Friday, June 10, 2011

Review of Muddy Waters Report on Sino-Forest

Since Muddy Waters (MW) issued a report on June 2 accusing Sino-Forest (TRE) of institutional fraud, TRE stock price has been pummelled. Some analysts have stood out to defend for TRE, and an analyst at Dundee Capital announced that MW research is a pile of crap.

I have looked into this pile of crap in detail, and here I’d like to share my review.

I saw the following specific allegations in MW report. For each allegation, I will put what MW said, what Sino-Forest said, and my opinions with analysis.

1. Yunnan $231.1 million standing timber sale is unreasonable


The $231.1 million sale of timber in Lincang city, Yunnan province is largely fabricated, because such amount exceeds the applicable harvesting quotas by six times, and transporting the harvested logs would have required over 50,000 trucks driving on two-lane roads winding through the mountains from this remote region, which is far beyond belief (and likely road capacity).


The revenue was very clearly disclosed in MD&A filed for Q1 and Q2 of 2010 as the revenue resulting from the sale of the standing timber - there is no cutting or transport involved.

Opinion: The sale is questionable.

In TRE 2010 Annual Information Form (AIF) there is the following regarding standing timber sales.

“Pursuant to the sales contract, the buyer is required to harvest the standing timber within 18 months from the date of the contract.”

Accordingly, the buyer needs to cut down the trees in 18 months, therefore, we might need to further check with local forestry regulator about 2011–2012 harvesting quotas, and ask locals about or go there to observe the harvesting activities. Over $200 million of trees in one city to be cut down in 18 months, probably you can see legions of Chinese scattered everywhere chopping down trees there.

2. Raised $3.05 billion in total, only $1.2 billion injected onshore


Sino-Forest has raised a total $3.05 billion from the capital markets, but only a maximum of $1.2 Billion of cash has been injected onshore according to the SAIC filings.

Opinion: SAIC filings do not support the allegation.

SAIC filings record the registered and actually injected capital by foreign investors, but injecting cash to subsidiaries in China does not necessarily to go through capital. For example, TRE and any of its offshore BVI companies can lend money to any of TRE’s subsidiaries in China, and SAIC does not regulate and record this lending.

The exchange from foreign currency to Chinese currency RMB must be approved or registered with another government department, SAFE, so to check how much funds were actually injected onshore, we need to look into SAFE records, not SAIC filings.

3. During 1994-1997, the revenues from its Leizhou EJV were fabricated


TRE breached its commitment to contribute equity capital to the EJV, Leizhou Eucalyptus Resources Development Co. Ltd, and fabricated its revenues by the EJV.

Appendix A5: Letter by Leizhou Forestry Bureau (JV partner) dated Feb 27, 2008 says TRE injected only $1 million and the EJV had never had actual operations till letter date due to lack of Cash.

The $12.4 million TRE stated that Leizhou Forestry owed to TRE resulted from EJV cessation in 1999 was fabricated.


1996 Annual Report

In 1996, wood chip production in the Leizhou EJV accounted for approximately 35.8% of total production. Leizhou EJV: 212,500 BDMT, all products exported.

An initial capital contribution of $1,000,000 was made in 1994. No further capital contribution was made in 1996.

1997 Annual Report:

TRE entered into an agreement to cease EJV operations. As settlement, Leizhou Forestry Bureau owed TRE $12.4 million, which would be paid with standing timber

Opinion: Revenues generated by the EJV during 1994-1997 are questionable; no evidence shows the $12.4 million settlement was fabricated.

No hard evidence pointed out that the $12.4 settlement was fabricated, as the arguments regarding the EJV operation cessation from TRE side could be another story.

The focus here should be the revenues generated from Leizhou EJV, as Leizhou Forestry Bureau stated in its letter that the EJV had never produced actually till 1997. Though the letter is one side’s story in a divorce, it is a formal government document, and there wasn’t any motivation for the Leizhou Forestry Bureau to lie about the production, because a successful EJV in 1990s would be a huge achievement for the local officials.

As TRE 1996 and 1997 annual reports indicated that all products from Leizhou EJV were exported, export records with customs or foreign exchange records with SAFE during that period would be able to validate the revenues.

4. Standing Trees transactions through offshore BVI companies are fake


The transactions are artificial and the traded trees are phantom trees. Business confidentiality, VAT tax, income tax, etc, are excuses to cover the fraud. Under Chinese laws, TRE offshore BVI companies cannot do businesses inside China directly, and there is no way to escape VAT tax.

Opinion: No hard evidence

It’s true that a foreign company must establish a local company to do business in China, and escaping VAT tax can lead to life imprisonment.

A foreign company can invest in to and divest out of China, can export to and import goods from China, but cannot buy and sell goods inside China without going through its subsidiaries there.

However, there is at least one way for a foreign company to sell standing trees in China without paying VAT and income taxes, though it is in the grey area and could bring trouble in the future. The loophole here is to change the standing timber into capital of a company and then sell the ownership to the buyer. An example is as follows:

Suppose a scenario: A foreign company has set up a subsidiary, company A, in China, which bought $100 million value of trees. And the foreign company also has two offshore BVI companies B and C. Now a Chinese buyer is willing to purchase the trees at $200 million.

Transaction process: A takes the timber as capital valuated at $100 million to register a wholly owned subsidiary company X inside China –-- A transfers it ownership in X valuated at $100 million to B –-- B transfers its ownership in X valuated at $200 million to C –-- C transfers its ownership in X valuated at $200 million to the Chinese buyer.

In this process, since B and C are registered in BVI, in which capital appreciation incurred, therefore no VAT and income tax incurred inside China.

5. Sino-Forest’s timber holdings in Yunnan is overstated


The timber holding is overstated significantly according to government reports related to master agreements, forest rights issuances and their corresponding value.

Opinion: No hard evidence with regard to master agreements and valuation; the standing trees TRE actually purchased and sold are questionable.

Master agreements are similar to framework agreements, and are subject to changes even after government approval; therefore, it’s reasonable that there is difference between government documents and TRE filings.

It’s impossible to accurately calculate TRE’s forest value by using the numbers in the government reports. What support the valuation of those forests in the government reports? When was the valuation date? What difference between TRE’s forests and the average forests in the area?

The numbers in Chinese government documents related to local achievements and resources, such as forestry resources and foreign investment received are usually equal or larger than actual numbers. Accordingly, the numbers in government documents indicate that TRE’s investment and standing timber sales might be quite different from its annual reports. Further verifications with local government and forestry farmers are needed.

6. Dodgy timber agents

(MW described 3 agents; here I am taking one of them, because of similar allegations)


Bo Hu is a tiny company established one month before signing the master agreement with TRE. Bo Hu is registered in Guangdong, so its selling forest in Guangxi to TRE is questionable.

Opinion: Being small and new is ok, but the agent’s jurisdiction brings question.

In China, it is common that one large mountain is divided into numerous pieces and every local household gets one piece. This is actually the reality in my hometown, a city in Hunan, China. When the standing timber in the mountain is to sell to one buyer, a new company, of course, pretty tiny, would be registered by households collectively, and all households would sign an agreement with the new company, and then the new company would sign a master agreement with the buyer. This small new company certainly would be registered locally. In the case of TRE and Bo Hu, it is questionable that Bo Hu was registered in Guangdong but sold trees in Guangxi to TRE.

Also, Bo Hu did not actually own the trees, so the agreements between Bo Hu and actual plantation rights owners should be verified.

7. Stealing money and other allegations

Opinion: No hard evidence, but there were questionable cash transfers.

Though the numbers in audited financial statements a company submitted to SAIC are usually different from the company’s consolidated financial statements, the SAIC audit reports indicated the existence of unusual cash transfers between TRE’s agents and its subsidiaries.


  1. Nice Analysis, James. Very interesting insights.

  2. I have to second that, interesting analysis.

  3. Where theres smoke, theres fire. As Rick Pearson said, Shorts only have to be 10% right. And it certainly seems MW was at least 10% right.

  4. Hello James,

    Excellent analysis, would love to see you post your view after June 14's earning call.

    There is a Chinese page for Sino Forest, it is embedded in Sino Panel's site.

    However I do agree with your assessment. The company's comeback to you is that Sino Forest is listed on Toronto. It majority owned Greenheart in HK does have a Chinese web site though.