Officials Probe Sino-Forest Imbroglio

07/18/2011 7:30 am EST


Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

It looks like Canadian market authorities are stepping in to make sure no other problems are lurking on Canadian exchanges, note Gordon Pape of the Internet Wealth Builder.

The announcement from the Ontario Securities Commission (OSC) that it has launched a "targeted review" of certain companies listed on Canadian exchanges never once mentions China.

The carefully worded press release refers only to "companies having significant business operations in emerging markets." Many Canadian mining and petroleum companies could fall into that broad net, but they won’t.

The real focus of this investigation is Chinese companies that have obtained listings on the Toronto Stock Exchange and the Venture Exchange. The OSC is clearly worried about inadequate disclosure in the listing process, and pointedly notes that its staff will pay special attention to the roles played by auditors and underwriters "who act as important gatekeepers with responsibilities under Ontario securities law."

The inquiry was clearly triggered by the meltdown of Sino-Forest (Toronto: TRE) following allegations from a US research firm that the company grossly overstated its timber assets in China. Investors fled, and the share price dropped from $25.85 at the end of March to as low as $1.29 on June 21. (Shares have since rallied, and closed on Friday just above $4.)

It appears it will be several months before we get a clear picture of exactly what is happening within Sino-Forest, and whether investors have been victims of fraud. But even before all the facts are in, there are those who are predisposed to expect the worst.

Writing for Forbes last month, influential Asia-watcher and author Gordon G. Chang had this perceptive comment on doing business in China:

It is exceedingly difficult to build a private business in the state-dominated Chinese economy without committing high crimes and misdemeanors. Entrepreneurs, as a practical matter, have to lie, cheat, and steal every day just to keep their businesses going. In these circumstances, do you really think they tell the truth to auditors, underwriters, and regulators?

The OSC is finally getting around to asking the same questions. It took them long enough—it has been 17 years since Sino-Forest obtained its listing in Canada.

Since then, dozens of companies have followed the same trail, many obtaining listings through reverse takeovers of existing Canadian shell companies. There is nothing illegal or even unusual about this practice; many legitimate Canadian firms have used it for decades. But the disclosure requirements for a reverse takeover are not as stringent as for companies who must file a full prospectus to obtain a listing.

OSC chairman Howard Wetston said that the inquiry "is part of our ongoing effort to protect investors and strengthen market integrity."

He added: "Issuers who access our market, and the advisors who support them, have important responsibilities to investors, and we will take regulatory action as warranted to ensure these responsibilities are met."

I have no problem with the OSC launching an investigation if it believes the problem goes well beyond Sino-Forest. But by doing it publicly, before there is any evidence of wrongdoing by anyone, puts every China-based company with a Canadian listing under a cloud.

Few people are going to want to take a chance on a stock that could be de-listed within months, even one that appears to offer excellent value.

In this case, the OSC might have been better advised to conduct its inquiry in private, and inform the public once all the facts were known. If evidence of outright fraud became apparent during the course of the investigation, the OSC could announce the immediate de-listing of the specific company along with appropriate legal action. In that way, the Commission could avoid tarring everyone with the same brush.

At this point, we have no idea how long the inquiry will take. The press release says only that OSC staff have already contacted selected companies and their advisors "and will continue to do so over the coming weeks".

The Commission also intends to talk to the stock exchanges, and such organizations as the Investment Industry Regulatory Organization of Canada and the Canadian Public Accountability Board.

All this suggests that we should not expect a report before fall at the earliest. That’s a long time for a cloud to be hanging over this segment of the stock market. Of course, identifying fraud should be a priority for any regulator, but what we’re seeing here is guilt by association.

It should have been kept under wraps for now. But having made public the fact the investigation is underway, it is now incumbent on the OSC to wrap it up and publish its findings as quickly as possible. This is not a time for foot-dragging.

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