June 15, 2011 / 7:00 PM / 8 years ago

Q+A: Sino-Forest's struggle to counter Muddy Waters

TORONTO (Reuters) - Sino-Forest TRE.TO, a Chinese tree-planation operator accused by a short-seller of fraudulent accounting, has failed to satisfy investors with its answers to allegations that center on its complex business structure.

Investors and some analysts are dismayed by the Toronto-listed company’s inability or unwillingness to present convincing proof that a report on Sino-Forest by research firm and short-seller Muddy Waters is wrong.

As a consequence, its stock has fallen more than 80 percent since the beginning of June and touched a five-and-a-half-year low of C$2.85 on Wednesday. The company has lost roughly C$4 billion ($4.1 billion) in market capitalization in the last two weeks alone.

The following are some of the main questions raised in the controversy:

What are the allegations that Muddy Waters has made?

Muddy Waters has attacked Sino-Forest’s extremely complex operating structure, questioned the size of its tree-planation ownership and accused the company of misleading its auditors.

The short-seller believes that the sole purpose of Sino’s complex structure and its use of “AIs,” or “authorized intermediaries,” as sales agents for its trees is to “fabricate sales transactions.”

It also claims to have evidence that a large portion of Sino’s timber sales in China’s Yunnan province are fabricated, as Sino’s claims exceed the size of its timber holdings in the province and the applicable harvesting quotas in effect. It has also accused Sino of falsifying its books and overstating the size of its tree purchases.

It has accused Sino of poor corporate governance, as a number of the company’s directors are former employees of Ernst & Young — the accounting firm that acts as Sino’s auditor.

What moves has Sino made in light of the allegations?

Sino has set up a committee of its independent directors to investigate the allegations. The three-member committee has retained the services of three law firms and accounting firm PwC to assist with its investigation.

The company has asked securities regulators in Canada to investigate the trading of its shares by Muddy Waters and its associates. The Ontario Securities Commission has also opened an investigation into the matter.

Sino, however has cautioned that its internal review will take up to three months to complete, due to the difficulties tied to gathering information within China.

What has Sino’s response been so far to the allegations?

Sino has slammed the Muddy Waters report as “inaccurate, spurious and defamatory.” It has said there are no inaccuracies in its corporate filings, reports and financial statements.

The company claims that the AIs are legitimate customers that act as sales agents and make the company more efficient.

Sino has stated its disclosures thus far on the size of the plantations are accurate and it is in the process of furnishing documentation to prove its ownership.

Why are investors still unconvinced by Sino’s defense?

Investors are skeptical as the company has refused to disclose the identity of its customers and exact locations of its plantations. The company claims this is proprietary information and making it public will only damage its long-term growth prospects.

Sino says it does not wish to identity its AIs, as the Chinese forestry business is highly competitive and disclosing this information would result in the loss of its competitive advantage.

Why does any of this really matter? Does it affect others?

The company’s inability to refute the allegations has not only pummeled the price of its own securities, but it has also tainted other Chinese companies with North American listings.

Shares of these companies have sold off recently following the allegations against Sino-Forest. The debacle has also caused investors to steer clear of new issuances in the offshore yuan bond market.

The scandal has also hammered shares of Greenheart Group (0094.HK), a company that is majority owned by Sino-Forest.

Reporting by Euan Rocha; editing by Frank McGurty and Rob Wilson

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