A black eye for Bay Street

With proper governance, the Sino-Forest scandal would have never happened.

Sino-Forest Corp.’s trading price is shown on an electronic display at the TSX in Toronto on Tuesday, June 7, 2011 (Photo: Norm Betts/Bloomberg/Getty)

At a recent dinner in Toronto honouring Canadian corporate directors, Spencer Lanthier, a former member of the Bank of Canada’s board, told the crowd, “This city, this province, this country has a reputation of being the best location to carry out white-collar crime—corporate fraud—in the industrialized world.” As if to underline Lanthier’s words, the Ontario Securities Commission last week made headlines with its allegations of malfeasance against Sino-Forest Corp., and an accompanying cease-trade order.

A commercial forest-plantation operator in China, Sino-Forest is listed on the Toronto Stock Exchange. The OSC’s investigation, and a subsequent $7.3-billion class-action lawsuit by investors against the directors and officers of Sino-Forest—along with the company’s auditors, Ernst & Young—follow June accusations by the independent investor-led research firm Muddy Waters that Sino-Forest was “massively exaggerating its assets,” overstating its timber investments in one Chinese province by $900 million. Once more, the company was accused of having “a convoluted structure whereby it runs most of its revenues through ‘authorized intermediaries,’” and raised capital in what was tantamount to a “multi-billion dollar Ponzi scheme,” with “substantial theft.”

While none of the OSC’s allegations have been proven in court, if these acts occurred at a Canadian stock-exchange-listed company, it would further taint Canada’s reputation. Actions like those alleged by the OSC and Muddy Waters shouldn’t be allowed to happen. And an examination of Sino-Forest’s governance structure reveals shortcomings that would have raised the eyebrows of any seasoned observer.

Among the issues highlighted in the class-action lawsuit’s statement of claim is the fact the chair and CEO roles were occupied by the same person, Allen Chan (now resigned, after he and four other executives were singled out by the OSC). The company’s independent directors do not appear to possess any forestry industry experience. Chinese forestry experts that were retained to validate the company’s alleged forestry holdings owned stock in Sino-Forest. Attendance by directors has also been problematic, with two directors attending just 13% and 22% of meetings, to choose just two examples. Unfortunately, Sino-Forest is hardly an outlier. The Securities and Exchange Commission in the U.S. recently established a task force to address abuses by Chinese companies accessing U.S. markets through “reverse mergers.” Twenty-five NYSE-listed Chinese companies have so far disclosed accounting discrepancies or have seen their auditors resign. Shares have been halted in more than 20 Chinese companies, and five Chinese companies have been delisted.

The 2009 scandal around the massive accounting fraud at the Satyam Computer Services Co. represented a high-water mark for fraud and defective corporate governance in India. We will see how the alleged fraud at Sino-Forest and several other Chinese companies plays out.

China and India collectively represent a market of 2.5 billion people with GDP growth rates hovering around 9%. Clearly, they are lucrative markets for Anglo-American companies. These countries are, however, two of the most corrupt nations in the world, ranking 78th and 87th, respectively, according to Transparency International’s corruption index. If Chinese and Indian companies seek access to public money from western capital markets, to integrate more fully within the global economy, they must reform their corporate governance and accounting practices.

Many Chinese and Indian companies have a small number of significant shareholders, typically company shareholders or management. In China’s case, guanxi is prevalent, which means personalized networks of influence, or entrenched conflicts of interest and opaqueness, with law on the books but not enforced. The importance of an independent and effective board of directors cannot be overstated. It is not enough to rationalize Chinese and Indian companies at present as “investor risks.” Market regulators, representing the public interest whose mandate it is to protect investors, have an obligation to require compliance with listing standards and take firm action when this is not the case to signal investor protection and deterrence.

Boards of directors of companies listed on Canadian, American and British stock exchanges have an obligation to be independent and effective. Directors need to be judicious when accepting directorships of Indian and Chinese companies, as they could very easily become ensnared in alleged violations of the Corruption of Foreign Public Officials Act, the Foreign Corrupt Practices Act or the new U.K. Bribery Act.

I’m often asked for advice by directors who have been approached to sit on the boards of North American–traded companies that have a majority of their assets or activities in a problematic country like India or China. On my blog at, I’ve published a detailed checklist of what should be agreed to in writing before accepting such an appointment. And the fiasco at Sino-Forest offers an important cautionary tale about the necessity of doing your homework before saying yes.

The governance shortcomings of the company were several. Sophisticated directors are well-advised, when their reputation and assets are put at risk in sitting on any board with operations in corrupt jurisdictions, to insist on proper governance safeguards.

It’s a mistake not to do one’s governance due diligence at the front end of a board appointment. Once one is sitting on the board, and has accepted the status quo, it may be too late and a price may be paid—and not only the price of a reputation. Just ask the investors who helped Sino-Forest raise $3 billion over the past eight years—or their lawyers.

Click here for Richard’s supplementary blog post on how to avoid replicating Sino-Forest’s mistakes >>