Susan Mallin CIM ,CFP

Introduction and Background

The recently released 111 page Sino Forest 2nd Interim report along with the 43 page supplementary report from the advisory panel, and all of the attachments have created mixed reactions in the public. Several newspaper articles and other various opinions on this report since it was made have been quite negative. Nevertheless the company has stated that the audit process is almost complete, and that they have not found fraud. Though at first glance the report can come across as being somewhat “messy”, it certainly provides excellent information and explanations on how they conduct business and why certain processes of the business are conducted the way they are. At the same time it makes one raise an eyebrow here and there. Various constraints and differences when conducting business in China can create the need for business models that may not seem to make sense in western style terms and can end up creating a mixed bag of misunderstandings. However, the model used for Sino Forest makes sense for what they are doing in China and further, many reasonable explanations for the differences have been elaborated on and explained. The most important initial part of evaluating a company for fraud is being able to prove the cash and the assets and that was the main focus of this 2nd interim report.

The opaqueness of a business model can give rise to suspicion and can lead one to believe they have something to hide. The questions are, if they are hiding something, what is it, why, is it appropriate, or is it illegal? Back in the old days when I worked for a bank, one of the things most investigated by the accounts monitoring department was “layering”. This is the activity of constantly moving money around in order to create opaqueness and difficult to follow paper trails. The purpose was to look for money laundering activities. However, in some instances the initial suspicious activity amounted to nothing once a deeper understanding of the reasons behind such activity was understood. In order to understand if a business model makes sense, it’s important to utilize a top down macro approach first to understand if the underlying “suspicious” activities align with the over all purpose and the unique constraints of the business. One could easily focus on just the negative parts of the business or micro-think specific segments of the audit report and conclude that enough imperfections summed up, equate to criminal wrong doing. Though the report had some negative aspects for which many of them can easily be explained away, the bigger allegations are still somewhat unsolved.

Who’s in charge of this audit?

1) The Audit Committee of the Board

Boards of Directors and their committees rely on management to run the daily operations of the business. The Board's role is better described as oversight or monitoring, rather than execution. Responsibilities of the audit committee typically include:

• Overseeing the financial reporting and disclosure process.
• Monitoring choice of accounting policies and principles.
• Overseeing hiring, performance and independence of the external auditors.
• Oversight of regulatory compliance, ethics, and whistleblower hotlines.
• Monitoring the internal control process.
• Overseeing the performance of the internal audit function.
• Discussing risk management policies and practices with management.

2) External Auditors

Sino Forest normally engages Ernst & Young as their external auditor, but has brought in PwC to help with this special purpose audit.

Here is an interesting publication on how audit committees work with external auditors.

2) Legal Teams

Provide expert opinions, weigh evidence and its admissibility or relevance.

The first steps in general for this audit is to decide on the scope of the allegations and decide on a master plan on which will be the areas of focus. The committee decided that the primary focus would involve 4 items: 1) timber asset verification 2) timber asset value 3) revenue recognition and 4) related party transactions.

The 43 page report issued from the independent advisory committee (PwC) outlines the steps taken during their audit and results. It reads almost like a day-to-day diary of what they did, who they talked to, and what obstacles they faced etc. It clearly states that it should be read in conjunction with the main 111 page report from the independent committee and not as a stand alone document.

Processes

Cash confirmation

The IC (independent committee) first employed the advisory committee (PwC) to verify the cash balances. PwC confirmed 80% of the cash balance from 28 out of the 300 (or so) bank accounts where the bulk of cash lay. They mentioned that they took steps to verify the cash balances using planned procedures designed to mitigate the potential for manipulation of the process. Constraints in this process were evident in the fact that visiting 300 bank branches across the country would be time consuming and costly. Thus examining the main accounts was the mandate. The company has a little over 500 million in cash. The mandate was to verify 80% of claimed cash, of which they were successful.

Cash Burn

There has been one analyst that claims that the company will run out of cash within 6 months. Yes this has been expensive, but some expenses are not apt to be repeated on a go forward basis. They went from 835 million to 571 million in cash from July-Nov. Going forward, I exclude the paid 90 million senior notes, 65 million in bank loans re-payment, 25 million in advisor fees, add interest of about 30 million per quarter, and the net outflow is more like 65 million per quarter. With 571 million in the bank, that’s at least 8 quarters (2 years).

Electronic data gathering

This process is the preservation and forensic imaging and collection of all server data used for communication, predominately emails. The next step is to determine the key people in which the data should be studied. There were 23 individuals that were priority, with 8 of those 23 as top priority. (page 7 advisors report).

The purpose was to establish internal reaction to the MW allegations (I wonder what those emails were like, perhaps a lot of swearing). Other mandates were to find any communication with forestry bureaus, about the bureaus, bureau confirmation letters, and communications with AI’s and suppliers. This process was filtered and narrowed several times adding new search words for specific targets.

They used a set of search words (sort of like Google) which produced 11,174 documents. From there, they identify and sort through the relevance. After various eliminations they were left with 401 documents for follow up.

In some cases, management was required to provide written responses to some of the emails and many were presented to management for explanations during the interview process. These were not provided for viewing to the general public.

Factors affecting the process

Legally, collecting email data has to go through proper protocol otherwise it may affect the admissibility of any evidence. The independent committee wanted to meet with management and other employees to explain the procedure and importance of the audit and to mitigate the employee “sensitivities”. A legal hold notice was then sent to all employees on June 14th. A problem occurred when the forensic team showed up at the Guangzhou office on the 13th (the day before the hold notice was issued). The forensic team was denied access by Ms. Chen. However on the 15th they were provided access.

I’m sure many are asking themselves; why on earth would a company have 300 bank accounts? It’s actually not that uncommon for a company that spans operations over several jurisdictions. China employs top down central planning strategies, but these are then decentralized and implemented at the local level. This means applying for business licenses and registrations are done at distinct local levels. A second factor pertains to foreign capital injection allowances per business project. Sino Forest acts as a parent company for all of its subsidiaries and is allowed to move money between these entities for simplicity. This could explain why most of the money can be found in 28 of the 300 banks accounts.

Before you can count trees, you need to know this first:

In order to understand how the various timbers can be accounted for, one must have an understanding of the various ways to own a forest and what paperwork is given for each. It is also important to understand the differences of various tree “ownership” allowed/preferred for the Wholly Foreign Owned Enterprises (WFOE) and the British Virgin Island (BVI) legal structures.

For the most part, only the Government can own the land in China. Everybody else can purchase various rights, and usages which are all primarily done by contract. Thus, deeds to land are non-existent and “ownership” is proved through undisputed contracts to rights.

There are two ways in which Sino Forest engages in timber plantations: Planted or Purchased. It is important to know the distinction as they both have different contracts with regards to legal rights and subsequent supporting documentation.

Planted Plantation - leased land where you plant the trees yourself. These leases can last upwards of 70 years. In China, if you have rights to land and you plant trees on it, the trees belong to you by law. However, you need to have a permit to cut the trees down for commercial purposes. Permits are allocated based on the harvesting quotas of the region, and companies engaged in harvesting must have a special “harvesting business license”. These planted plantations are done using the WFOE structure.

Purchased Plantation - the purchase of existing trees in various maturities and species. In this situation you are only purchasing the trees, but are not engaging in leasing the land. The original “owner” still has the right to use the land, but has simply sold the trees as is. These purchased plantations are primarily done using the BVI structure, but can also be done with the WFOE structure. A growing trend to purchase through the WFOE has emerged as the business laws in China evolve and become more accommodating.

Master Purchase Agreements - the framework document used to purchase standing timber from a supplier or group of suppliers for a specified price range and a specified area, during a specific time frame. The agreements usually include a provision to lease the land (once harvested) for re-planting. Under the agreement they have a fixed number of years to acquire the trees. Time can range such as 3 years (Guangxi), or even 14 years (Hunan) with an average of about 5 years. Once acquired they usually hold the trees for up to 3 years and then sell. In most cases the trees acquired are mature at the time of acquisition.

Documents of contractual ownership proof:

Planted plantation = plantation certificate

Purchased plantation = executed purchase agreement (other documents described later)

AI and Suppliers

The intermediaries are an important part of the standing timber purchase and sales. On the other hand, the use of these middlemen creates the opaqueness that can give rise to suspicion.

Authorized Intermediaries (AIs) – Chinese domiciled organizations that act as middlemen conducting various services for various foreign corporations. They are also known as “wood dealers”. They are used primarily for conducting the business when using the BVI offshore structure.

AI activity – Have the end user customer base for timber sales, provide assignee/assignor services (contracts), and payment settlement services. Often the AIs sub contract the appropriate harvesting and transport company to deliver the raw product to various buyers. Some manufactures, will sub contract the harvesters themselves. In other cases the AI will buy and hold on behalf of an investor/speculator client.

Suppliers – Sometimes also called agents, who have received contractual rights with the village committee of collectively owned forests to re-contract entitlement to trees and/or lease rights, or forest management operations to 3rd part parties. These agents help to consolidate small parcels into appropriate commercial sizes needed. For the most part, they are only allowed to sell to licensed forest companies. Typically they cannot go direct to the AI or the end use manufacturer. The forest companies are the ones that will formulate the appropriate forest management plan and apply for the respective cutting quotas.

Here is an example of an AI in China: (I don’t know if this company does business with Sino Forest, but I liked the chart they show)

Here is an interesting article on the Intermediary business in China

Back ground on forest land (macro view).

The government utilizes a top down macro strategic approach to manage the country’s forests. They in turn, delegate duties down to the provincial and local forest bureaus to implement and monitor the strategic plans. Much forestry land was allotted to the rural people many years ago under the great collective land reforms undertaken in China to give the people distinct land usage rights for individual economic benefit. These laws continue to evolve. These land usage rights are transferable by contract to third parties.

China is the biggest exporter of wooden products and has a net deficit of domestic log inventory to imported logs. They have been trying to implement strategies to narrow this gap. In many instances the lack of investment and the impatience of not allowing trees to mature has led to deforestation, soil erosion, flooding, and desertification. In turn, this can have a negative effect on the entire agriculture sector (food supply chain) for the most populous country on earth. China has extensive forest coverage, but ranks extremely low in the world with regards to age and maturity of trees.

Challenges in China are addressed strategically using their usual top down approach and communicated within their 5 year plans. In the last 12th five year plan, significant importance was placed on industrializing agriculture (which includes forestry). China normally fosters, encourages, and gives preferential treatment to corporations with operations that fit within their macro plan.

My breakdown of the 12th five year plan.

Why use a supplier or agent when purchasing the trees?

As a commercial scale forest company, it would not make economic sense to negotiate with hundreds of individual households to purchase individual fragments of forests in an area from single households. Besides, these decisions are made at the village committee level and in many cases the people in the village have already contracted out their portion of forest operations to the village committee itself. There is a political process as described here

Once the village has made the decision to sell/lease/contract out, they authorize a supplier who by law must act in good faith and have the authority to bind the collectives into a proper agreement with a 3rd party, such as Sino Forest. Based on past mishaps of other corporations, and because of the bureaucratic nightmare, a company would have to be insane not use an agent for this purpose. However, agents or village leaders have been known to have misled corporations in the past, and thus, trust, knowledge, and relationship with your agent is one of the most important functions in the process of procuring forest land. We are used to operating under a property law system, but in China where there is no property law per se, it’s all based on contract law. In fact the contract is the fundamental basis for rights legitimacy in China, so much so, that even all employees are hired using contracts.

How to verify the timber?

In western standards a simple deed would suffice. However, that’s not how it works in China. Property is designated with a specific use (as per the top Government instructions) such as grassland, agriculture, economic forest, or timber forest etc. Further, it is broken down by lease rights, use rights or both. Different jurisdictions, different land use purposes and rights, equals different issuance of paperwork. In general, the property law is mostly based on performance of contract which underscores the validity of ownership in lieu of the non existing land deeds. In the case of standing timber purchases, one would want title ownership to the trees (in our view), but those documents are not standard issue. The contract has more credence there, and that is what the Chinese people are accustomed to.

Despite the fact that property laws are virtually non existent, that is not the case for contract law. In 1999 China passed the Uniform Contract Law (UCL), for which we should all be familiar with. The general provisions are:

1) Conclusion of contracts
2) Effectiveness
3) Performance
4) Modification and assignment
5) Termination
6) Liabilities for breach

Contract rights are taken very seriously in China, and all must contain a clause on agreed methods of dispute resolution. Many contracts can have several conditions within its overall scope. However, one or two breaches of conditions within do not necessarily invalidate the entire contract. (This is important to know as I move closer to the OSC issue)

Article 56 China Contract law:

Where a contract is partially invalid, and the validity of the remaining provisions thereof is not affected as a result, the remaining provisions are nevertheless valid.

For contract example purposes, if the supplier presents an area of trees to Sino Forest to purchase they do so by contract, and if the contract has performed, meaning the money has been paid and there are no disputes, the contract can be valid even if one of the conditions has not fully been met. However a complete breach, such as failure to deliver can void the contract in its entirety and the party in breach is liable for damages. In this case, Sino Forest would be granted their money back if the supplier was in such breach of contract as to make the whole performance impossible. Disputes can occur between parties, and in such case it goes to the government officials of various levels to decide the outcome. Sino Forest relies on the supplier to have engaged in the proper legal protocol and authorization to act on behalf of the collective village. As much due diligence as Sino Forest can do, they are not in control of overseeing and monitoring the contractual legalities and relationship between the collectives and the agent.

While the land reform system in China continually evolves there is talk about ramping up the speed and consistency of issuing title documents for trees without corresponding land leases. In the meantime, the tree purchases are verified with other documents.

Currently there are only 5 ways to verify timber ownership rights for a foreign corporation:

1) Fully Signed Purchase agreements – the master framework which includes price, location, hectares, time frame, future lease provisions. This is signed between Sino Forest and authorized selling agent (supplier).

2) Contract agreements – contractual agreements and obligations between authorized suppliers and Sino Forest.

3) Set off payments – a series of receipts for payment of the timber and proceeds of eventual timber sales.

4) Plantation rights certificates – these are given to entities that have the timber rights and the land lease rights (and the closest thing to a deed that we can relate to). Sino Forest is given these only through the WFOE entities after they have also entered into their contractual rights to lease the land. They are not given to the BVI entities, since they do not lease the land through the BVI structure. Usually the BVI will transfer the rights to lease over to one of the WFOE structures when the time comes.

5) Forest Bureau Confirmations – acknowledges rights to standing timber only. These confirmations do not seem to be standard practice and the bureaus signed off on them as favors to Sino Forest, with many of them stating that they found Sino Forest too demanding in their requests for paperwork. Normally, the practice would be to issue plantation right certificates, but in order to have that, one needs to be engaged in both timber rights and land lease rights at the same time. One legal opinion is that the confirmations satisfy that the trees are not under dispute and that the purchases have been reviewed and approved by the relative forest bureau (aka the Government). It is a comfort that the summation of the above 4 points have been validated and approved. The bureau must also register the change.
Copied page 6, 2nd paragraph 2nd Interim report

“Forestry bureau confirmations are not officially recognized documents and are not issued pursuant to a legislative mandate or, to the knowledge of the IC, a published policy. It appears they were issued at the request of the Company or its Suppliers. The confirmations are not title documents, in the Western sense of that term, although the IC believes they should be viewed as comfort indicating the relevant forestry bureau does not dispute SF’s claims to the standing timber to which they relate and might provide comfort in case of disputes. The purchase contracts are the primary evidence of the Company’s interest in timber assets.”

Based on the land use system in China, the only ways to verify assets are with the plantation rights certificates (planted plantations on leased land for WFOE), the purchase and sale contracts, set-off payment receipts for standing timber transactions, and the forest bureau confirmations, as well as overall contract performance in the case of the BVI. Considering the forest bureau typically will not provide the plantation certificate unless both timber rights and land lease rights are done simultaneously, it has been impossible to obtain the specific plantation certificates documents for the BVIs which never engage in land leases directly. Tree ownership “title” documents are an issue for all companies dealing in tree only purchases.
Sino Forest has obtained various legal advice that the purchase agreements for timber could go through the process of approval with the local forest bureau, and as such, they ask for a confirmation letter from the bureau as indication that the bureau reviewed and approved the contract (and the approval of the 3rd party contractual way in which it will own the trees). If they are unable to obtain the confirmation, (a major condition of performance) it voids the contract and Sino Forest does not have to engage the purchase further. Sino Forest obtained 100% of the confirmation certificates. The independent audit found no evidence that these certification letters were forged.

Confirmed Timber = 99.2%

17.9% of all timber holdings were classified as planted plantations and all were confirmed with corresponding planted plantation certificates.

81.3% of all timber holdings were classified as purchased plantations and were confirmed with all of the issued and relevant documents: 1) the forest bureau confirmations, 2) signed purchase agreements, 3) contractual right contracts, 4) set-off payments.

The above equates to 99.2% of timber assets verified with relevant documentation currently issued and legally binding in the PRC.

(The contract point #3 as mentioned above, is the main issue the OSC had concerns with and the primary reason for the cease trade order, which will be explained later in this report)

In addition to the above documents, they have reviewed the purchase contracts as well as the corresponding set-off transactions (payments) and confirm that total documentation actually represents 106% of the disclosed timber. The additional 6% is explained on page 5 of the press release – Chart Summary of Timber Assets by Verification Source. See footnote 3. They have leased bare land for replanting and because there are currently no trees yet, they don’t include these hectares under management on their books.

Considering that only the timber rights dually combined with land lease activation is what provides a plantation certificate; and we know that leases are not activated on much of the current standing timber land, it is natural NOT to have the plantation certificate for all timber holdings. Other timber holding are verified by other means as outlined. Many newspaper columns are either making an error or misleading the public by saying “Sino forest can only prove 18% of their timber with plantation certificates.” What they omit is that 18% actually consists of 100% of planted plantations. The other 82% is standing timber (purchased plantations) without current lease activation. These timber assets are verified through purchase contracts and government approvals not plantation certificates. Sino Forest cannot produce these plantation certificates for non leased land out of thin air like some sort of magician, because they are not standard issue in the first place on this type of arrangement.

Contract Law

Sino Forest has timber ownership validation either through the planted plantation certificates or by contractual ownership.

Text copied from this website

A lawfully formed contract is legally binding on the parties. The parties shall perform their respective obligations in accordance with the contract, and neither party may arbitrarily amend or terminate the contract.

Article 49 Contract by Person with Apparent Agency Authority

Where the person lacking agency authority, acting beyond his agency authority, or whose agency authority was extinguished concluded a contract in the name of the principal, if it was reasonable for the other party to believe that the person performing the act had agency authority, such act of agency is valid.

For a Sino-foreign Equity Joint Venture Enterprise Contract, Sino-foreign Cooperative Joint Venture Contract, or a Contract for Sino-foreign Joint Exploration and Development of Natural Resources which is performed within the territory of the People's Republic of China, the law of the People's Republic of China applies

Article 5 Construction of forestry shall be guided by the approach of forest ranging as the basis, universal forest protection, great forestation efforts, combination of cutting and planting, and sustainable utilization.

Article 6 The State encourages research of the forestry science, popularizes advanced forestry technology and raises the level of forestry science and technology.

Article 7 The State protects the legitimate rights and interests of forest growers, alleviates their burdens according to the law, forbids law-breaking imposition of levies and fines on them, and forbids the imposition of contributions and mandatory fund-raising on them.

The State protects the legitimate rights and interests of the collectives and private individuals who have contracted for forestation; no organization and private individual shall encroach upon the ownership of trees and other legitimate rights and interests entitled according to the law to the collectives and private individuals who have contracted for forestation.

Article 16 The people's government at various levels shall formulate long-term forestry plans. State-owned forestry enterprises, institutions and natural protection zones shall, according to the long-term forestry plans, formulate their forestry operation programs, which shall be implemented after submission to and approval of the competent authorities at a higher level.

The competent forestry authorities shall guide rural collective economic organizations and state-owned farms, pasture lands, industrial enterprises and mines in the formulation of their forest operation programs.

Article 17 A dispute between organizations in connection with the ownership and the use right of trees and woodlands, it shall be up to the people's government above the county level to resolve it according to the law.

A dispute between private individuals or between a private individual and an organization in connection with the ownership of trees and the use right of woodlands, it shall be up to the people's government at the county or township level to resolve it according to the law.

Purchase and sale set-off payments for BVI’s:

This is an explanation of how they transact for the purchasing and sales of standing timber.

1) Written instructions from a BVI to an AI (that has/owes money to a Sino Forest BVI) to use a specific amount of money (belonging in the accounts payable to Sino Forest account) to purchase X amount of standing timber from supplier A.

2) Written notification to Supplier A that payment is coming through AI to settle the purchase.

3) Written confirmation from the AI that the payment has been made to Supplier A

4) Written confirmation from Supplier A that payment has been made in the specified amount.

The above 4 documents together close the loop of one purchase agreement for a BVI entity and provides evidence of partial performance of contract. Sino Forest was able to provide all documents relating to these transactions.

The problem with this method is obviously that the suppliers and AIs are not obligated to show the auditors the movements of the money within their own bank accounts. The auditors did go through various SAIC filings of intermediaries and found significant accounts payable to Sino Forest. There are limitations however, to the completeness of SAIC filings. Many suppliers cited privacy or tax reasons, or even usage of several of their own off setting transactions since many AIs are connected to their own parent company’s and other subsidiaries.

It would be easier if the AIs were more cooperative and open about releasing financial documents. However, looking at it from their point of view, it’s understandable. For the most part they probably don’t really know what’s going on. They have most likely heard of various acronyms in their life, like FBI, CIA, KGB, CNBC, OMG, and are probably wondering who the BLEEP are the OSC and the RCMP? And why do they want to look at my bank account? There was criticism regarding the PwC report where they state that management wanted to set up and be present at the various appointments. I’m inclined to think that under the circumstances, without management influence they probably would not have talked to them at all.

Sino Forest and the AIs act on a principal basis. Once the AI purchases the standing timber from Sino Forest, the deal is considered sold and proceeds are allotted to the accounts payable to Sino Forest. Often the agreements state that the AI must sell to an end user within a certain time frame so that the harvest is done in a reasonable time frame as stipulated and the land can then be returned to Sino Forest for lease and planting purposes. However, this does not necessarily mean that the trees have been harvested, it could very well have been sold and paid within an appropriate timeframe but returning the land for re-planting may take longer based on harvesting quotas in the region or sometimes the customer is an investor. Selling to an investor is ideal in some situations when a return of the land for land lease purposes is not needed or ideal right away. Sino Forest is not obligated to lease the vacant land in all instances. In fact they have several years to act on the lease provisions within the master framework between Sino Forest and the supplier. Therefore the sale of timber assets and corresponding land leases do not have to have matching growth patterns.

Macro view between land leasing & timber purchases:

Although China has allocated various land use rights to the people, those who have timber forest land use rights may not be able to have the best economic benefit from it. Even though wood is in high demand, quotas allotted for cutting the trees are strict and in some areas minimal. A person might own the trees, but if they can’t cut them and put them into production, there is no economic benefit for them. The cutting quotas have doubled for the industrialized plantation owners with modern forestry planning strategies, and have decreased for the individual collective plantations. In many cases the collectives have been put behind the eight ball and need to contract out the forest management to corporations. If the trees are at or near maturity, it’s best to sell them without the lease rights for the time being. Once the trees are cut, the person with the land rights can re-plant and thus economic benefit can be repeated faster. However, many opt to give up the land lease rights to the corporation and receive “rent payment” or in some cases profit sharing opportunities. The government encourages the people to work for the forestry corporations. Depending on the collective village situation, direct economic benefit to the individual household may not be apparent on a sale. Some news reports identify individuals who proclaim they have “never seen a dime” after the timber/or lease rights were transferred to a corporation. But one needs to understand that individuals may have current mortgages on their trees, or the village committee may have agreed that the majority of the proceeds would be used to build a school, or roads etc for the collective benefit as opposed to individual gain.

The use of the AIs and Suppliers to handle the money on behalf of Sino Forest could be considered a business risk. The management states that the AI model is based on relationships and trust, and obviously without it, Sino Forest could possibly be swindled here if an AI misappropriates the accounts payable. The strength lies in the fact that the contractual obligations along with performance are strongly relied on in China and is a popular way of conducting business. Based on potential risk, it would be paramount to have close business relationships and trust. How close? Seems to be the question and relates to the accusations of ‘related parties’. There is nothing wrong with having related party transactions, as long as they are disclosed and accounted for properly. Sino Forest and the AIs all state they are conducting business as un-related parties.

In some ways it reminds me of my job. A client has their money in an account with me. When selling XYZ stock, the proceeds typically settle within the same client account. I use that money plus profits to purchase a different stock, ABC. However, if somebody from a different country thought that my client could not have possibly bought that stock because their bank account didn’t show the corresponding transaction. And further, the ABC company says they have never heard of my client (because the stock is held in nominee name), they could accuse my client of being opaque and a criminal. Then the authorities of (insert other country) come and investigate me as someone who is potentially aiding and abetting my client, I’m going to be a little perplexed as to why and wonder what’s not to understand here? So in some ways, I’m an AI too.

Others might state that the AIs simply don’t have big enough business operations in order to harvest and transport the timber they sell and thus they are not viable operations for such mass volumes of business Sino Forest may throw their way. However, Sino Forest may transfer the harvest quota to the AI, but most AIs don’t have a harvesting or transport license in addition to their wood dealer licenses. The majority of harvesting is usually sub contracted to an appropriately licensed harvester, who is a separate company. Some AIs may advertize that they will also harvest….but it is done via sub contract or, unless they own two complimentary companies. In some cases the end-use buyer (manufacturer) will use their own sub-contractor for the harvesting.

It reminds me of my friend who is a mortgage broker. He is one of the biggest mortgage brokers in the city and closes over 50 million dollars of mortgage business in a year. You would never know it though because he works out of his basement. He does not have a sign on his lawn. He does not have a team of underwriters, or a handful of appraisers, a team of lawyers, or 100 million sloshing around in his bank account. He has a smile, a business card, a computer, and a blackberry. All other duties are all assigned to the appropriately licensed people as needed, and of course the mortgages are funded via 3rd parties. He also has a broker license which is a sub contract to another broker. On top of all of this, he has about 100 other mortgage brokers that subcontract under him. He works from his basement and makes as much money as most CEOs. Seems rather suspicious doesn’t it? Things are not always as they seem on the surface.

Taken from this web site:

Agents and Distributors: There are few regulations specifically applying to the conduct of agents and distributors in China. Contracts between foreign companies and Chinese entities acting on their behalf are governed by general contract laws and regulations. A number of experienced foreign trading companies and consultants, most likely located in Hong Kong or a major coastal Chinese city, represent a wide variety of foreign manufacturers in China. Also, certain foreign-invested enterprises are vehicles for distribution within China.

Chinese trading corporations, under the present trade regime, are still primarily export oriented, but handle purchasing transactions for Chinese end users with no direct links to foreign manufacturers. Agreements between foreign companies and Chinese entities to establish consignment sales and service centers are increasingly common. Trade shows and trade missions are also useful ways to begin marketing a foreign product in China. Direct hiring of Chinese individuals as sellers and agents is constrained, in part, by existing labor laws and policies, and the linkage between social and welfare benefits and employment with a Chinese entity.

Page 16 interim report copied 5th paragraph “BVIs as investment vehicles”

Many foreign investors, including well known multi-national companies, hold their investments in China in special purpose vehicles established overseas in jurisdictions with a familiar and internationally accepted system of corporate governance. By way of example, over 75% of blue chip companies listed on the Hong Kong Stock Exchange (Hang Seng Index constituent stocks excluding the Finance Sub-Index) utilise British Virgin Islands holding structures, including for their investments in China. This reduces the uncertainties of operating under relatively new and untested Chinese corporate structures, and enables investors to enter into shareholding arrangements under familiar Western structures, governed by a common law system. The British Virgin Islands has been a particularly popular jurisdiction in which to establish such companies, because of the lack of corporate income tax, capital duty and stamp duty on profits or issue or sale of shares. The use of such special purpose companies, one for each investment, also facilitates raising capital offshore and restructuring such companies without the uncertainties and delays inherent in the domestic Chinese system which requires a host of government approvals for even minor changes to a company ownership or structure.

Timber Rights Diligence Process

Each BVI timber purchase contract has an accompanying Forest Resource Survey Report. This report provided coordinates, conditions, total plantation area, forest coverage, tree types, tree details, density, transport conditions, social and economic conditions. The survey reports are almost all exclusively done by one survey company; which raised concerns with the OSC.

Page 6 of Schedule IX

“SF will commission a forestry survey company, Survey Company #1, which is a fully qualified forestry company certified by Forestry Society of Guangdong Province, a society under the supervision of Guangdong Province Forestry Administration, to conduct a formal and full scale survey report on the forestry resources of the targeted plantation including species, yield, age of stand and area, etc., which is used for internal purposes only (see Attachment A3a and B3a)”

Although the survey lends credence to the validity of the purchase arrangements, it was mainly used in part for internal business purposes to evaluate the land and investment potential and analysis especially in relation to the volume of timber and price to pay. It did not form a part of the valuations for balance sheet purposes. Maps are only borrowed and viewed from the bureau and they are not allowed to keep them or make copies. This is apparently due to national security issues in China.

China is very picky on who is allowed to perform mapping and land surveys. They are especially not very fond of foreign companies having or retaining maps and worse, try bringing in sophisticated GPS technology; that could land you in jail. For maps and surveys laws see here:

The Forest Acquisition Department (FAD) of Sino Forest

This FAD department typically conducted the due diligence by examining the maps, spot views of the area in question, current plantation certificates if available from the supplier. In addition they visited the Forest Bureau to look at any registrations and to confirm there were no existing disputes. The internal controls of the purchases are quite extensive and require several internal approvals but thorough use of the process seems to be inconsistent within the company depending on the BVI or WFOE structure as it pertains to purchasing trees (less paper work), or leasing (much more paper work).

As mentioned earlier, the BVI purchases are not able to obtain a plantation certificate because they don’t simultaneously engage in the land lease rights, but could they obtain copies of the existing plantation certificates from the original owners? According to Sino Forest and Chinese officials,…not always. The supplier typically should have negotiated with the village heads and farmers for their agreements prior to approaching Sino Forest and could present these documents as evidence of proper chain of custody. However, even the forest bureau admits, that not all the plantation certificates have formally been issued in all areas, even though the farmers have the rights and can transfer those rights regardless. Not to mention that land use rights can be mortgaged, in which case the certificates are held at the bank. If the purchaser of the contract assumes the mortgage, the certificate will not be available. I notice that Sino Forest has several mortgages attached to various trees, whether those were assumed or obtained after the fact is unclear.

Here is the “Smoking Gun” Fraud Allegations from the OSC:

Remember earlier, I said that the agent has a contract with the village committee? This contract is separate and apart from Sino Forest. However, based on past case studies of land transfer problems which almost always arise from the fault of agents or village heads not getting majority votes, there becomes a risk for Sino Forest subsequently engaging into a contract with the agent which could end up being disputed by the households. If a dispute arises, the government is in charge of a resolution. During the period of dispute, the trees in question are forbidden to be cut down. In order to prevent such problems, Sino Forest says it will only work with agents they know and trust and they will also perform spot checks and some due diligence in the village to obtain comfort that the contract will be favoured. Technically, they are not obligated to verify all of the details in the contract between the villagers, the committee and the agent. The agent is supposed to have the capacity and authority to represent the collectives to enter into a contract on their behalf with a 3rd party.

The purchase contract is what seems to have gotten Sino Forest into hot water with the OSC. Here is their sample contract:

Here is the clause that raised the concern:

Party B warrants that it has already obtained Plantation Rights Certificates of the People’s Republic of China or other certification documents certifying its valid ownership of the timber to be transferred to Party A (for details, please refer to the Appendixes hereto), that it and the Original Forest Owners of the Timber will assist Party A in going through procedures for registering the change in ownership of the Timber and /or of the plantation land use rights and that it will be responsible for coordinating the resolution of any disputes between Party A
and the Original Forest Owners of the Timber.

Party B is the agent who signs off that he warrants that he has each household’s existing plantation certificate or related document and that we are to see appendixes for details.

The fact that the BVI purchases did not have all of these corresponding documents (from the individual farmers), the “OSC expressed grave concern and said that in the absence of documentation it is per se evidence of fraud” (page 39 of interim report) The Sino Forest management team said they rely on the representation of the supplier that they have done their due diligence and have proper authorization. Sino Forest said they do random spot checks with the villagers to obtain comfort in the supplier.

It seems to me that lack of documentation lies with bureaucracy issues in various government levels within China. Surely the forest bureau that approves the purchase contract has also scrutinized and approved the legalities regarding the supplier too! If the government forest bureau is de facto rubber stamping these transactions and recording them in their books, and providing a confirmation letter of such, this should satisfy contract validity. It looks to me like the lack of full 100% supporting documentation from the agent may give rise to a higher propensity for the contract to be disputed down the road, but not fraud.

The agent must act in good faith yes, but Sino Forest, despite doing due diligence on the agent, need only believe that the agent was acting in good faith and with the proper authority. However, they don’t do business on this “belief”clause, they actually go out and test the strength of the farmer/village/agent contract to get a feel for potential disputes down the road.

Article 49 Contract by Person with Apparent Agency Authority (repeat from contract law section)

Where the person lacking agency authority, acting beyond his agency authority, or whose agency authority was extinguished concluded a contract in the name of the principal, if it was reasonable for the other party to believe that the person performing the act had agency authority, such act of agency is valid.

When the OSC originally issued the cease trade order on the company indicating that Sino Forest appears to be engaging in acts of misrepresentation and fraud and thus ordered the resignation of certain officers including Allen Chan, my initial reaction was that they must have found something very big. I later attended the hearing that was called to try and find out more information. At the hearing, OSC lawyers expressed that the amount of documentation was staggering, and what had been obtained so far gave the appearance of certain contraventions to the Securities Laws. One of the lawyers for Sino Forest concurred with the vast amount of documentation, but he also said that the company was still in the process of retrieving specific documents that could be used in their defence. Now that the documentation retrieval process is almost complete, the Sino Forest management expressed satisfaction, yet whether the OSC has had their concerns satisfied is yet to be known.

Going back to contract law: Where a contract is partially invalid, and the validity of the remaining provisions thereof is not affected as a result, the remaining provisions are nevertheless valid.

This means that although the clause states there is an appendix with supporting documentation, the fact that it may be incomplete does not make the contract void. In fact if the rest of the contract is performing, such as the money transfer and the forest bureau confirmation, the contract as a whole is still binding. Theoretically, the only thing that can potentially void this contract is a dispute arising from the farmers or collective committee, which would be a breach at the agent level and which would be mitigated at the government level. On the other hand, the lack of full supporting documentation can be something that Sino Forest uses as a voidable clause for its benefit.

On the other hand, when Sino Forest enters into the entire land lease contract, there is much more paper work. Much more due diligence occurs because these lease right contracts can last up 50 years. This can be deemed that an entire generation will not have the land returned to them for personal economic benefit for a long time, other than lease payments.

The murkiness can result in the fact that several contracts are in play, but it is not necessarily unusual.

Some provinces and villages work like this for tree rights:

Contract #1 – the households contract over to village committee their forest management rights

Contract #2 – The village committee contracts to an agent (in some cases the agent has paid the village for the trees at this point)

Contract #3 – the agent may further contract to another agent (sometimes this happens)

Contract #4 – the agent contracts to Sino Forest (either tree rights, and/or future lease rights). In addition to this, the agent holds the “ownership” for Sino Forest by contract if done through the BVI. The forest bureau confirmation letter point #2, states that the bureau has approved the contract method of ownership when using BVI. Note: the agent has been paid at this point according the contract provisions, and his company is holding the trees for Sino Forest (similar to the way that I hold stocks in nominee for clients).

Here is their due diligence process and constraints within the process.

Forest Bureau Confirmations

The confirmation letters are received in lieu of a plantation certificate for the timber purchases where the land lease rights have not been undertaken.

Copied from page 41 part of 4th paragraph

“According to the legal opinions, if in a particular locality the work of registering plantation rights and issuing the new format of Plantation Rights Certificates has been delayed, and it is not possible to obtain the old form of Plantation Rights Certificates, and the BVI needs to prove the legality of its plantation rights to a third party, the BVI may apply to the competent department in charge of forestry administration at county level or above where the timber is located for the issuance of a “certification letter or confirmation letter” to prove the lawful rights that the BVI holds over the timber, and in such a case, such a certification letter or confirmation letter may be seen as valid proof that the BVI has the right to own the timber. Management has advised that they relied upon such opinions and also believe that these confirmations provide additional comfort in the event of any dispute.”

Relevant points in the confirmation letter:

1) Bureau confirms it has reviewed timber purchase contract before issuance of confirmation.

2) Forestry bureau approves the contract arrangement under which timber is transferred to the BVI’s (sort of like nominee for BVI)

3) Forestry Bureau agrees to issue plantation right certificates to the BVI’s and register its timber ownership according to the schedule of municipal or city government implementation for plantation rights certificates

4) Forestry bureau confirms that subject to applicable laws the BVI is entitled to harvest, transport, and sell the timber once it grows to full size.

The plantation certificates are not actually issued since they don’t have any for standing timber only, but forestry registries are evolving and apparently they will begin to issue standard certificates in the future for standing timber, hence point #3. They have not uncovered any emails during the investigation that would indicate that any of these confirmations were falsified. But they did discover that certain gifts were sent. One of the audit exercises was to re-authenticate the confirmations from various forest bureaus. This has been successful in some areas and is still an ongoing process for the others who have agreed and the new confirmations are in process.

By the way, bribes are bad, but gifts are deemed a good business practice in China as understood in this article.

Portions from page 45 regarding comments from forest bureau’s

1 All of the forestry bureaus acknowledge the activity of SF in their jurisdiction. A number expressly indicated that foreign offshore companies were not entitled to obtain Plantation Rights Certificates; but most expressly acknowledge that a foreign company was able to buy timber and sell timber.

2 It was also clear that the forestry bureaus were of the view that the only means to establish legal rights with respect to the sale of standing timber alone was through contract.

3 A number of the forestry bureaus indicated they had active relationships with SF and were aware of its activities as a buyer. In two instances the forestry bureau confirmed that SF was the largest owner of plantation forest areas within their jurisdiction.

It’s obvious to me that the forest industry and its various levels are fragmented and without the conformity of a national registry system or a consistent documentation process. Clearly the forestry bureaus acknowledge the existence of Sino Forest as an operating business in the area.

In China where systems and data are not as streamlined and lack consistency across regions, the propensity for documents to be forged (as is rumoured) is high, most business, people, and government rely on the evidence of various individual pieces of the puzzle as opposed to one letter saying the puzzle is complete.

Sino Forest management and independent committee are satisfied that based on all the examined puzzle pieces that they have confirmed the contractual ownership of all the timber they have claimed, and to date, none of the assets have been disputed to the Chinese officials by any collective groups. Whether or not this will satisfy the OSC, is yet to be seen.

Timber Valuation

Lately news has surfaced that Sino Forest has abandoned the timber valuation plan. This is not true. The valuation plan is proceeding as we speak as part of normal course of business (they do it every year). They are simply saying that due to time constraints it won’t fully be ready by the end of the year.

Standing timber has always gone on the balance sheet on a cost basis and never as market value. New accounting rules (2011) stipulate that going forward planted plantations (the 18% of holdings) will have to go on as market value less costs. Outside consulting firms for forest valuations take time. Valuations occurred at the beginning process of timber purchases (as mentioned earlier) as part of their due diligence and as management tools. The audit committee obtained evidence that the purchase price paid for various timber was in line with the going rates at the time. Market value is fluid over time and the true value is observed on the eventual sale of the timber. Timber sale prices have also been verified to be in line with the going rate at the time. But for those in a hurry and want to value them now, you could perform a “net realizable value” test. Look at transactions done in the past which generated a consistent margin of about 50%. This tells you the fair value is in excess of cost. Take a look at published sources of log prices in China, they will show a much higher market value than cost. You could also do a discounted cash flow valuation of the entire timber assets, but that introduces all kinds of assumptions which make it less reliable. No matter how you slice it, the timber assets certainly don’t look like they went on the balance sheet at inflated valuations as they were accused of doing.

Conclusion

So far, the interim report shows a complex business model justified by difficulties and untested foreign corporate structures and an evolving property rights legal system operating under a different government structure than we are used to. The current urbanization efforts and forest sector are highly sensitive issues for the Chinese government. They have been industrializing their agriculture for years (which includes forestry) and which can displace people and seem unfair at times. The role of Sino Forest in this industrialization process is surely not unnoticed by government officials even at the highest level. They acknowledge and are well aware of the problems. As hard as I’ve looked, I cannot find one article from Chinese papers that state the government is doing any of its own investigating on Sino Forest. However, I have seen articles regarding investigations of other companies and corresponding swift and steep punishment specifically for bribes and various corruptions. Juxtapose to this, the inaction of the Chinese government on Sino Forest is an indication of the knowledge and approval of their current business mandate and structure.

If agents, forest bureaus, and companies are unlawfully engaging in fraudulently acquiring timber rights from collectives, it could pose serious legal problems and most likely lengthy jail sentences. A criminal would also most likely be shunned by his friends and not hob knobbing around with other forestry and government officials. I recently came across this picture of Allen Chan at the Yiwu forest convention that took place in November this year which is now published on their web site.

If the assets are enforceable by contract, the contract needs to be iron clad. The most important parts of the contract are; mutual acceptance, consideration (money paid) and the entitlement to the property. Obviously anything can go wrong in the performance of any contract, in which case the wronged party gets compensated. However, if the government provided lawful, easier, and more transparent documentation to the entitlement of the property, it would put a lot of this uneasiness to rest. The forest bureau confirmations are comfort in the respect that the government acknowledges the timber purchases, but making them official documents would go a long way.

For many it’s hard to believe the trees exist when the profit for the tree sales is allotted into an accounts payable entry as opposed to the cash transaction directly into a Sino Forest bank account. The same can be said when buying the trees from using an accounts receivable as opposed to a more transparent withdrawal from a Sino Forest bank account. This payment method really is the crux of the issue that leaves many to believe the payments did not in fact transpire, and thus the contracts would as well have to be phoney. Understandably, the process of such ‘in and out” money for foreign corporations can be costly and tedious, which is why 3rd parties often provide RMB settlement services. But with easing of currency rules in China, perhaps there is another way going forward to settle these transactions to provide a more transparent trail.

In the meantime, the investigation is still ongoing and will provide more answers to some of the lingering questions that everyone may have. They still have interviews pending with AIs and suppliers, as well as relationship mapping between the parties. There is no question that this company is undergoing a rigorous inspection. With the independent committee, PwC, the OSC and the RCMP (most likely the Chinese Government too), if there is a fraud in this company they will most likely find it.

A note on comments
I welcome comments, however comments posted are moderated by both myself and my firm. If you have a specific question regarding the audit report that I did not address it’s best to email me.

Susan Mallin, CIM, CFP, Investment Advisor Investment Services Toronto, Personal Financial Assessment, Investment Services and Investment Accounts, Investment Products