Friday, July 8, 2011

Can Paulson sue Sino-Forest and its Directors and Auditors for his loss?

According to a news report titled "Sino-Forest On The Ropes, Battered By Short-Seller", after Sino-Forest's shares were pummelled by a report from short seller Muddy Waters who alleged the Company was a fraud, Paulson & Co sold off its entire holdings in Sino-Forest and took a $574 million loss.

Can Paulson sue Sino-Forest and its directors and auditors for his loss?

Lawyers will probably say that it depends. Sino-Forest has hired PwC to investigate the allegations. On one hand, if the investigation results showed Sino-Forest as a fraud, Paulson certainly could launch litigations. But the Company's assets probably were not enough for its debts; directors would say they were duped by the management, and the auditors would state that an audit is not designed to detect fraud. On the other hand, if the Company was vindicated by PwC 's investigation, Paulson probably would not be able to sue the Company.

But my answer to the question is YES. Paulson can sue Sino-Forest and its directors and auditors right now without considering Muddy Waters' allegations or PwC's investigation results, because there are numerous material misstatements and misrepresentations in Sino-Forest' financial statements.

1. Overstated cash flows from operating activities by $4 billion for the period of 2003 to 2010

Cash flows from operating are one of the most important factors for investors to make investment decisions. Sino-Forest has unscrupulously overstated cash flows from operating in every year since 2003. According to the financial statements, the aggregate cash flows from operating activities for the period of 2003 to 2010 were $3.3 billion, which should be negative $0.7 billion and was overstated by $4 billion.

During the period 2003 to 2010, the company generated $4.3 billion of revenues from its standing timber business, and correspondingly about $4 billion operating cash flows have been reported in its consolidated statements of cash flows by using indirect method.

But these $4 billion cash flows never occurred. The Company has applied a business model of BVI (British Virgin Island) companies + AIs (Authorized Intermediaries) for its standing timber business since 2003. According to the explanation of the model by CEO Allen Chan, BVI companies have never received real cash from the standing timber transactions. The following is taken from Mr. Chan’s remarks in the Company's Q1 2011 conference call scripts:

"Fourth, the AI pay the proceeds from the timber sales to the end users to a Sino-Forest designated purchasing agent rather than direct back to the BVI company. The AI pays under the terms of the contract, but since the BVI subsidiary cannot hold a bank account in China, cash is no exchanged.

In the fifth step, the purchasing agent utilizing the money from the AI, purchases more parcels whose ownership is transferred to the BVI company. Sino-Forest directs the AI to use the proceeds from the sales, which is a receivable to Sino-Forest, to purchase new plantation assets through an agent on behalf of Sino-Forest that had been already been identified by Sino-Forest."

It’s very clear that on the Sino-Forest’ accounting perspective the process of standing timber business is as follows:

Standing timber ---- accounts receivables from AIs ---- more standing timbers

There was no cash ever flown into Sino-forest in this process, so the company overstated its cash flows from operating by $4 billion for the period of 2003 to 2010.

2. Serious non-compliance with Chinese tax laws

Under Chinese tax laws, a foreign company doing business inside China has mandatory obligations to pay income tax. Sino-Forest started selling standing timber inside China through its BVI companies in 2003, but these BVI companies have never filed or paid income taxes in China. According to Sino-Forest’s financial statements and applicable tax laws, as of December 31, 2010, the unpaid tax and interest on tax overdue for its standing timber business amounted to $0.51 billion; and the Company also was facing $0.14 – 1.4 billion of penalties. This non-compliance with Chinese tax laws is so serious that all assets in China owned by Sino-Forest could be seized by the Chinese government for unpaid tax and penalties.

Sino-Forest is listed on TSX. According to Canadian Audit Standard 250 “Considerations of Laws and Regulations in an Audit of Financial Statements”, compliance with laws is the responsibility of management, but the auditor has responsibility of obtaining sufficient appropriate audit evidence regarding compliance with tax laws.

There have been two laws governing income tax on foreign companies in China. Before 2008, it was Income Tax Law of the People’s Republic of China on Enterprises with Foreign Investment and Foreign Enterprise, plus related rules of implementing, explanations and circulars (Thereinafter “the Old Law”). The tax rates on foreign companies under the Old Law ranged from 15% to 30%.

Starting from 2008, all companies except for local proprietorship and partnership have been under the Enterprise Income Tax Law of the People’s Republic of China, plus rules of implementing, explanations and circulars (Therein after “the New Law”). The tax rate under the New Law is 25% for all companies except for withholding tax rate for foreign companies and preferential tax rates for certified hi-tech and small size low-profit companies.

Both the Old Law and the New Law mandate a foreign company to pay income tax when doing business in China. According to regulations of tax collection, the daily interest on tax overdue is 0.05% and the penalty is 50% - 500% of the total overdue.

There are two ways for a foreign company to pay income tax. One way is registration. A foreign company, by itself or through its local organization such as an office or a representative, registers with local SAIC and tax bureau, and then remits advance tax instalments monthly or quarterly and makes annual tax filing within 5 months after year ending.

The other way is withholding, which usually applies to dividends, interest income, royalties, rentals, and consulting fees, etc. This way, a foreign company does not need to register with SAIC or tax bureau. When a client makes a payment to the foreign company, or redirects a payment to a third party on behalf of the foreign company, the client must withhold 20% of the payment and remit it to a local tax bureau on behalf of the foreign company within 5 days under the Old Law, or 7 days under the New Law, and then send a copy of tax remittance to the foreign company.

Whether it is registration or withholding, the foreign company will definitely receive a copy of tax filings or tax remittance and will then clearly know how much income tax the company has paid. According to Sino-Forest’s financial statements and new releases, the Company’s BVI companies that have sold standing timber since 2003 have never paid income tax in China. In footnotes to its financial statements, the Company stated that its AIs should withhold and remit incomes taxes on behalf of the Company, but apparently the AIs have never done so because even the CFO of the Company does not know whether the AIs have ever paid taxes for the Company or not according to his answers to tax related questions at Q1 2010 conference call.

According to the segment information in Sino-Forest’s financial statements, during 2003 to 2010, its standing timber business generated $4,316 million of revenues and about $1,930 million of net income. Even using possibly lowest tax rates, as of December 31, 2010, the corresponding unpaid tax and interest on tax overdue amounted to $426 million and $85 million respectively, and the penalties ranged from $136 million to $1,360 million.

3. Understated tax expenses and overstated net income by $263 million during 2006 to 2010

Based on segment information in Sino-Forest’s financial statements, the Company generated $1, 768 million of net income before tax during 2006 to 2010, and recorded $139 million of tax expenses. Under the applicable tax laws, even using possibly lowest tax rates, the tax expenses should be $402 million, therefore, the company understated tax expenses by $263 million and consequently overstated overall net income by $263 million.

4. Numerous material inconsistencies and irregularities

Since the Company started to sell standing timber in 2002, there have been numerous numbers and statements in Sino-forest’s filings and releases, which were inconsistent, or contradictory, or even unbalanced, here are some examples:

Example 1: No justification for the business model of BVI companies + AIs

In Q1 2011 conference call scripts, Allen Chan, CEO of Sino-Forest, explained why they used BVI companies + AIs for standing timber business as follows:

“In the 1990s, an international company operating in China would have to use an offshore subsidiary to help it conduct business in the country. In those days, we could not form the Wholly Foreign Owned Enterprise or WFOE for short, on-shore.”

But Sino-Forest did own four WFOEs when it started to use the model of BVI companies + AIs in 2003. These four WFOEs were: Jiamin WFOE, Jiasu WFOE, SFR WFOE, and Jiafeng WFOE.

Actually, Sino-Forest started its standing timber business before 2003. According to its 2002 annual report, the Company sold 8,100 hectares of standing timber during the year; however, there was no mention of AIs’ and BVI companies’ involvement in standing timber business at all in the report.

Also, before 2008 all WFOEs in China were able to enjoy multiple years of tax-exemption (tax holidays), but there have never been tax holidays for foreign companies, therefore, from the tax advantage point of view, Sino-Forest should use WFOEs instead of BVI companies. If it was for the reason of AIs, the Company certainly should use a model of WFOEs + AIs instead of BVI Companies + AIs.

Example 2: The issue of harvesting permits has been omitted since 2005

According to Forest Law of the People's Republic of China, the land of all forests is owned by the government, and is not tradable. The use right of the land of a forest and the ownership of trees (plantation) in the forest can be traded together or separately. To cut down any trees in a forest, the owner of the plantation should apply for a harvesting permit (logging permit) from the local government (local forestry bureau or its agents).

Without harvesting permit, the standing timber alone in a forest in China is not marketable. A harvesting permit stipulates how many trees and what trees with what size in what area can be cut down, therefore, without a harvesting permit, the two sides of a standing timber transaction cannot determine the volume and the market value of the timber.

Harvesting permits are also an effective method for the standing timber seller to control the risk of uncollectable accounts receivable, especially when a large area of plantation is sold, as usually a harvesting permit will be issued for each small parcel of forest.

When Sino-Forest first started selling standing timber in large volume, the Company actually applied and controlled harvesting permits. In both 2003 and 2004 annual reports, there was the following related content:

“In addition to instituting these instalment payments, we also seek to control our credit risk from sales of standing timber by not releasing the logging permits to the buyer until we have received substantially the amount outstanding under the sales contract.”

But since 2005, harvesting permits (logging permits) have never been mentioned in the Company’s annual reports.

Have its auditors checked the harvesting permits of the standing timbers it sold? Maybe.

Example 3: Hiding income taxes payable from being seen in balance sheets

Before 2005, in Sino-Forest’s financial statements tax provisions were recorded in Income taxes payable in balance sheets.

In 2005 financial statements, the Company adopted an innovative accounting practice – hiding the majority of Income taxes payable into Accounts payable and accrued liabilities. In 2004 balance sheet, the taxes payable balance was $18.5 million, but in 2005/2004 comparative balance sheets in 2005 financial statements, the$18.5 million was changed into near $0.5 million, and $18 million was moved from Income taxes payable to Accounts payable and accrued liabilities.

Since then, the majority of income taxes payable were hidden into Accounts payable and accrued liabilities in every year’s financial statements. To know how much income taxes were unpaid, investors have to look into the footnotes. But even reading through the related footnotes, investors would still be in the dark, because the footnotes only tell part of the story. The following is from 2010 footnotes:

“As at December 31, 2010, this provision is $156,941,000 [2009 – $98,863,000], which amount relates to the profits of the Authorized Sales Activities earned by the BVI Subsidiaries during 2010 and in the three preceding years including discontinued operations, and is included in accounts payable and accrued liabilities.”

As it stated that the $157 million of tax provision was for 2007 to 2010, how much was it for the years before 2007? How much was the total balance? It appears the Company just does not want to show it to investors.

Example 4: Unbalanced tax liability balances

As there were no future tax assets reported in Sino-Forest’s financial statements and tax payments usually should not be negative, in any given period the tax expenses per income statements should be equal or larger than the increase in tax liabilities per balance sheets. But according the financial statements, the tax expenses were much less than the increase in tax liabilities for the period 2007 to 2010.

During 2007 to 2010, the total tax expenses per income statements were $140 million, but the tax liabilities in balance sheets increased $230 million from December 31, 2006 to December 31, 2010. The $90 million of increase in tax liabilities over total tax expenses means either the $157 million of tax provision for 2007 to 2010 was substantially understated or the financial statements for the period were not balanced.

Example 5: Misinterpreting tax regulations to understate tax expenses

Note 18 in the 2010 financial statements stated the following:

“The PRC tax authorities issued Circular 19 in February 2010 (the “Circular”) stating that the deemed profit percentage for certain activities should be a minimum of 15%. The activities subject to this minimum percentage appear to include sales of plantation fibre. The Company has been assessing the effect of the Circular on the BVI Subsidiaries and monitoring its interpretation and its application by the PRC tax authorities. Based upon the Company’s analysis to date, the Company has recorded income tax based on a deemed profit rate of 15% for 2010.”

The above statement by Sino-Forest is totally a misinterpretation of the Circular 19. The online version of the origin Circular is as follows:

The Circular 19 clearly stated that the tax authorities will determine a foreign company’s income taxes first based on its accounting records and books. Only when it is difficult to determine income taxes because of incomplete or improperly recorded records and books, the tax authorities would designate a profit rate, which ranges from 15% to 50% for different industries, to the total revenue to determine the income taxes.

Sino-Forest is an established public company, and its accounting records and books are certainly well recorded and kept. The statement by Sino-Forest regarding the Circular 19 appears to me that Sino-Forest intends to hide or destroy its well recorded accounting books in an attempt to make Chinese tax authorities designate a much-lower-than-actual profit rate when determining income taxes on the Company’s standing timber business.

DISCLAIMER: I do not guarantee the accuracy, completeness and reliability of this article. In no event I shall be liable for any kinds of damages resulting from the use of this article.