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Plantations owned by Sino-Forest are seen in the village of Tang Kong, near Gaoyao in southern China.ADAM DEAN FOR THE GLOBE AND MAIL

It's a simple question that investors of any company would want to know: How, exactly, does the business work?

But it's a query that Sino-Forest Corp., the scandal-plagued Canadian-listed forestry company, is having a lot of trouble answering.

A committee of Sino-Forest directors, assisted by PricewaterhouseCoopers LLP, have spent five months and $35-million investigating the company's business practices. In response to a short-seller's allegations that Sino-Forest had exaggerated its Chinese timber holdings and inflated revenue, the committee published its interim findings last week.

Sino-Forest management hailed it as a refutation of the fraud allegations it had denied all along. The report did, for example, verify that Sino-Forest had the all the cash in bank accounts it claimed it did. But the 111-page document still left a pile of questions on the table, including two of the most crucial of all: How does its business work, and with whom, exactly, does it buy and sell trees?

The murky business model

What the committee has found so far suggests a series of questionable links between Sino-Forest and the entities that supply it with trees, as well as potentially troubling relationships with the brokers it uses to sell wood to customers. Those brokers are called authorized intermediaries, or AIs for short.

Sino-Forest's business model is opaque and exceedingly complicated. The company says it does most of its business and generates the bulk of its revenue and profit through offshore subsidiaries based in the British Virgin Islands. The company says the BVI subsidiaries buy trees from suppliers in China and then resell those assets through the AIs, which are also based in China. Sino-Forest claims the BVI subsidiaries, as foreign entities, are unable to own and sell trees under Chinese law, so it uses the suppliers and AIs.

How this business model generates actual revenue for Sino-Forest is still unclear. Sino-Forest does not pay suppliers directly for timber assets and the AIs do not pay money to Sino-Forest after a sale is completed. Rather, the funds are redeployed by the AIs to the suppliers to buy more Chinese timber on behalf of Sino-Forest. The company call these deals "set-off arrangements."

Sino-Forest books revenue and profit from these arrangements, claiming it is buying trees for a lower price from the suppliers than the AIs are selling them to customers for.

The company, however, says it doesn't know if the AIs and suppliers pay tax on these deals. It has taken provisions – $160-million (U.S.) – to cover potential tax liabilities in China.

The directors' report raises red flags about using suppliers, AIs and BVI subsidiaries as this "contributes to the lack of visibility into title documentation, cash movements and tax liability since cash settlement in respect of the BVIs standing timber transaction takes place outside of the company's books."

Verifying the deals

The convoluted BVI structure means that anyone wanting to verify the transactions that Sino-Forest claims generates its revenue and profit must get supporting documentation from the suppliers and the AIs.

Yet when the directors' committee asked Sino-Forest management, including company co-founder and former CEO Allen Chan (who resigned in August), to identify Sino-Forest's business partners, they dragged their feet. In fact, they may have provided false and misleading information to the committee.

The report says Mr. Chan and other managers took more than two months to disclose the "basic details of relationships/inter-relationships between AIs and to disclose the identity of 'holding companies' and individuals with the ultimate beneficial control of AIs and suppliers." As well, management did not provide full names and contact information of the principals of these companies and some addresses provided were incorrect. Sino-Forest management also delayed access to company personnel records and when personnel records were provided they "appeared to be inconsistent" with other records obtained by the [committee]" the report says.

When the committee finally gained access to a few AIs and suppliers, they failed to independently verify any of the deals that Sino-Forest says generates the bulk of its revenue and profit.

According to the report, the committee and its advisers were "unable to review any documentation of AIs or suppliers which independently verified movements of cash in connection with such set-off arrangements between suppliers, the company and the AIs used to settle purchase prices paid to suppliers by AIs on behalf of Sino-Forest."

Troubling connections between business partners

The committee did, however, discover evidence that Sino-Forest may have "close" relationships with AIs and suppliers. If Sino-Forest is, in fact, found to be doing business with related parties, then its entire business model would be thrown into question and the value of the deals done with such parties would be affected.

Undisclosed related-party transactions might also be considered fraudulent activity by the OSC and the RCMP, which are both investigating the company.

The committee's investigators identified 14 Sino-Forest suppliers where "former Sino-Forest employees, consultants or secondees are or have been directors, officers and/or shareholders," the report says. These suppliers accounted for more than 40 per cent of Sino-Forest's plantation purchases between 2006 and the first quarter of 2011.

Among them was Yuda Wood Co., an entity with which the committee found evidence of "close co-operation" with Sino-Forest. This included the possible payment of Yuda's startup capital by Sino-Forest, a co-ordination of business activities and joint control of some of Yuda's bank accounts. The report also noted that two Sino-Forest employees formerly controlled the holding company of Yuda.

Huang Ran, Yuda's legal representative, has an ownership interest or is a director in a "number" of Sino-Forest suppliers, the report said. The committee also identified other situations which suggest Sino-Forest "may have close relationships with certain suppliers, and certain suppliers and AIs may have cross-ownership and other relationships with each other."

Sino-Forest's new CEO, Canadian Judson Martin, said he has provided information to the independent directors' committee attempting to explain the apparently close relationships between the company and its business partners.

"What we have to make sure is that the relationships that do exist do not violate any of the rules that we have to abide by," Mr. Martin said in a recent interview. "We have done an analysis on that and have presented it to the committee to review and I'm hoping that they are going to understand it, accept it and we move on. But that is their call. It's their decision."

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