In the latest example of corporate mismanagement and corporate governance, FORELAND Fabrictech Holdings may have lost control over its wholly owned subsidiary, Fulian Knitting Co, in China, it warned on Wednesday (Originally Reported May 9 2018).
The saga originally began with a customer claim that was originally filed in 2013 by a customer of Fulian Knitting Co, Jiangxi Longdu Clothing & Accessories Weaving Limited Company (‘Jiangxi Longdu’) [江西龙都服饰织造有限公司 ]. The total claim amounted to RMB290 million.
Timeline of Events
The Announcement disclosed that ‘On 17 November 2013, Jiangxi Longdu complained that the Textiles supplied were defective (the ‘Complaint’)’. The Company conducted investigations from 19 November 2013 to 6 December 2013. On 9 December 2013, Jiangxi Longdu demanded from Fulian a total compensation of RMB290 million for all losses and damages it had incurred in connection with the alleged breach of the contract and defective products’ (the ‘Claim’). The Company disclosed that ‘On 12 December 2013, the Company had engaged the Fujian Minhua Law Firm [福建闽华律师事务所] to provide its legal advice on the merits of the Claim.’
On 26 December 2013, the Company announced that Fujian Minhua Law Firm, among other things, recommended the Company to engage an independent auditor firm to assess the Claim and to determine a reasonable compensation amount based on the actual losses suffered by Jiangxi Longdu.
On 3 January 2014, the Company announced that the Company and Jiangxi Longdu had jointly appointed Fujian Huatie Certified Public Accounting Firm (‘Fujian Huatie’) [福建华铁会计师事务所有限责任公司] to assess the Claim and to determine a reasonable compensation amount of losses suffered by Jiangxi Longdu. Fujian Huatie has on 31 December 2013 issued an appraisal report concluding that the reasonable compensation amount is RMB275,284,800.00 (‘Appraisal Report’). It also disclosed that the Company was served on 30 December 2013 a notification of statement of claim from Jiangxi Longdu for the sum of RMB288,666,700.
On 10 February 2014, the Company disclosed that ‘A Board of Directors meeting was convened on 22 January 2014 to discuss the Claim. Pursuant to the discussion, the independent directors are of the view that the Company shall approach Jiangxi Longdu in relation to the appointment of a (i) reputable local audit firm; and (ii) reputable local law firm, to conduct an independent re-assessment on the Claim (the ‘Appointment’); or the Company shall consider convening an Extraordinary General Meeting (‘EGM’) to seek shareholders’ views and support in relation to the settlement of the Claim. The Management has different opinion in relation to the proposal to convening the EGM at the moment because of the time constraint in responding to Jiangxi Longdu.’
On 6 May 2014, the Company announced that it has entered into a settlement agreement with Jiangxi Longdu to fully settle the compensation claim of RMB275.3 million and a late interest payment of RMB7.7 million.
On 7 August 2014, the Company announced that its auditors had issued a disclaimer of opinion on the Company’s audited financial statements for FY2013. The Auditor noted that Fulian entered into a settlement agreement with the customer and an amount of RMB282,992,774 was paid. Management had relied on a legal advisor in the PRC for legal advice with respect to this customer claim and the compensation amount was based on an appraisal report issued by a PRC accounting firm. In a board of directors’ meeting held on 22 January 2014, the independent directors of the Company who held office on that date and who are also the Audit Committee members on that date, had a difference in opinion with Management on the handling of the claim and had required the appointment of another reputable audit firm and reputable law firm to conduct an independent re-assessment of the customer claim. The customer claim was settled subsequent to the end of the reporting period without an independent re-assessment of the customer claim as required by the independent directors and Audit Committee members. The auditors were not able to obtain sufficient appropriate evidence to satisfy themselves as to the reliability of the evidence provided by the legal advisor and the accountant which was relied upon by Management for this customer claim. The auditor has not been able to obtain appropriate audit evidence to satisfy themselves with regards to bank balance and fixed deposits of Fulian totalling RMB292,298,353 as included in the Group’s cash and cash equivalents at 31 December 2013.
On 22 January 2015, the Company announced the appointment of BDO LLP (‘BDO’) as an independent reviewer to, inter-alia, perform an independent assessment of the Claim. On 25 May 2016, the Company announced the Executive Summary of BDO’s findings (‘Report’). BDO had noted in their Report that before entering into a settlement with Jiangxi Longdu, the Management:
- Did not appoint a third party to carry out an independent quality assurance test to verify Jiangxi Longdu’s claim relating to the defective dyed textile;
- Did not provide full information on Jiangxi Longdu’s purported claim against Fulian to Fujian Minhua Law Firm and seek their advice on how to defend Fulian and mitigate Fulian’s ‘exposure’ to the purported claim;
- Did not accept the Company’s former independent directors’ requests to seek a second legal opinion and to appoint a reputable audit firm to re-assess Jiangxi Longdu’s purported claim against Fulian;
- Did not request Fujian Hua Tie to comment on the accuracy, veracity and/or reasonableness of the items listed in the List of Economic Losses in the Appraisal Report. Fujian Hua Tie also did not take into account whether insurance policy(ies) that Jiangxi Longdu was supposed to purchase covered its purported claim against Fulian;
- Did not obtain documents to support Jiangxi Longdu’s claim of RMB1,510 per jacket for the alleged damage to 191,170 units.
- Did not obtain documentary evidence to substantiate the accuracy, veracity and/or reasonableness of the items amounting to RMB1,510 per jacket claimed by Jiangxi Longdu in the purported List of Economic Losses;
- Did not obtain documentary evidence from Jiangxi Longdu to demonstrate that Jiangxi Longdu had taken steps to mitigate its losses as well as documentary evidence to demonstrate that Jiangxi Longdu had compensated Mega Chinese Limited (‘Mega Chinese’) [香港昌中有限公司] for the cancellation of the contract;
- Did not engage a more renowned law firm/audit firm to re-assess Jiangxi Longdu’s purported claim against Fulian in view that the purported claim was substantial.
In summary, the management was negligent throughtout the process prior and during the course of the transaction, not applying a basic duty of care towards the entity as is expected of the management’s responsibility to defend the company against the legal claim.
In respect of Jiangxi Longdu’s purported claim against Fulian, BDO expressed:
- Doubt on the veracity of the complaint made by Jiangxi Longdu, including the date on which it was purportedly made;
- Doubt on the veracity of the claim made by Jiangxi Longdu against Fulian;
- Doubt on the claim for Economic Losses of RMB1,510 per winter jacket for 191,170 units.
- Doubt on the purported sample sent to SGS-CSTC Standards Technical Services Co., Ltd by Jiangxi Longdu for testing and on the veracity of the contract between Jiangxi Longdu and Mega Chinese;
- Doubt on the veracity of the purported defective dyed textile;
- Doubt on the accuracy, veracity and/or reasonableness of the items listed in the List of Economic Losses comprising the following:
Material costs – RMB196 per winter jacket
Business expenses loss – RMB120 per winter jacket
Wages costs – RMB198 per winter jacket
Loss of profit – RMB453 per winter jacket
Packing and transportation costs – RMB35 per winter jacket
Delivery loss – RMB278 per winter jacket
Branding loss – RMB230 per winter jacket
- Doubt on the existence of Hong Kong Yong Sheng [香港永胜行], the shareholder of Jiangxi Longdu.
The findings shed light on the dangers of arbituary nature of the legal claim, unsubstantiated amounts and incolclusive evidence to support the claim.
The fact that the original auditors did not gain a strong understanding of the legal issues surrounding the company for FY 2013 and subsequently ratified the accounts illustrates the underlying inherent issues surrounding client-auditor relationship, that the auditors findings can be limited by the information released by the client.
The example also strongly points towards an inherent structural issue/risk with the accounting and regulatory nature of China. The fact that there was no safeguard or requirement to relinquish authority from members of management who may not have had the shareholders interest at heart, and that there was no framework advocating transparency during the process of the legal claim.
Former executive chairman Tsoi Kin Chit – who resigned in August 2016, and was publicly reprimanded by the Singapore Exchange in November 2016 – has been “increasingly reluctant” to cooperate in matters relating to Fulian which he is effectively controlling, Foreland said in a filing to the Singapore Exchange. In December 2016, Foreland had lodged a complaint with the Commercial Affairs Department against Mr Tsoi, centred on 290 million yuan (S$61 million) paid as compensation by Fulian to a customer claim which was originally filed for in December 2013.
Previously, Mr Tsoi had lead Foreland’s directors to believe that he would cooperate, because he had been willing to sign negative assurance confirmation on financial results on several occasions, Foreland added. “With that, the directors had reason to believe that there was still some control over Fulian.”
In essence, a director who also has a controlling stake in the company, has ran off with the subsidiary, and all the resources allocated by the parent company. This latest set of events highlight the failure of the board to place proper controls over the ultimate authority of the subsidiary, through proper legal structuring and corporate governance guidelines.
However, in an e-mail on May 6 this year, Mr Tsoi stated that he would not cooperate or allow the company access to Fulian’s funds and also declined to change the legal representative of Fulian from himself to executive chairman Yang Meng Yang.
This was in response to an e-mail sent by Foreland on May 5 to propose an urgent meeting to discuss outstanding matters to complete an audit so that the company could hold annual general meetings for FY2016 and F20Y17, and issue the annual reports for the financial years.
On May 9, Foreland’s lawyers in China issued a due diligence report on Fulian, which disclosed a total of 26 court proceedings against the subsidiary, contrary to Mr Tsoi’s negative assurance confirmations and records in Fulian. Mr Tsoi’s staff in Fulian had omitted the court proceedings in their financial records; as such, these court proceedings were not included in the auditor’s reports.
Foreland said that it will continue to vigorously pursue the legal proceedings against Mr Tsoi. Foreland has a net carrying amount in Fulian as at May 9 of 61.1 million yuan (S$12.85 million).
Shares of the Chinese textile maker are suspended from trading on SGX as of 9th May 2018.