Forward-Looking Fact-Based Fraud Detection System (2/3)

Forward-Looking Fact-Based Fraud Detection System (2/3)

In our unrelenting effort to serve value investors and the public, “to explain, exhort, encourage, inform, educate, advise” in the timeless wise words of the late Dr. Goh Keng Swee, one of the founders and chief economic architect of modern Singapore, we like to share briefly about a listed corporate example.

This Asian F&B/FMCG company had “brand visibility” but also had potential accounting issues that begged further accounting transparency and disclosures.

The objective is not a specific targeting of companies but to highlight the risks involved in thematic investing and to illuminate on how multitude of companies might be avoided using the forward-looking fact-based system described in the four categories of commonly-used tunneling methods as shared earlier.

More importantly, we hope to play our small part in crafting Singapore to be a special Home filled with Love and the right values through the sharing of our insights.


Puppet Master: The Pyramidal Story of PT Davomas Abadi

At the corporate level, shares of most companies in Asia are not as widely held as those in the West. The table below summarises the prevalence of nominee and trust accounts by primary ownership category for 1,386 publicly traded corporations in Asia.

Indonesia is shown to have one of the highest percentages of firms with nominee accounts or trust holdings that hide the ultimate identity of the shareholders.

When corporate transparency and governance is measured this way, the Philippines and Singapore clearly ranked at the bottom, while Taiwan is ranked at the top.

The controlling owner with the ultimate beneficial ownership is like the dalang or puppet master behind the screen, sitting at the apex of the complex pyramidal, cross-holding or dual-class structure controlling the puppet firm(s) with dexterity through layers of intermediate companies.

They can opportunistically misrepresenting economic prospects given weak enforceable legal rules of investor protection in emerging markets.

Insiders closest to the dalang would have advance knowledge of the dalang’s short-term plans, such as major contract wins or business restructuring in asset disposal that could trigger a jump in the share price, or issuance of shares that are dilutive to existing shareholders. Insiders can then transfer  resources within the group of companies and its affiliates via related-party transactions, positioning themselves ahead of the minority investors.

Source: Carney and Child (2013), Changes to the ownership and control of East Asian corporations between 1996 and 2008: The primacy of politics, Journal of Financial Economics 107: 494-513)

We often wondered aloud and lamented at the low valuations in Asia as compared to the West. Why is it that Asian entrepreneurs do not see the need to build “moats”, instead preferring to be the dalang?

Asian entrepreneurs whom we spoke to over the past decade are often perplexed and exasperated why sales and earnings growth at their companies do not necessarily translate into corresponding market capitalisation growth. Over time, some of these entrepreneurs feel unappreciated and eventually give up on using the capital markets as an integral part of the ecosystem to grow their businesses.

They no longer put all their hard-earned assets and earnings into the listed vehicle; crown-jewel assets often remain privately-owned. They are often tempted to expropriate and tunnel out assets and resources out of the companies into their private pockets through related-party or money-go-round accounting transactions.

The “value investor” would find these “value traps” attractive, patting themselves on their backs for any short-term gains, not knowing that these were all engineered by the dalang to suck in naive capital and that the returns can unwind any time.

Although Indonesia is an investor favourite, corporate governance is a longstanding concern. The case of PT Davomas Abadi, supposedly Indonesia’s second-biggest cocoa processing and chocolate firm, is instructive on the ills of the dalang.

PT Davomas Abadi – Stock Price Performance

Davomas began in 1990 when the founders saw the opportunity in capitalising the potentials of Indonesia’s agribusiness by establishing cocoa powder processing and cocoa butter production facility in Tangerang, West Java.

Listed in the Jakarta Stock Exchange in 1994, it grew to become the largest exporter of semi-processed chocolate products (cocoa powder and cocoa butter) in Indonesia with international trading houses and large chocolate manufacturers in Europe and US as their customers. Davomas became a darling stock with its growth prospects and technologically-advanced facilities.

In April 2007, the main shareholders Tse Kam Bui and Husein Sutjiadi sold a 24.9% stake to a handful of investors at Rp400 per share, raising about IDR 610.2bn ($67 million). Reputable foreign institutional investors became significant shareholders.

In May 2009, Davomas shares were suspended because it defaulted on its $238 million 11% guaranteed senior bonds due 2011. Shareholders agreed to a restructuring plan involving an exchange offer for the original bonds and a $33 million shareholder loan.

The shareholder loan was from the secretive majority owner Tse Kam Bui who controls five BVI-registered companies that together hold a 51% stake in Davomas. The debt to the BVI companies was immediately repaid via a rights offering for those shareholders.

The original bondholders took a 50% haircut and exchanged for $119 million variable interest rate guaranteed secured bonds due 2014 and retained security over the assets of Davomas and the BVI companies.

In March 2012, Davomas once again defaulted on its debt due 2014. In June 2012, Davomas shockingly reported new debt of IDR2.87 trillion to PT Aneka Surya Agro (PT ASA), allegedly a supplier to Davomas. Although the debt represented more than four times equity and more than double its IDR1.32 trillion in revenue, no other information about the transaction was given.

A second debt restructuring was entered into in July 2012. Strangely, the restructuring was approved by the supplier PT ASA but the vast majority of the company’s secured bondholders were not made aware of the bankruptcy court proceedings.

The June 2012 debt restructuring called for the conversion of all outstanding debt into equity in Davomas. However, the debt-to-equity conversion requires the consent from the general meeting of shareholders and the shareholders’ meeting in September 2012 was cancelled due to confusion regarding the identity of the persons entitled to represent the majority shareholders, namely the secretive Tse Kam Bui.

The irregularities in its financial statements remain unexplained. Later, it was suspected that PT ASA belongs to this secretive controlling owner, the dalang behind all these undisclosed unusual related-party transactions in intercorporate loans.

In January 2013, Davomas was fined by the IDX exchange IDR150 million ($15,500). The aggrieved bondholders and shareholders are still demanding for justice for the multi-million default.


The listed F&B company whose shares are rather illiquid is a pyramidal firm part of a larger complex indebted business group and appears to be in a turnaround situation with improving financial numbers.

At a cursory look after a big-bath asset write down and asset disposal it was still struggling with continued deterioration in sales and gross profit from core businesses as announced in their recent interim results. Without going into details, we are cautious of these issues:

(1) Complex web of unusual unsecured interest-free inter-corporate loans

These loans potentially mask the net debt position of the group where huge loss-making subsidiaries and associates used the inter-corporate loans and deposits to possibly secure further loans e.g. S$22m in funds.

This is especially so when the funds flow to as many as 15 unaudited “dormant” and “inactive” subsidiaries, traceable in the footnotes to an unaudited inactive subsidiary incorporated in external countries where it has no business operations or sales;

(2) Unusual long-term investments

Long-term investment held in opaque unquoted investment funds with impairment allowances;

(3) Financial Supports

Questionable off-balance-sheet contingent liabilities such as financial support to hugely loss-making subsidiaries, with net deficit of millions of dollars disclosed in the footnotes.

Withdrawal of such propping would result in non-viability of the going concern status, triggering another round of multi-million asset write-down, reducing total shareholders’ equity by at least a third;

(4) Disputable Assumptions In Impairment Test

Impairment test of the multi-million dollar goodwill and intangible assets of the subsidiaries which are hugely loss-making while estimates of the growth rates are lowered substantially from the previous fiscal years. Also discount rate is not increased but instead lowered despite the higher risk.

(5) Capitalising Of Operating Leases

Capitalising on millions of dollars of operating leases and also pushing liabilities into the “off balance-sheet” contingent liabilities instead of recognising it as liabilities in the balance sheet;

(6) Cash-flow Statement Mis-classification

If the underlying economic substance of these impairment losses and impairment allowances were a result of shifting inter-corporate loans around, there is potential shifting of these items between the statements of cash-flow categories in operating and financing activities to inflate the reporting in cash-flow from operation.

Thus, before investing money in these supposed value stocks, we strongly urge the retail investor to spend only 15 to 20 minutes of his or her time to search the following key words in the PDF copy of a company’s annual reports:

(a) “Unsecured”, “interest-free”

(b) “Other Receivables”, “Guarantees”, “Financial Support”, “Prepaid Expenses”, “Prepayments”, “Advances”, “Other Current Assets”

(c) “Other Payables”, “Accrued Expenses”, “Other Current Liabilities”, “Other Non-Current Liabilities”

(d) “Amount Due from/to Related Parties and Directors”, “Amount Due from/to Subsidiaries”

(e) “Restricted Investments”, “Deposit Pledged”, “Pledged”, Investment in “Unquoted Shares”, “Unquoted Investment Funds”

(f) “Deferred Tax Liabilities”, “Deferred Tax Assets”

(g) “Impairment”, “Write-down”, “Exceptional item”

(h) “Contingent liabilities”

(i) “Dormant”, “Inactive”, as well as the place of incorporation in offshore havens such as British Virgin Islands. Trace whether the unsecured interest-free inter-corporate loans, cash deposits and investments in unquoted funds have flowed to these un-audited dormant and inactive subsidiaries and associates which in turn use them to secure more loans;

(j) “Joint(ly)-controlled”, “Joint Venture”, “Business Associates”, “Associates”, “Associated Company”;

(k) “Going concern”, “Disclaimer of opinion”, “Emphasis of matter”, “Restatement”

We also urge investors to take a quick read of the excellent empirical research paper “Incentives to Inflate Reported Cash from Operations Using Classification and Timing” which was published in the top-tier journal The Accounting Review by Singaporean accounting academic Professor Lee Lian Fen, currently a faculty member at the Carroll School of Management, Boston College.