Money for Nothing
8 August 2001
In Hong Kong, companies have up to 4 months to issue their annual results (cut last year from 5 months), and you can be sure that the most entertaining ones come out at the last minute. Wading through the flood of March year-end results at the end of July, we came across a company which, if you are not one of its suffering shareholders, will keep you entertained for hours just thinking about it.
Hung Fung Group Holdings Ltd (Hung Fung) was floated on the SEHK main board on 12-Mar-98, in a deal sponsored by Lippo Securities Ltd and co-sponsored by Dao Heng Securities Ltd and Capital Asset Management Ltd.
Lippo has been absent from the sponsor market for some years - Hung Fung was one of their last IPOs, close on the heels of the classic GKC Holdings Ltd - more about that another time.
The warning signs were there if you read the prospectus in detail.
Big jump in track record
First warning sign: look at the track record of 3 years and 4 months to 31-Jul-97. Turnover in the last 2 years had grown 13% and 20%, while profits had grown 19% and 26%. But for the year about to end, 31-Mar-98, the forecast was profits of not less than $44m, up 84%.
Spectacular growth above a trend should normally be discounted. All too often with small IPOs, the "prospectus year" on which the stock is priced becomes the best ever year and it is all down-hill from there.
Second warning sign: the board was thin - there were only 3 executive directors, being the 1986 founder Mr Chan Chun Hung (Mr Chan), his wife Ms Wong Kin Ching, who joined in 1991, and Ms Wong Wan Kuen, who was "responsible for the financial operation of the Group" but the prospectus did not state any accounting qualification. She joined the group in 1995.
Of the two "independent non-executive directors", one, Mr Au Son Yiu, was a consultant to Dao Heng Securities Ltd, which was one of the co-sponsors of the IPO.
While we have no particular criticism of Mr Au, we believe that in general, links between independent directors and sponsors (or any adviser) should be discouraged, because it may place a director in a conflict of interest if he feels on the one hand that he should ring the alarm bell but on the other hand that it may embarrass a sponsor of the deal.
The other INED was Mr Goh Gen Cheung, now Chairman of ProSticks.com.
High pre-IPO dividends
Third, combined net profits in the 40-month track record were HK$74.3m, and in the last 16 months before the IPO, Mr Chan, who with his wife owned 100% of the group, took dividends of HK$72m. This left the group dangerously short of working capital before the IPO. In Nov-97, just after the HK market crashed, the group borrowed a short term loan of HK$10m from an unnamed finance company (not a bank). The prospectus states:
"Should the group fail... to gain access to the net proceeds of the New Issue, and should it be unable to generate adequate funds internally or to obtain further banking facilities, the Group may experience financial difficulties to repay the short term loan".
Now the IPO of 50m shares only raised gross proceeds of HK$50m and net proceeds of $40m, for the minimum 25% public float. So they were raising less than they had paid in dividends in the last 16 months.
All of this begs the question, why didn't Mr Chan lend the $10m to the company himself, and why did he need to take the company public? He could have taken just $32m in dividends and left the remaining $40m in the company, as much as was raised by the IPO. Perhaps he had other demands on his resources.
The IPO was 1.02 times subscribed in its public offer - what is technically known as a "flop". There were 196 applications, of which (amazingly) 149 were for 2,000 shares each, satisfying the SEHK requirement for 100 shareholders. Of the 45m shares offered to the public, 10m went to a Co-sponsor, and 2m each to two underwriters. That meant that demand from "independent" investors was only 71% of the IPO.
The company got its results for Mar-98 out on 26-Aug-98, near the 5-month deadline. Of course, it met its prospectus forecast for the Mar-98 results (which was made only a month before the year end) recording exactly $44.6m net profit, up 86%.
The next interim results for six months to Sep-98 showed not 86% growth but....0.2% growth in turnover and 0.5% growth in net profit. A 1-cent dividend was paid, totalling $2m. Writing on 30-Dec-98 Mr Chan stated:
"the outlook for the second half-year [to 31-Mar-99] is conservatively optimistic".
Referring to the US interest rate cuts he wrote:
"The traditional peak season around Christmas should be positively affected by such developments"
He was certainly in a position to know, 5 days after Santa had done his stuff and weeks after the last Christmas containers packed with toys left for America.
On 12-Jul-99, Hung Fung placed 19m new shares to Sino Asia Investments Ltd (owned by a Mr Michael Lee) and 5m new shares to Entrust Ltd (owned by a Mr Arnold Chan), both at $0.52 per share and both "independent third parties". The placing agent was Times Securities Co Ltd. Net proceeds were $12.77m. The placing, at just over half the IPO price, may be indicative of financial pressure.
The results for the year to Mar-99 were released on 26-Aug-99, again almost at the 5-month deadline. Turnover grew 7.8% but pre-tax profit fell 39.2%. The net profit of $43.4m was cushioned by a one-time recovery of $11.3m of excess tax provided for in prior years. So much for "conservative optimism".
No dividend was paid, but the company declared a bonus issue of 1 warrant for every 5 shares held, with an exercise price of $0.47 and expiry 28-Sep-01.
The interim results for Sep-99 saw turnover up 16.9% but net profit down by 29.7% to $16.7m. No dividend was paid. In early 2000, the stock began to take off in the heat of dotmania. On 8-Feb-00 Mr Chan placed 20m existing shares at $1.23 through Kingston Securities Ltd, and subscribed 10m new shares at the same price, making a net sale.
Next, on 5-Mar-00 the company announced a UPSS (Utterly Pointless Stock-Split) in which its shares were split 10 for 1, and the board lot was increased ten-fold to 20,000 shares, meaning that the minimum transaction size (shares are traded in board lots) would remain the same. Small-caps are in the habit of declaring stock splits and bonus issues of shares in the mistaken belief that it somehow makes their shares "cheaper", overlooking the fact that investors are happy to own blue chips which trade at prices in tens of dollars.
On 28-Aug-00 (again near the 5-month limit) the results for the year to Mar-00 showed turnover up 20.5% but profits down 39.6% to $26.2m. No dividend was paid. Hung Fung began talking about its Apr-00 investment in Toysmatch.com, a toys portal whose subscription page is to this day is "under construction". Hung Fung also stated:
"in order to strengthen the sales and profitability, the Group has set up a new trading company - Chaolian Toys Trading Co., Ltd. ("Chaolian"). Chaolian is backed up by over 500 toys manufacturing factories in the [PRC]....it is expected that sales orders will be increased and the trading business will provide a steady turnover and profitability in the next fiscal year."
Chaolian - remember that name, it comes up later in our story..
Now things begin to heat up. On Monday 9-Oct-00 Hong Kong's Independent Commission Against Corruption (ICAC) announced that Mr Chan was arrested on 7-Oct-00 "in relation to a $90 million credit scam allegedly facilitated by bribery involving a bank's senior staff."
A 33-year old former assistant general manager of Dao Heng Bank was arrested on 4-Oct-00 for having allegedly accepted advantages in return for granting credit facilities to a subsidiary of Hung Fung.
It was alleged that the banker had accepted advantages from Mr Chan, including free trips to the Mainland and Macau, in return for approving about 36 letter of credit applications which were based on bogus business transactions with four different shell companies.
The ICAC said that as a result, credit facilities totalling $90m were granted to those shell companies between Apr-99 and Dec-99. ICAC investigation revealed that two sisters, respectively proprietors of the four shell companies, were Mr Chan's "close associates".
Chan had allegedly instructed the sisters to withdraw money from the accounts of the 4 shell companies on several occasions after Dao Heng remitted the loans, and the funds were transferred to the bank account of Hung Fung's subsidiary shortly afterwards. ICAC investigations also revealed that in Sep-98, the then-bank manager had allegedly prepared a favourable report to recommend that increased credit facilities be extended to Hung Fung's subsidiary.
As far as we know, the investigation is continuing, and no charges have been laid.
Someone must have got wind of the arrest, because the Hung Fung share price fell 61% from $0.044 on 3-Oct-00 to $0.017 on 5-Oct-00, the last day before the arrest, amid heavy volume.
On 14-Oct-00, Hung Fung announced that all 3 executive directors had resigned, and 3 new executive directors were appointed in their place, all nominated by Mr Chan. The new directors were 2 professional accountants, Mr Tam Sun-wing (Mr Tam) and Mr Allan Ho Sun-fung (Mr Ho), and the existing accounting manager, who resigned her directorship 19 days later.
This was followed on 16-Oct-00 by an announcement in which Mr Chan "confirmed" to the new board that:
"the Company and its subsidiaries have never received any monies, assets or credit facilities by illegal means, and that the latest available unaudited consolidated management accounts of the Group reveal that the Group still sustains a profitable operation."
To back this up, the new board published extracts from the latest management accounts (to Jul-00, which says something about the internal reporting problems) showing 4-month turnover of $84.5m and profits before tax of $2.46m. Balance sheet items were also produced.
The announcement also revealed that Mr Chan pledged 762.84m shares (about 31% of the company) to Shenyin Wanguo Securities (HK) Ltd and 300m shares (12%) to Hantec Finance Ltd between 21-Sep-00 and 5-Oct-00 and that none had been sold.
On 3-Nov-00 Hung Fung announced the issue to HK-listed Wang On Group Ltd (Wang On) came in with HK$3m for a 2-year 5% note convertible at $0.015 per share, representing 7.45% of the enlarged share capital. Thomas Chan Chun-hong, a director of Wang On, was appointed as an executive director of Hung Fung.
All of the banks of the Group had suspended or terminated their credit facilities and some of them wanted their money back. Total debts to banks and lessors amounted to $126m, and accounts receivable stood at $69m.
The directors also noted that cash and bank balances were down to $1m compared with $66m in the Jul-00 management accounts. A bank steering committee would appoint independent investigating accountants and this was one of the things they would seek to explain.
It also emerged that Mr Chan had pledged his entire 62.7% holding in Hung Fung to Kingtson Group Holdings Ltd. Disclosure reveal that this was at least 1/3 owned by a Ms Carman Choi Ka-man.
On 17-Nov-00, Hung Fung received a notice from Mr Chan after a High Court order to stop the transfer of the shares. On 1-Dec-00 the company reported that Mr Chan had repaid the loan to Kingston (disclosures showed this happened on 24-Nov-00) and on the same day pledged the stock to a new lender called E-Bigger Investment Ltd which was giving "urgent and active consideration" to providing the Company with a working capital loan of HK$30m. That money has not, as far as we know, come through, and the owners of E-Bigger have not been disclosed.
Entire board replaced
On 7-Dec-00, Hung Fung announced that both the independent non-executive directors had resigned along with executive director Mr Tam, who had served just 2 months. Five days later, Mr Ho resigned, meaning that all the executive directors appointed on 11-Oct-00 had now resigned. The entire board had changed in the space of less than 2 months.
On 7-Dec--00 Mr Charles Lo Ming-chi (Mr Lo) was appointed as executive Chairman and two new INEDs, Mr Wu Wing Kit and Mr Simon Yuen Chi-choi were appointed on 7-Dec-00.
Mr Lo is an accountant and an executive director of a small HK-listed loss-making food and property group called Multi-Asia International Holdings Ltd. Mr Wu has numerous independent directorships and is or was a partner with law firm Fred Kan & Co, while Mr Yuen is an accountant. Four days later Mr Richard Chin Wai-keung (Mr Chin) was appointed as an executive director.
On 28-Dec-00 Hung Fung announced a delay to its interim results because:
"the accounting records of many subsidiaries and associates of the Group are incomplete."
On 22-Jan-01 the stock was suspended at $0.013 and has not traded since.
On 28-Mar-01 Hung Fung released an update on the now dire situation. They reported that 3 of the 4 accounting staff had left in Nov-00, and revealed that the then directors had conducted a visit to the Dongguan factory (which operated under a processing agreement) in an attempt to gather accounting records. In a masterpiece of understatement, they wrote:
"As the Factory handles the entire production of toys for the Group, the Directors are of the view that the financial results derived from its production activities may be material to the Group as a whole."
No kidding. However, the scouting mission was unsuccessful because
"at that time access to its premises was denied by some of the Group's PRC creditors who were demanding payment of sums due from the Group for raw materials purchased."
The blockade was subsequently lifted and the board sent the auditors to conduct a factory visit at the end of Feb-01. Modest production was underway, with about $10m of orders in the first quarter of 2001 and sales of $11.5m in the last quarter of 2000. Bank debts at 31-Dec-00 were estimated at $126m of which $31m was due in the Mainland. On the assets side, In relation to 3 customers, they wrote:
"Based on information available to the Directors, the Group recorded account receivables of about HK$103 million due from Fei Da Trading Limited, Nan Yue Light Industries Trading Limited and Wei Er Bao Toys Limited, three major PRC debtors of the Group, as at 31 August 2000 which accumulated since April 2000 and remain unsettled up to date."
The investigating accountants were named as Deloitte Touche Tohmatsu. Litigation from customers and bankers was piling up.
Meanwhile on 5-Mar-01, Wang On had sold the $3m convertible note to an "independent third party".
On 11-Apr-01 Mr Chin resigned his executive role after 4 months on the job and briefly became an "independent" non-executive director before the company realised that you cannot qualify as independent if you've been an executive, so he's just a non-executive director.
On 4-Jun-01 Hung Fung announced that Sin Hua Bank Ltd had petitioned to have Hung Fung and its subsidiary wound-up for amounts due of $12.2m, while Wing Hang Finance Co Ltd had filed a writ for $2.28m due.
Riots, vanishing customers, attempted kidnap
Results statements from Hung Fung seem to come in pairs - on 26-Jul-01 we got the interim results to 30-Sep-00 and the final results to 31-Mar-01. It now emerged that 9 months earlier, there had been a riot in the factory in which some of the plant and machinery were "seriously damaged" and:
"due to the relocations of the Group's accounting department from Hong Kong to the PRC and a riot in the Group's PRC factory in October 2000, certain underlying books and records of certain of the Company's subsidiaries were either lost, or could not be located"
In our world, that which cannot be located is best described as "lost", a term which might also be applied to the three PRC major customers of the toys trading business whom we mentioned earlier - the board now wrote:
"The major customers for trading toys were 3 PRC customers and in turn they became the 3 major debtors of the Group. However, upon the Group's attempts to collect the debts from the 3 major PRC debtors when the debts were due, it was found that they had all disappeared and could no longer be located."
The 3 vanished "customers" owed $117m to Hung Fung at 31-Oct-00, up from $103m at 31-Aug-00. Since the toys trading business began in Apr-00, these new customers had never paid their bills. As the board put it, the customers "were granted particularly favourable terms".
Now remember that toy trading company, Chaolian, which in Aug-00 Mr Chan said Hung Fung group had "set up"? It certainly was a set-up. It turns out that Hung Fung did not own it all, but that it was a sole proprietorship in Chao Zhou, PRC owned by a Mr Lam Man Lung (Mr Lam). Hung Fung now says:
"the Group's business relationship with Chaolian ended abruptly in mid-December 2000 when Mr. Lam Man Lung was arrested by the 'gong an' (Public Security Bureau of the PRC) for his involvement in the attempted kidnap of Mr. Chan... and the demand of a ransom."
Well we guess that is the kind of behaviour that would sour a relationship! Hung Fung wrote off $20m of "unrecoverable inventories", financial support to Chaolian and deposits with other toys suppliers made through Chaolian. Hung Fung also discontinued its investment in Toysmatch.com and wrote off the $4.3m receivable from it.
It remains unclear whether there is any connection or identity between the 4 "shell companies" in the ICAC announcement and the 3+1 PRC customers and Chaolian. Perhaps the equation of numbers is a coincidence.
All told, Hung Fung reported a loss for the year of $279m, or about 11.25 cents per share, 9 times its pre-suspension stock price, leaving it with net liabilities of $70m. The auditors disclaimed their opinion.
© Webb-site.com, 2001