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The roots of the Sino-Forest mystery Add to ...

In the early days of 1994, a little-known Hong Kong entrepreneur named Allen Chan launched what seemed like a promising joint venture in the southeastern city of Zhanjiang in China’s Guangdong province.

The unimaginatively named Zhanjiang Leizhou Eucalyptus Resources Development Co. Ltd. was to produce micro-density fibre boards from timber harvested at a nearby plantation controlled by Mr. Chan’s fledgling company, Sino-Forest Corp. China’s economy was growing fast and its demand for wood was rising just as quickly. This new business was poised to fill that demand.

Partnering on the deal with Sino-Forest, which would soon obtain a stock market listing in Canada, was the Leizhou Forestry Bureau – an arm of the Chinese government.

For Mr. Chan and his co-founder at Sino-Forest, a former Forestry Bureau official in Guangdong named Kai Kit Poon, the Leizhou deal served as a key pillar in the initial stages of building their business. Between 1994 and 1997, Sino-Forest would report $60-million (U.S.) in sales from the venture.

There was just one problem: The Leizhou joint venture never produced a single panel, according to a key executive involved in the project.

More than 17 years later, things are quickly unravelling for Mr. Chan and Mr. Poon.

Sino-Forest is now enmeshed in a devastating scandal, and accused of participating in what could turn out to be one of the largest frauds in Canadian stock market history. Mr. Chan has lost his grip on the company; on Sunday he resigned his executive posts at Sino-Forest (while taking on a new title, “founding chairman emeritus”) after the Ontario Securities Commission alleged that he and other executives and directors appear to be engaged in activities that they know, or ought to know, “perpetuate a fraud.”

Part of what is so astonishing is that Sino-Forest and its business activities failed to arouse serious suspicions or concerns with most investors until June of this year when a short seller named Carson Block and his firm, Muddy Waters LLC, first levelled accusations of fraud against the company.

For more than a decade and a half, Mr. Chan, a martial arts enthusiast, aficionado of classical Chinese literature and former restaurant employee, along with Mr. Poon, an avid ballroom dancer, had presided over what was, by all appearances, an unparalleled Chinese business success story. By simply buying, managing and selling trees and forestry assets in mainland China, the firm’s profit increased from $3-million in 1994 to $395.4-million in 2010.

Mr. Chan and Mr. Poon’s business seemed perfectly positioned to cash in on the country’s roaring growth and burgeoning appetite for natural resources.

Instead of raising capital on the Hong Kong stock market or even Shanghai or Shenzhen, Mr. Chan and his business associates targeted Canadian investors, whom they said were better acquainted with the forestry sector. Sino-Forest listed on the Alberta exchange through a reverse takeover of a dormant shell company in 1994. In 1995, the company graduated to the Toronto Stock Exchange.

Sino-Forest has since raised more than $3-billion from debt and equity markets, mostly with the help of Canadian lawyers, accountants, analysts and investment bankers, and mostly in the past eight years. Investors bought into the company’s promise of a bright future – a promise that seemed to be backed by steadily rising profits. At its peak in March, the company boasted a market value of more than $6-billion (Canadian), making it by far the largest forestry firm on the TSX.

Sino-Forest says it used most of the funds to boost its forestry portfolio in mainland China, which it claims now exceeds 780,000 hectares. Despite healthy profit margins that often topped 50 per cent, Sino-Forest has been almost perpetually cash flow negative as it has spent more money buying trees and other forestry assets than it has generated through sales or by raising capital.

Now, Sino-Forest’s shareholders are stuck. Last week, the OSC halted trading in the stock, stating that the company appears to have engaged in “significant” deals with related parties, misrepresented its revenue, and exaggerated the size of its Chinese timber holdings “by providing information … which may have been false or misleading.”

The OSC move gave new momentum to the fraud allegations made by Mr. Block and Muddy Waters in June, which, in essence, accused the company of lying about its revenue, its business model, and its claims to control $3.1-billion (U.S.) worth of timber assets.

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