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Individual Paper: China Taifeng Bedding Holdings Limited

LIN Liye [S9044705Z] School of Economics

ACCT004: Accounting Fraud in Asia • G1 • Professor KEE Koon Boon

School of Accountancy • Semester 2 AY 2014-15

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Executive Summary

From the IPO prospectus to the annual reports and announcements, there are many warning signs that warn investors of the poor corporate governance and the risks involved with investing in Taifeng. Within the prospectus, the poor reputation of “independent directors”, the heavy reliance of Taifeng on TTG for its sales and supplies, as well as the multiple connected transactions between Taifeng and TTG, are the clearest warning signs. After the IPO, even though Taifeng’s management did not signal to the market by selling down shares in the company, other methods were used to tunnel out wealth from the listed entity. Such transactions were given names such as “finance lease agreements”, “loan agreements”, and “prepayment to suppliers”. In addition, the resignation of Deloitte as auditor in 2013 and the accusations of unpaid wages found in online forums should serve as clear warnings to investors of the poor state of the company. Through this case study, the aim is to enlighten readers of the difficult task of navigating through the Asian capital jungle, and hopefully readers will get a better understanding of the common tricks used to hide wrongdoings by the insiders who enrich themselves at the expense of minority shareholders. Introduction

The company in focus is China Taifeng Bedding (“Taifeng”), SEHK: 873, a Hong Kong-listed company with operations in Shandong, PRC. This company has not been targeted by short sellers, but with its maneuvers in the capital markets and various suspicious corporate actions taken since its IPO in 2010, it is likely that the company is a fraudulent entity that has been abusing minority shareholders since its inception. The structure of this paper divided into three key sections: the IPO period, the subsequent rise in stock price from mid-2010 to end-2011 and thereafter. With this structure, the purpose is threefold: the first is to allow readers to understand the clues available in the prospectus to avoid treating Taifeng as a cheap play on Chinese domestic growth. The second is for readers to spot financial and non-financial clues that point to misbehaviour in the company, and the third is to recognize the techniques used by the managers in tunneling out wealth from the listed entity. The hope is to illustrate that one does not need industry knowledge to detect fraudulent activities with the company. In Taifeng’s example, knowledge of the fluctuations of the cotton prices and how it translates to revenue growth is not necessary, simply because there are many other “common-sense” red flags and many other ways to tunnel out wealth. Also, all information is obtained from public sources as well as disclosures made by Taifeng, so any investor will be able to reach the same conclusions easily with thorough research.

Business Description of China Taifeng

China Taifeng Bedding (“Taifeng”) is located in Shandong Province, one of the largest cotton producing provinces and a major cotton textile producing area in the PRC. Situated in Laiwu City of Shandong Province, its production base occupies a total gross floor area of over 230,000 sq.m. and houses six cotton yarn workshops and one bedding product workshop. Taifeng’s bedding products business began in 2003 as a distributor of bedding products. The company then acquired the bedding products manufacturing business of Taifeng Home Textile in 2006. A large portion of its bedding products are sold as branded bedding products in China under its

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‘‘TAIFENG’’ brand and a smaller portion are sold as OEM bedding products and are consumed overseas. Since IPO, the company’s OEM sales have stopped and Taifeng is currently focused on domestic sales alone. In 2009, Taifeng was ranked by Euromonitor as the eighth largest bedding products manufacturer in terms of retail sales value in the PRC bedding product market, accounting for 0.4% of the total market share.

Section 1 - The IPO: Drawing first blood from minority investors

Value Trap

Taifeng was IPO-ed on 11 June 2010 on the Hong Kong Stock Exchange. The IPO price range in the prospectus was between HK$2.06 to HK$3.09, giving a market capitalization range of HK$2,060m to HK$3,090m. This implies a 2009 historic PE ratio of 8.3x - 12.4x, which appears very attractive for a company that is growing top line at 28% and net profit at 132% YoY. Would-be IPO Investors would have been fooled by the “value stock” that seemed so attractive and cheap on quantitative measures.

Birds of a feather flock together

So what are some of the red flags that an investor would need to look out for when reading company prospectuses? One of the tell-tale signs in the IPO prospectus is the fact that certain “independent” directors and executives are also on the boards of other failed or fraudulent companies. These executives and directors lend their names easily to such companies for compensation or profit-sharing schemes unknown to the public. As the saying goes, birds of a feather flock together, the presence of these directors with any company is a key red flag that readers should take note of.

For example, Mr. Chan Kin Sang, one of the “independent directors” of Taifeng, was also a director on several listed companies in Singapore and Hong Kong that have all performed badly or entangled in fraudulent activities. It is unclear how Mr. Chan was an independent director, given his relationship with the company secretary Mr. Pang at People’s Food Holdings Limited, as well as Taifeng’s collaboration with Goldmond Holdings Limited (later known as Combest) soon after the IPO, of which he was also an “independent” director. A quick check on the companies below that Mr. Chan was affiliated with would serve as a quick warning sign to any investor worth his or her salt. Many of these companies had been delisted or had suffered very poor stock price performance.

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Mr. Pang Wai Hong, the financial controller and company secretary as at IPO, was the chief financial officer of People’s Food Holdings Limited from 2000 to 2008, a company which was delisted from the Singapore Stock Exchange on 6 Jan 2014. He was also an independent non-executive director of China Renji Medical Group Limited, a company listed on the Hong Kong Main Board but which had seen its stock price performance from its peak of nearly HK$300 to its current HK$0.212. With the track record of the two insiders and their affiliation with fallen companies, their proximity to Taifeng does not bring reassurance to the minority investor.

Related “independent parties” In this paper, Taifeng Textiles Group (“TTG”) and Combest will appear regularly in transactions involving Taifeng. The close working relationship with Taifeng on suspicious terms make it hard to believe that these two companies are “independent third parties” as disclosed in the prospectus. The multiple transactions between these entities provide many opportunities for

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insiders to tunnel out wealth from Taifeng through inflated sales prices or prepayments to suppliers etc. Relationship with TTG

TTG was simultaneously Taifeng’s largest customer and supplier from 2007 to 2009 in the IPO track record period, and TTG was founded by Taifeng’s current management, who then sold it off to “independent directors” on 26 June 2008. TTG was currently principally engaged in the manufacturing and sales of cotton fabrics and property development. TTG was Taifeng’s largest customer in terms of sales of cotton yarns, bedding products and other materials for the years ended 31 December 2007, 2008 and 2009, which together accounted for 39.0%, 22.1% and 16.0% of total revenue during the same periods. TTG was also Taifeng’s largest supplier in terms of purchases of raw cotton, fabric and other materials for the years ended 31 December 2007, 2008 and 2009, which together accounted for 39.3%, 37.1% and 29.3% of total raw material purchases during the same periods. Taifeng also leased from TTG two properties which comprise four parcels of land, and the properties were leased for a term of 20 years commencing from 22 May 2009 and expiring on 21 May 2029 at a monthly rent of RMB350,000 and RMB775,000, respectively.

With so many connected transactions, there are many inherent risks involved and investors are unable to fully decipher the materiality of the transactions because TTG is a private entity without public disclosures of its financials. Due to the complex connected transactions and the many possible ways available to tunnel out wealth by management to another private entity, investors should ask themselves if they are willing to take on such risks before investing in the IPO.

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To hide fictitious cash, Taifeng needs a friendly banker – Laishang Bank

In the prospectus, there were three banks that were listed as principal bankers of Taifeng, including Bank of China Laiwu branch, ICBC Laiwu branch and Laishang Bank. Headquartered in Laiwu City, Shandong Province, Laishang Bank was honored as the small and medium-sized bank with the best corporate management in 2011, in an appraisal activity organized by the Institute of Finance and Banking of Chinese Academy of Social Sciences. The bank has won the award for the fourth years in a row. The key issue here was that the chairman of Taifeng was one of the directors of Laishang bank, and had resigned in 2010 right before Taifeng’s IPO so as to avoid a conflict of interest. However, looking at the large cash balance of Taifeng from its IPO in 2010 till 2014, it is highly suspicious if the cash balance can be accurately verified given the use of a small local bank with a personal connection to Taifeng.

Clues within the IPO Financials

Taking a look at the financials presented in the prospectus, the careful investor must ask several questions on what is presented in the 3 financial statements. Firstly, after looking at the income statement:

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For a business selling a commodity-like product like blankets and cotton yarn, it is indeed very difficult to achieve such high net margins that Taifeng had achieved. For such products, we do not expect much pricing power given 1. cotton yarn is a low value-added product which is easily sourced from other competitors and 2. the pricing power for blankets is difficult to imagine as there is little to differentiate between brands. Despite these concerns, Taifeng managed to achieve an 18% net margin in 2009.

Another thing to note is its distribution and selling expenses. For low-value bulky items like cotton yarn and blankets, it is hard to imagine that its selling expenses amounted to only 1.6% of revenues in 2009. With logistics costs in China at around 15% of GDP, it is difficult to imagine how Taifeng has such great cost controls on transportation and advertising and still manage healthy double digit growth.

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Moving on to the balance sheet, there are several other telltale signs to the cautious investor.

Taking a closer look at the balance sheet, we see some familiar red flags that were discussed over the length of the Accounting Fraud module, such as prepayments and pledged bank deposits. More will be elaborated on this in the later sections.

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There were also significant sums of prepayments to suppliers that grew nearly 20x from 2008 to 2009, which could be used to provide liquidity for suppliers that were facing cash flow problems. Ostensibly to lock in cotton prices in 2009, the prepayments line item is commonly used by fraudulent firms to hide their misdeeds, so investors would need to be more comfortable with what this was for before investing in the company. Again more will be elaborated in the later sections.

In the footnotes, Taifeng disclosed that it had also given RMB60m of guarantees in 2009 to banks for TTG, which was supposed to be an “independent” third party. Even though the company disclosed that the guarantees would be released upon listing, the question is why Taifeng insisted on calling TTG an “independent” party when it clearly was not. This was a clue that Taifeng was not being fully honest with minority shareholders in the prospectus.

As such, we have found that there were many clues, financial and non-financial, there were hidden in the prospectus. It is up to individual investors to spot the irregularities and be cautious of investing in Taifeng’s offering.

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Section 2 – Clues to avoid getting attracted by the share price momentum in 2010

For this section, the focus will be on the period after IPO, from mid-2010 to mid-2011, where the stock price was on a bull run. The purpose of this is to allow investors to find clues certain red flags and decipher between a company that is good and saw stock price appreciation versus a fraud that only aims to enrich insiders. On 26 April 2012, when the FY11 annual report was published, the stock was trading at HK$2.34, implying a 4.4x trailing PE and had a 4.6% dividend yield. Investors are warned against placing too much faith in quantitative screens.

Relationship with Combest

Taifeng disclosed in its IPO that it had entered into a cooperation agreement with Combest, a PRC healthy bedding product chain management company with over 2,000 franchised stores in China in late December 2009. According to a public announcement made by Goldmond Holdings Limited (Stock code: 8190) a reverse takeover was done by Combest, which allowed Combest to list on the SEHK without issuing a prospectus. Mr. Huang Quan, one of Taifeng’s substantial Shareholders, was deemed to be interested in 164,500,000 shares, representing 6.26%, of Goldmond as at Taifeng’s IPO. Taifeng reported that it would be responsible for the research and development of the new products and manufacturing of them upon successful development while Combest would be responsible for the sales of the new products through their distribution network.

31 Oct 2010 - Subscription of new shares in Combest Holdings Limited

On 31 Oct 2010, Taifeng disclosed that it had conditionally subscribed 100m Combest shares at HK$0.40, or a total net consideration of HK$39.5m. The subscription was termed as a “strategic investment” for the “long term business development” of Combest. The investment coincided with the peak of Combest’s stock price around the end of 2010. Taking a look at the announcement, there were few clues available as to whether this was a fair transaction for Taifeng, but investors should look at Combest’s financials and its short listing history through a

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RTO as a clue.

19 Nov 2010 - Acquisition of land and properties

Taifeng had also acquired land use rights of a parcel of land in Laiwu City, Shandong from TTG soon after IPO at a total consideration of RMB68.8m. The acquisition of land use rights shortly after IPO as a way to tunnel out wealth is common among Chinese fraudulent companies, and one notable example would be Dukang Distillers. Perhaps this is because it is difficult for outside investors to ascertain the true value of the land that was involved in the transactions. This is further compounded by the fact that the land use rights was obtained from the “independent third party” TTG instead of an outside party. There begins to appear a pattern of repeated collaboration with TTG throughout Taifeng’s listed history with significant transactions involving hundreds of millions of Yuan, which appears to be the chosen vehicle for the management to tunnel out money from Taifeng. As we shall see later now, there are various other transactions that raise further questions on the fairness in the dealings with TTG. Even though there was an independent valuer Jones Lang Laselle Sallmans, giving a fair value of RMB68.9m, there are other parts of the contract that are suspicious. In addition, the original purchase cost of the lands to TTG was approximately RMB2,760,000 and the book value of the buildings built on the lands and the fixtures attached to the lands is approximately RMB44,590,000. This would give a premium of over RMB20m from book value, assuming the book value is fair. Besides the announcements above, there are few other material disclosures to detect fraud. It seems as though the management of Taifeng did not choose to do a typical pump-and-dump scheme where they would offload shares to unsuspecting investors at the peak. In fact, the shareholdings of senior management remained largely constant, with some of them adding on small stakes to their holdings as well. It may seem as though the management is signalling

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confidence in the stock, but as seen in the later developments, this was merely a façade. Next, we will move on to the schemes that Taifeng had used to tunnel out wealth as well as other clues that would help to detect the fraud. Large, expensive bank borrowings despite ample cash balance One thing that stood out was the large bank borrowings recorded in the balance sheet, which was guaranteed by “independent parties”

From the extract above, the total bank borrowing in 2011 of RMB164m required an interest rate of 5.14% to 13.12%. This seems exorbitant for a company that is growing rapidly with a lot of cash from the recent IPO, when its “cash balance” of RMB843m in 2011 was only earning 0.01% to 0.5% interest! If Taifeng were able to fund its operations without any debt, the company would have saved RMB14m in interest expenses in 2011.

There were also other suspicions about the cash balance. Firstly, the entire borrowing is repayable within a year, yet Taifeng paid a large premium over the risk-free rate. For a one-year loan, the China benchmark interest rate was around 5% to 6.6% from 2010 to 2011, and what Taifeng paid represented a curious 4% premium over the risk free rate given its cash balance

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was five times the total borrowings. Secondly, why did Taifeng borrow only short-term loans? Some possible reasons could be that the company required short-term liquidity, that Taifeng wanted cheaper loans and hence it took only short-term loans, or that banks were unwilling to lend longer-term due to Taifeng’s credit risk. However, the first two reasons are easily countered with the argument that the RMB843m in the balance sheet was more than enough to fund short-term needs, unless the “cash balance” is non-existent. The third reasons sounds plausible, and is an important clue to readers who see similar large cash balances coupled with short-term bank loans in other listed companies. Questionable loan from major shareholder majority owned by Chairman

In addition, one should also ask about the loan from the largest shareholder Harvest Sun, which is majority owned by the Chairman of Taifeng. Given the huge surplus of cash, it is questionable why Taifeng still requires a loan from its largest shareholder. The RMB27m loan as of FY2011 carries an interest rate of 5.25% payable, which amounted to RMB1.4m in finance expenses in the same year. This seems like a way for the Chairman to park his money in a “safe” place to earn a higher interest than what he could have earned from the state-owned banks, which were charging much lower interest rates. Below is a screenshot from Bank of China’s website, which showed the deposit rates in Feb 2011. With deposit rates ranging from 0.4% for demand deposits, no wonder the Chairman wants to “invest” with Taifeng at 5.25%!

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Source: Bank of China Resignation of Deloitte as auditor of Taifeng

On 10 Dec 2013, Deloitte resigned as auditors of Taifeng, “as [Deloitte] cannot reach an agreement with Deloitte on the audit fees payable to Deloitte for the financial year ending 31 December 2013.” This may sound like a valid reason until we look at Labixiaoxin, which also used the same reason to justify why PwC had resigned as auditors on 12 May 2014. Anytime an auditor resigns “voluntarily”, minority investors should take this as a warning sign.

Alleged unpaid wages found on online forum

The last clue in this section could be found from an external website forum http://minsheng.iqilu.com/questions/display/3050 dated 30 December 2011, where a user claimed that Taifeng had not paid wages to factory workers for six months, and urged government officials to check into the issue. While one might argue that such posts lack credibility and that the accusations could be baseless, a cautious investor should investigate further into the company that is so cash rich.

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As things might have it, below was a photo taken from a Tumblr account dated 20 Jan 2015, 3 years after the initial forum post. Workers in Laiwu City, Shandong were protesting on the streets, asking Taifeng to pay up their owed salaries. As of 30 June 2014, Taifeng disclosed in its interim report that it had cash balances of RMB1.9b and a net cash position of RMB1.4b. It is curious why a company with over a billion Yuan does not have the ability to pay wages to factory workers that would amount to a few million Yuan at most.

Section 3 - The “murdering” and “hiding of the body”

Since IPO to the interim report as of 30 June 2014, the majority shareholders did not sell down their stakes in Taifeng. Hence, if the management were tunneling out wealth, they would have to do it via other means. In this section, the details of some of these transactions will be discussed. Finance lease with CDB Leasing On 29 May 2013, Taifeng reached a sale and leaseback agreement with CDB Leasing, a wholly-owned subsidiary of state-owned China Development Bank for total lease payments of approximately RMB421,723,000 (equivalent to HK$533,826,000), comprising the principal sum of RMB340,000,000 and interest of RMB81,723,000 (equivalent to approximately HK$103,446,800), subject to adjustment, for a term of 5 years. Firstly, this leads to the initial question of why Taifeng would want to go into such a contract given they have ample cash balances to pay the entire principle sum easily, because the interest rate of 7.3% is much higher than the 0.5% that the “cash balance” was earning.

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2013 2012 2011

Secondly, the reasons that Taifeng gave to justify the finance lease were so as to “replace the existing short-term loan facilities, which are subject to periodic renewals, with a more stable facility. The lower interest rate under the Finance Lease Arrangement compared to the interest rate under the short-term loan facilities also reduces the finance costs of the Company.” To verify the claim made by Taifeng, a quick look into the FY13 annual report would suffice.

One can see that bank borrowings continued to increase at a rapid pace, rising from RMB316m in 2012 to RMB428m in 2013, in addition to the new finance leases. This was contradictory to what the management had said previously. In the 2013 AR, over RMB219m of the finance leases were booked as “later than five years”. However, the finance lease agreement with CDB Leasing was only for 5 years, and as the annual report was as of 31 Dec 2013, 7 months had passed since the lease agreement was announced on 29 May 2013. This means that all the non-current leases should be booked under “Later than one year and not later than five years”. However, in the 2013 AR, Taifeng had booked RMB219m as leases “Later than five years” without disclosing any explanation!

This is in comparison to the extract below from the 2013 interim report, where no finance leases were booked under “Later than five years”. This change in classification is strange and makes no sense at all.

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Loan to suppliers On 1 April 2014, Taifeng announced that it had entered into two short-term loan agreements with TTG and Laiwu Fengze worth RMB237m and RMB243m respectively. It is questionable why the company took nearly four months to disclose this transaction, especially when the maturity date of these two loans were in 11 June 2014 and 15 June 2014 respectively, just two months after the announcement. This is akin to hiding information from minority investors and giving them an incomplete view as to facilitate a better investment thesis. The reason that Taifeng gave to justify these two loans was to “make better use of its funds and provide [it] with a reasonably high return.” If this is indeed the case, then why did Taifeng not want to give back the excess cash through dividends to shareholders? Change in classification of prepayments to suppliers

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To illustrate how the prepayments to suppliers work, the above screenshot is an extract from the FY2012 annual report, which showed how TTG purchased RMB227m of cotton from Taifeng in 2012, but received RMB210m in prepayments based on what was disclosed as of FY2012. It seemed as though Taifeng was booking revenue growth using its own money, booking increases in receivables and in retained earnings and making its earnings look good. Taifeng had sought to confuse and hide its misdeeds to shareholders as well. Comparing the classification of trade and other receivables, there was a big restatement of accounts where the prepayments to suppliers nearly doubled to RMB511m for FY2012 from previously stated RMB298m. If we include the loan receivables, then the amounts that were tunneled out of Taifeng in FY2013 increased to RMB900m, or an 80% increase YoY!

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Looking at the consolidated balance sheet for 2012 in the FY13 and FY12 annual reports, Taifeng also restated its bank borrowings from RMB103m to RMB316m in order to for the balance sheet to balance. It is curious how the management could have stated erroneously the amount of bank borrowings in the FY12 annual report when the amount borrowed from the bank should have been very obvious in the first place.

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Conclusion From the IPO prospectus to the annual reports and announcements, it is clear that there are many warning signs that warn investors of the poor corporate governance and the risks involved with investing in Taifeng. Within the prospectus, the poor reputation of “independent directors”, the heavy reliance of Taifeng on TTG for its sales and supplies, as well as the multiple connected transactions between Taifeng and TTG, are the clearest warning signs. After the IPO, even though Taifeng’s management did not signal to the market by selling down shares in the company, they used other methods to tunnel out wealth from the listed entity. Such transactions were given names such as “finance lease agreements”, “loan agreements”, and “prepayment to suppliers”. In addition, the resignation of Deloitte as auditor in 2013 and the accusations of unpaid wages found in online forums should serve as clear warnings to investors of the poor state of the company. Through this case study, the aim is to enlighten readers of the difficult task of navigating through the Asian capital jungle, and hopefully readers will get a better understanding of the common tricks used to hide wrongdoings by the insiders who enrich themselves at the expense of minority shareholders.