino-Forest is fraudulently exaggerating the value of its assets. The price of Sino-Forest stock plummeted 70% in one week.
So how did GMI Ratings know that there were problems with Sino-Forest’s business so far ahead of virtually anyone else? Its accounting model trawls annual and quarterly accounts for perverse accounting treatments and significant negative governance events. In the case of Sino-Forest, both divestiture and restructuring events were flagged early. In addition, red flags appeared against at least four each of our revenue recognition, expense recognition, and asset-liability valuation accounting metrics.
Among the allegations made by Muddy Waters were that the company had inflated the value of its timber holdings, provided “fraudulent data” to an outside company that evaluates Sino-Forest’s assets and had used false or related intermediary companies to buy its plantation holdings. Carson Block, who heads Muddy Waters Research, led the attack on the company. Sino-Forest’s business involves buying plantations of trees in China, holding them for two or three years while they increase in value, and then selling them for a profit. Mr. Block has alleged that Sino-Forest would have needed thousands of trucks to harvest and transport all the logs from a recent sale of holdings in the province of Yunnan. Citing Sino-Forest’s “convoluted” corporate structure, which includes more than 40 subsidiaries in China and 16 in the British Virgin Islands, Mr. Block implied that the company used these entities to redistribute cash raised by the company and also alleged that many of Sino-Forest’s forestry sales are made to related parties. Sino-Forest has called Muddy Waters’ claims “inaccurate, spurious and defamatory.” The Ontario Securities Commission began an investigation of the situation, and Sino-Forest began an internal review.
In August 2011, the Ontario Securities Commission (OSC) suspended trading of the company’s shares – at this point GMI Ratings had to suspend its AGR rating due to lack of accounts to analyze, but we’d already had our say. The OSC also ordered senior officials of the company, including CEO Allen Chan, to resign. Within a day the commission rescinded the order forcing the resignations. Allen Chan resigned on his own volition on August 28, 2011 due to the ongoing investigation. The company appointed William Ardell to take over as Chairman and Judson Martin to take over as CEO. Mr. Chan will serve as Founding Chairman Emeritus of the company and will be fully available to assist Mr. Martin with operational matters.
Then in November 2011 the Royal Canadian Mounted Police launched a criminal investigation into allegations that senior company executives may have committed fraud.
On March 30, 2012, a Canadian court granted Sino-Forest Corp protection from its creditors, and the company started looking for a buyer under the terms of an agreement with some of its note holders. The agreement allows the company to pursue its sale to a third party, or if no buyer emerges, a restructuring that would let note holders acquire nearly all of its assets. Sino-Forest was granted protection by the Ontario Superior Court of Justice under the Companies’ Creditors Arrangement Act, the equivalent of U.S. Chapter 11 filing.
Meanwhile, spending more than $50 million on its investigations, on November 15, 2011, Sino-Forest said an independent committee found no evidence of fraud at the firm following the Muddy Waters allegations. Worryingly, the committee also said it had been unable to verify the company owned all of its forests.
On November 24, 2011 it was disclosed that a special investigation into claims of fraud at Sino-Forest Corp. would not include an independent valuation of the trees the company says it owns, leaving open a key question raised by short-seller Muddy Waters. One of the last major concerns to investors and investigators is what the trees are worth. Despite earlier statements that implied that the special committee would hire an independent consultant to determine whether the valuations were accurate, a company spokesman said the committee’s final report would not include that information.
On December 12, 2011, Sino-Forest announced that it would miss an interest payment on its debt and did not know when it would be able to publish its earnings statement, thereby putting the company in default on $1.8B worth of bonds. The company said it was working with auditors to address outstanding inquires.
On January 31, 2012 a final report into fraud allegations at Sino-Forest left many questions unanswered, with little new detail on the value of its timber holdings or its opaque ties with suppliers. In its final report, the committee admitted it had failed to answer all the questions on the company’s business practices in China, including ones about related-party transactions and the valuation of its forestry holdings. In a highly technical 13-page report, the panel of lawyers and auditors said it had not been able to assess whether Sino-Forest had a proper “arm’s length” relationship with the owners of land on which it had contractual rights over the timber and businesses to whom it sold its wood.
Calling into question the usefulness of retaining Mr. Chan as Chairman Emeritus, Win Fair Holdings Group Limited has entered into an agreement with the company’s subsidiary Suri-Wood Inc. to provide it with certain corporate services at a fixed monthly fee of HK$250K for the fiscal year 2010. Sino-Forest’s founder and former Chairman and CEO Mr. Chan serves as a director of Win Fair Holdings Group. In addition to these related party transactions, other directors would seem problematic at best. In 2010, director Simon Murray attended only 12% of his scheduled board meetings. He has consistently had attendance problems over several years (he attended only 23% of scheduled board meetings and none of his scheduled committee meetings in 2009). Mr. Murray received a vote of approximately 25% against his reelection at the most recent annual meeting.
Taken in combination, these accounting, governance and environmental & safety concerns should have been a red flag to investors and debtors alike to divest themselves early of investment in and debt for the company.