Six years after short seller Muddy Waters issued a report damning Sino-Forest Corporation as a fraud and a Ponzi scheme, the Ontario Securities Commission has ruled that former CEO Allan Chan and four other members of its senior management (Albert Ip, Alfred C.T. Hung, George Ho and Simon Yeung) breached Ontario securities laws.

The decision

On July 14, 2017, after one of the longest hearings in the OSC’s history, the Panel of Commissioners who presided over the hearing ruled that Chan and the other respondents breached various sections of the Ontario Securities Act as a result of having knowingly “engaged in deceitful or dishonest conduct” regarding the company’s so-called “standing timber assets” and revenues, and either facilitated or acquiesced to material misstatements in public documents. In particular, the Panel found that approximately 70% of the total timber holdings by hectare that investors were led to believe Sino-Forest owned and approximately 70% of the revenue the company recognized between 2007 and 2010 cannot be verified. The Panel found that Chan “lied to the Board of Directors, the Audit Committee and E&Y about critical information which led to Sino-Forest’s inaccurate disclosure, which put Investors’ pecuniary interests at risk.”

Once the largest forestry company listed on the TSX, Sino-Forest’s collapse was swift and calamitous. Following the June 2011 release of the Muddy Waters report, which accused the company of exaggerating its timber assets and fabricating sales transactions, Sino-Forest’s share price plummeted more than 75%. The OSC quickly announced that they would commence an investigation, and in August 2011 issued a cease-trade order prohibiting all trading in Sino-Forest’s securities.

Since that time, Sino-Forest and many of its directors and officers, its auditors and the underwriters who participated in offerings of the company’s securities were named as defendants in class proceedings in Canada and the U.S. or faced scrutiny from the OSC. Ernst & Young, one of Sino-Forest’s auditors during the relevant period, paid $117-million in a settlement in the class action, and a further $8-million in a no-contest settlement with the OSC. More recently, BDO, which audited the company’s financial statements in 2005 and 2006, agreed to pay more than $8-million to settle the class action. A group of underwriters paid $33.5-million in a separate class action settlement.

The role of Guanxi

The hearing before the Commission, which spanned three calendar years and nearly 200 days, involved complicated evidence from a range of fact witnesses and experts. As a part of this voluminous evidence, the Panel heard extensive expert testimony about the Chinese custom of “guanxi”, which the Panel described as “the concept of drawing on connections in order to secure favours and reciprocal obligations … based on intricate and pervasive relational networks”.

A key defence advanced by the respondents was that the prevalence of guanxi in China explained the various instances of close cooperation between Sino-Forest and its suppliers and customers, which OSC Staff pointed to as evidence of fraud. According to the respondents, the relationships at issue in the case, while unusual or even unheard of in western business culture, were commonplace and necessary in the Chinese context.

The Panel did not accept this argument, and pointed to evidence that, in their view, demonstrated something more than a difference in cultural practices. In a notable passage, the Panel underscored the paramountcy of Ontario securities law given the strong connections between the company and the province:

[350] The Panel is cognizant of cultural differences that companies encounter globally; however, Sino-Forest was listed on the TSX, was an Ontario reporting issuer, raised US $3 billion of capital from Investors, and was required to issue financial statements prepared in accordance with Canadian generally accepted accounting principles. For the purposes of our analysis, Ontario securities law is paramount and overrides any explanations for illegal conduct being excusable in the name of guanxi, however it is defined.

Each of the respondents could face lifetime bans from participating in the Ontario capital markets, and could be ordered to pay up to $1-million for each violation of the Securities Act. A hearing to determine the appropriate sanctions has not yet been scheduled, but is expected to take place in the near future.