2011 06 07 ChinaMilk Final Report Executive Summary

ABCD
China Milk Products Group Limited Report on Independent Review 7 June 2011
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2.1
2.1.1
Executive Summary
Introduction
On 5 April 2010, the Exchange instructed the Company to appoint a special auditor to conduct an independent review on the Groups affairs.
2.1.2
By a letter dated 15 April 2010, the AC appointed us to perform a special audit on the Company on the terms instructed by the Exchange and those set out in our Engagement Letter.
2.1.3
In accordance with the terms of our Engagement Letter, our Report will be provided to the AC and the Exchange.
2.1.4
The purpose of our review is to report on: The document and factual integrity of the Companys announcements dated 5 January 2010 and 12 February 2010 in respect of the early redemption of the Convertible Bonds. Major cash disbursements from 31 March 2009 to the date of this Report. The manner in which the Company applied the monies obtained from the issue of the Convertible Bonds on 5 January 2007. Assess and comment on the Companys corporate governance and internal control structure.
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2.1.5 2.1.6
We set out our observations following the sequential listing of the issues stated above. The purpose of this Report is to present our findings arising from our review to the AC and the Exchange.
2.2
2.2.1
Scope of our review

We have conducted our review, to the extent possible, through an examination of the Groups records and interviews of individuals we viewed necessary to explain the workings of the Group.
2.2.2
We checked the information obtained from the Group and from interview of individuals against documents provided by the Group for our review and against publicly available information, where such information was available.
2.3 2.3.1
Restrictions on the use of Report

This Report is meant strictly for the benefit and use of the Audit Committee and the Exchange subject to the terms stated herein and in our Engagement Letter.
2.3.2
This Report is therefore not suitable for use or is it to be relied on by any person or persons other than those specifically identified by us herein or otherwise separately in writing. It is not to be used, quoted or referred to, in whole or in part, for any other purpose other than that stated herein or to be made available to any party without our prior written consent.
2.3.3
We note that the Company or the Exchange may, after consulting its lawyers and other professional advisers, decide to publish certain parts or the whole of our Report. Such decision is to be made by the Company and/or the Exchange. We reserve the right to review all materials proposed and/or intended to be published, and/or insist that the
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Report be published in full as a condition to our consent to the publication of our Report or any part thereof. 2.3.4 We will accept no responsibility or liability in respect of our appointment to persons other than the Company. We would also add that the procedures we performed in arriving at the findings in this Report do not constitute an audit carried out in accordance with Singapore Standards on Auditing or a review as understood by the Singapore Standards on Review Engagements, and consequently, no assurance is expressed, made or to be implied in accordance with these standards.
2.4
2.4.1
Companys attitude to our fieldwork

The Company is incorporated in the Cayman Islands. Its principal operating subsidiary, DQYL, is incorporated and has its principal place of business in China. Our fieldwork required us to attend at DQYLs place of business in China and conduct our interviews of individuals ordinarily domiciled in China.
2.4.2
We implemented a system known as an information request tracker. This allowed us to monitor compliance with the request made by us to the Group for information or documents. While we found the Group was professional in their treatment of us, the response we received to the majority of our request can only be characterised as obtuse and risible and the perception we formed cannot be said to be of a company ready to be transparent in its commercial affairs.
2.4.3
It is also apparent to us that the Company failed to reach the high prudential standards expected by the Exchange of a public-listed company.
2.4.4
Our last visit to DQYL ended on 22 June 2010. Our later attempts to arrange for a further visit to obtain more information for our review were thwarted by Mr. Liu after he took the position that we were acting outside the scope of our engagement.
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2.4.5
A major part of our review requires us having access to accurate information. We either obtain this from primary sources such as the Group and/or its bankers, or secondary sources, such as interviews with the Groups counterparties. Whilst we endeavoured to corroborate the information provided to us wherever reasonable and practical, we cannot verify that all the information provided to us by the various sources is accurate and complete.
2.4.6
The absence of information is itself information albeit it cannot be used to conclude on a particular transaction, but may be relied on to assist us in forming a view as to the conduct of the Group. In this regard, we record that we encountered numerous obstructions in our quest for information and the conclusions and observations we draw in this Report is based just as much on the absence of information as it is on the information gathered from both secondary and primary sources.
2.4.7
For example, we found it necessary to obtain the banks confirmation on the monies paid out to DQYLs counterparties. However, despite our many requests, we were told by DQYL that the bank manager was unable to meet with us.
2.4.8
The individual incidents we recall in this Report, when considered in isolation might appear innocuous or neutral in itself but they only take their colour and contributed to the formation of our perception from the combination and frequency in which we found them to occur.
2.4.9
We set out below a sampling of DQYLs reaction to some of our requests during our fieldwork: Interview with bank manager: We requested several time for the Group to arrange an interview with their bank manager in China. We were informed by DQYL that the bank manager refused our audience on the alleged basis that he was unable to find the time to schedule a meeting with us but in any event could not assist us in our intended inquiries.
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Interview with the alleged main contractor: DQYL arranged for us to meet and interview one Mr Zhang Hong Tao. Mr Zhang held himself out to us as the main contractor appointed by DQYL to do the improvement works. Mr Zhang said that he sub-contracted the work to his friends. We did not get a sense that Mr Zhang was indeed the main contractor since he neither owned a construction company nor was he sufficiently familiar with the improvements works done by DQYL as would be expected of a main contractor.
Interview with the cattle broker: DQYL arranged for us to interview one Mr Jiang Shan. DQYL informed us that Mr Jiang was one of three cattle brokers employed by DQYL. Mr Jiang was instructed by DQYL to source for replacement cattle for DQYL since the alleged milk-producing capabilities of the then current herd had abated allegedly due to over-milking. Mr Jiang informed us that the replacement cattle were below two years of age as compared to DQYLs which averaged five years. He also told us that the purchased cattle were born of the Groups sale of bulls semen. However, the cattle purchased were Australian Holstein but the Group only had and sold Canadian Holstein stock. We also found that the average age of purchased cattle was comparable to those already owned by DQYL. We draw two possible inferences from this: (i) Mr Jiang did not indeed broker the sale but was tasked by DQYL to masquerade as a broker; and/or (ii) Mr Jiang was indeed one of the three brokers but he was confused in his recollection of events that took place no more than 3 months before the date of the interview.
2.5
2.5.1
Announcement relating to the Early Redemption

On 5 January 2007, the Company issued USD150,000,000 Zero Coupon Convertible Bonds Due 2012. The Bondholders were entitled to redeem the Bonds at an earlier date in 2010 upon exercising a put option thereby requiring the Company to repurchase the Bonds. The Bondholders exercised the put option on 5 January 2010 thereby triggering
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the Companys obligation to repurchase the Bonds at an aggregate redemption value of USD170.56 million. 2.5.2 The Company announced on 5 January 2010 that:
The Board wishes to advise that the Company is still currently awaiting clearance from the State Administration of Foreign Exchange (SAFE) of the Peoples Republic of China (the PRC) for the remittance out of the PRC of approximately US$170.56 million, being for the full settlement of the Early Redemption at the Option of the Bondholders (including interest). The Company believes the delay is administrative and procedural in nature and there is no legal obstacle to the remittance of the same. [emphasis added]
2.5.3
On 12 February 2010, the Company announced, inter alia,

the Company does not currently have sufficient funds outside the [PRC] to effect the Early Redemption and is accordingly in default of its repayment obligations under the Terms and Conditions. ... It should be noted that any remittance of funds out of PRC entails a series of procedural steps and regulatory clearance, in respect of which the Company is currently unable to gauge the length of such a process.
2.5.4
This statement on its own adds nothing to the 5 January 2010 announcement. It is apparent that if the Company had sufficient funds outside the PRC to meet its obligations, then there was no need to obtain the approval of the SAFE.
2.5.5
Nevertheless, the 5 January 2010 announcement read with the 12 February 2010 announcement clearly says: a. b. The Company had sufficient funds to meet its obligations. The funds could not be remitted out from the PRC until and unless approval from the SAFE is obtained.
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c.
The delay caused by having to obtain approval of the SAFE was administrative and procedural in nature and therefore it was only a question of time before payment could be made.
d. 2.5.6
However, the Company could not gauge the length of the delay.
Mr. Loo provided to us certain emails 1 which indicate that the announcement of 5 January 2010 was released without his prior knowledge and approval. Mr. Loo, on receiving notice of the said announcement, sought confirmation from Mr. Liu Senior and Mr. Liu on the factual accuracy of the announcement dated 5 January 2010. Both Mr. Liu Senior and Mr. Liu confirmed that they have been following up with SAFE to obtain approval and that the Group has sufficient funds for repayment of the Bonds.
2.5.7
Mr. Loo also requested from Mr. Liu Senior and Mr. Liu: a. A copy of the PRC Legal Opinion, if any, as the announcement related to
PRC legal and regulatory issues. b. SAFEs written confirmation of the 35-day remittance period or the PRC
Managements written minutes of meeting with SAFE during which the 35-day remittance period was confirmed. c. Confirmation that the Company had adequate internal funds freely available
to support the remittance of USD 170.56 million. 2.5.8 On 13 March 2010 2 , Mr. Loo again queried Mr. Liu on the status of the SAFE application and the appointment of a PRC legal counsel. Mr. Liu reported that the PRC
This can be seen from Mr. Chois email dated 26 January 2010, Mr. Lams email dated 1 February 2010 and Mr. Ngs email dated 3 February 2010 and 11 February 2010. 2 Based on the minutes of the Audit Committee meeting held on 13 March 2010.
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legal counsel had been engaged and the name of the firm would be provided to the Companys secretary subsequently. 2.5.9 Based on the email correspondences provided by Mr. Loo, we noted that despite the repeated insistence of Mr. Sum and himself, including demand for urgent board meetings, the management of DQYL was unable to provide material information on a timely basis. 2.5.10 The Companys position becomes less certain and robust in an announcement dated 22 February 2010. The announcement reads in part as follows:
Management has represented to the Directors that the Company has sufficient funds in its bank accounts to meet the Bonds obligation. To this end and in due course, the Board intends to independently affirm this position. ... Management has advised the Directors that it has not made any formal application in writing to the SAFE for the approval of remittance of funds out of the PRC. However, the management had initiated discussions with SAFE officials on the proposed repatriation of funds out of China... The Board intends to engage PRC legal counsel to assist with the formal SAFE application procedures and to determine the reasons for the delay in obtaining SAFE clearance.
2.5.11
The Companys diffidence is apparent and the first of the two paragraphs quoted above shows that the Board had not satisfied itself of the Companys ability to meet its obligations before publishing the announcements dated 5 January 2010 and 12 February 2010.
2.5.12
In the minutes of the audit committee meeting3 held on 13 March 2010, it was recorded that the Company had insufficient cash resources to meet the early redemption obligations.
2.5.13
We have confirmed in our review of the Groups bank balances as at 12 February 2010 that the Group indeed did not have sufficient funds in its consolidated bank balances to
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meet its liabilities to the Bondholders. The Groups consolidated bank balance at 12 February 2010 was approximately USD85 million, just less than 50% of its outstanding obligations of USD170.5 million. 2.5.14 While it is apparent that the Group did not have immediately available funds to meet its liabilities, we are unable to comment if such liabilities could be met by mortgaging or liquidating its assets. 2.5.15 We nevertheless note that DQYL secured the rights to use agricultural land for its cattle in or around December 2009 for an amount of USD20.6 million4. This is a fixed one-time cost. The lease prohibits DQYL from sub-leasing or using the land for any purpose other than agriculture. DQYL also purchased cattle from overseas supplier in or around November 2009 for USD28.3 million. The Group made advance payment for the cattle on 25 March 2010. These expenditures were committed by DQYL immediately prior to the early redemption of the Bonds. 2.5.16 Had the Group not committed to purchasing the land use rights and the purchase of cattle, it would have approximately USD134 million in immediately available funds which, while still USD37 million short of its liabilities, would have been able to substantially meet the liabilities to the Bondholders.
Attended by members of the audit committee, representative of the Companys secretary, Mr. Liu and Mr. Lo, the external auditor from Grant Thornton. 4 The exchange rate of USD1 to RMB6.8 is applied throughout the Report
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2.6
2.6.1
Major Financial Commitments entered into by the Group

We reviewed four major projects entered into by the Group wherein payments were made by the Group against its obligations arising from such projects since March 2009 at an aggregate of approximately USD203.4 million: a. The joint venture agreement with HABC whereby the Group purportedly purchased a 40% interest in a JV Co. The Group paid approximately USD20.6 million for its purported interest in the JV Co. b. The Group spent approximately USD72.8 million on securing land use rights, working the land and cultivating crops. c. The Group commissioned Improvement Works to the farm and facilities and paid USD72.9 million over a period of 5 6 months ending in or around March 2010. d. The Group purchased replacement cattle in or around February and March 2010 and paid a total purchase price of approximately USD37.1 million.
2.6.2
The Company announced on 4 December 2009 that the Group entered into the final stages of completing the acquisition of 40% of the JV Co for approximately USD20.6 million, earmarked USD29.4 million to expand its farms and facilities and secured grassland and agricultural land for approximately USD20.6 million. However, the Group had in fact spent substantially more. We have not seen any evidence indicating that the Board contemplated and approved the announcement nor discussed or questioned the merits of the investments therein during the material time right after the announcement was made.
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Joint venture with HABC 2.6.3 We summarise our observations in respect of DQYLs purported investment in the JV Co below:
The Company announced in August 2008 that it had entered into an investment agreement with (i) the Heilongjiang Animal Breeding Centre (HABC), a Peoples Republic of China government owned agricultural bureau based in Heilongjiang province; and (ii) an independent third party to acquire a shareholding stake in a joint venture company. The Group would own 40% of the JV Co while HABC and the independent third party would own the remaining 40% and 20% of the JV Co respectively. The JV Co will then own the entire dairy cattle assets of HABC, including approximately 200 pedigree bull sires comprising approximately 100 Canadian Holsteins and 100 Australian Holsteins.
On 4 December 2009, the Company announced that following the completion of regulatory approval process and clearances, the Company has entered into the final stages of completing the acquisition of a shareholding stake in the JV Co. The Company also expected that the acquisition will be completed within [December 2009]. [emphasis added]
However, to date the Group has been unable to deliver to us any meaningful documents to evidence the completion of the acquisition. Instead, we are told that the acquisition is not complete pending fulfilment of certain conditions precedent, the particulars to which were not identified to us. It therefore stands to reason that since the acquisition has not completed, the shares have not been issued to the Group.
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We are therefore unable to conclude if the Group has indeed acquired any interest and/or any interest of meaningful value in respect of the JV Co notwithstanding that the Group has paid USD20.6 million towards acquiring such an interest.
Securing of land use rights 2.6.4 We found that DQYL expended an aggregate of approximately USD72.8million to allegedly secure land use rights, work the land and for the cultivation of alfalfa. The amount spent on working the land and for the cultivation of alfalfa totalling USD52.2 million was not announced by the Company. The work allegedly performed to improve the land was to flatten and aerate the land to make it suitable for the cultivation of alfalfa. Improvement Works 2.6.5 We are unable to offer an opinion on whether the improvement works done on the land was necessary or excessive and/or whether the costs of so doing was reasonable. The Company has objected to the appointment of a quantity surveyor by a majority vote (with Mr. Lai and Mr. Loo voting in favour of the appointment) and unless we obtain an independent valuation, we are unable to measure the amount paid by the Group against what is objectively commercial and reasonable. 2.6.6 The Improvement Works were allegedly performed on the farm and its facilities. The work was conducted over a period of 10 months between March 2009 and December 2009. DQYL paid USD72.9 million to its contractors in a period of 5-6 months ending in or around March 2010. 2.6.7 Our observations in respect of the Improvement Works are summarised as follows:
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a. One would expect salubrious farming facilities after spending USD72.9 million. However, the buildings and its facilities cannot be said by any stretch of reason to be no more than basic or at best average. We are however unable to conclude with any level or meaningful certainty since we are unable to rely on a quantity surveyors assessment of the alleged work done. b. DQYL was not able to identify with any specificity the alleged Improvement Works performed on the farm and facilities. We were brought on a tour of the farm and facilities and informed that works were variously performed to improve the underground drainage, enhance the integrity of the power supply and the planting of trees to prevent deforestation. c. The Board approval for the expenditure on the Improvement Works was not obtained nor have we seen any Board minutes whereby the Board was informed of the expenditure in relation thereto. Purchase of cattle 2.6.8 The Group also purchased replacement cattle allegedly on the basis that the then current population of cattle had reached diminishing returns on milk productivity. 2.6.9 However, we found that the dairy cows purchased and delivered were of similar average age of 5 years. 2.6.10 We also noted that notwithstanding the replacement exercise, the population of cows fell by approximately 53.5% over a twelve month period between April 2009 (21,747) and March 2010 (10,101).
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2.6.11
The replacement of cattle was not announced by the Company and it appears from our review of the Board minutes that the replacement exercise was never tabled for discussion at Board level nor was approval sought and given by the Board.
2.6.12
Further, notwithstanding the population decrease, the alleged utilisation and consumption of cattle feed increased by several times even after taking into consideration that consumption is likely to have increased during the winter months.
2.7
2.7.1
Non Compliance with Listing Manual and Accounting Standards

We have attempted to mark our observations on the Companys shortcomings against its obligations in the Listing Manual. We note that in doing so, we are making a judgment call on the interpretation of the relevant part of the Listing Manual. In that regard, we have applied a standard which we would have adopted had we been advising the Company and on the assumption that we had all the material information prior to the occurrence of the events we report on in this Report.
2.7.2
Rule 703 of the Listing Manual requires an issuer to announce any information known to the issuer concerning it or any of its subsidiaries or associated companies which:- (a) is necessary to avoid the establishment of a false market in the issuer's securities; or (b) would be likely to materially affect the price or value of its securities.
2.7.3
The Company however failed to announce its expenditure amounting to at least RMB355,000,000 in respect of the grassland improvements and the cultivation of alfalfa (the Undisclosed Expenditure).
2.7.4
The Groups net profit as at 31 March 2009 was RMB382,470,000. The Undisclosed Expenditure is almost equivalent to the Groups net profit as at 31 March 2009. Based on our review of DQYLs general ledger as at 31 January 2010, the Undisclosed Expenditure was expensed off in DQYLs accounts. In our view, the Undisclosed
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Expenditure is a significant expenditure which would materially affect the value or price of the Companys securities had this been announced by the Company. As such, we are of the opinion that the Undisclosed Expenditure should have been disclosed by the Company pursuant to Rule 703 of the Listing Manual. 2.7.5 The Company prepares its financial statements in accordance to the International Financial Reporting Standards (IFRS). There were 13 contracts supporting the Improvement Works undertaken by the Group (cf section 5.5 below). 7 contracts amounting to RMB360,100,000 were entered into by the Group prior to its financial year ended 31 March 2009 while 6 contracts amounting to RMB129,900,000 were entered into by the Group after its financial year ended 31 March 2009 but before its Annual Report for Financial Year 2009 was authorised for issue on 18 June 2009. 2.7.6 IAS10 of the IFRS requires the disclosure of all material non-adjusting events. 5 An event is material if the non-disclosure could influence the economic decision of users of the financial statements. Marked against this standard, the Company has fallen short of its obligations under the IFRS because substantial Improvement Works undertaken by the Group before its Annual Report for Financial Year 2009 was authorised for issue were not reported therein. The 6 contracts supporting these Improvement Works amounted to about one-third of the Groups net profit for the year ended 31 March 2009. 2.7.7 Collectively, these committed and non-recurring expenditures arising from the 13 contracts far exceed the Groups net profit for the year ended 31 March 2009. 2.7.8 The 13 contracts were not disclosed in the Companys Annual Report for the Financial Year 2009. The 13 contracts are relevant and material information that could influence the economic decision of users of the financial statements and should therefore be
See paragraph 21 of IAS10.
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disclosed in the Companys Annual Report pursuant to the Framework For The Preparation and Presentation Of Financial Statements of the IFRS. 2.7.9 Rule 1004 of the Listing Manual classifies transactions entered into by an issuer into 4 categories: (a) non-discloseable transactions; (b) discloseable transactions; (c) major transactions; and (d) very substantial acquisitions or reverse takeovers. 2.7.10 Rule 1006 of the Listing Manual states that a transaction may fall into category (a), (b), (c) or (d) of Rule 1004 of the Listing Manual depending on the size of the relative figures computed on inter alia the aggregate value of the acquisition of the consideration given or received, compared with the issuer's market capitalisation based on the total number of issued shares excluding treasury shares. 2.7.11 Rule 1014 of the Listing Manual states that where a transaction exceeds 20% of an issuers market capitalisation, it is classified as a major transaction. The issuer must immediately make a disclosure by way of an announcement and such transaction must be made conditional upon approval by shareholders in a general meeting. 2.7.12 We found that DQYL entered into contracts for the purchase of cattle from overseas suppliers in or around November 2009. The aggregate purchase price was approximately USD28,274,300 (SGD40,997,735)6 (the Overseas Cattle Expenditure). As of 30 November 2009, the Company had a market capitalisation of SGD203,115,000. The Overseas Cattle Expenditure amounts to approximately 20.2% of the Companys market capitalisation as of 30 November 2009. 2.7.13 If the Overseas Cattle Expenditure were expenditure outside the Groups ordinary course of business, the Overseas Cattle Expenditure would have to be announced pursuant to Rule 1014 read with Rules 1004 and 1006 of the Listing Manual as a major transaction as it exceeds 20% of the Companys market capitalisation. It is our view that
6
The exchange rate of USD1 toSGD1.45 is applied throughout the Report
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disclosure in these circumstances is imposed by the Exchange as such transactions would materially affect the price or value of an issuers securities. 2.7.14 Continuing with the assumption that the Overseas Cattle Expenditure would have been a major transaction under Rule 1014 of the Listing Manual if it were an expenditure outside the Groups ordinary course of business, it is our view that the transaction relating to the Overseas Cattle Expenditure is consequently material and ought to have been disclosed pursuant to Rule 703 of the Listing Manual.
2.8
2.8.1
No meaningful Corporate Governance

The Company states in the Groups Annual Report for Financial Year 2009, that the Boards primary duty is to ensure that the Company is managed in the best interests of shareholders as a whole while taking into account the interests of other stakeholders, and at the same time not losing track of its viability. certain matters must always be subject to review and approval by the Board. These matters include the approval of the Groups strategy and policies and material acquisitions and disposals.
2.8.2
We mark and comment on the Companys corporate governance structure against the Companys own pronounced standard.
2.8.3
The Group paid approximately USD72.9 million for the Improvement Works. Notwithstanding the substantial outlay, the Board minutes do not record any discussion at Board level over the merits of proceeding with the Improvement Works and no approval was obtained from the Board before the Group committed itself to the Improvement Works.
2.8.4
The joint venture agreement was brought to the attention of the Board only after DQYL had entered into the joint venture agreement. Accordingly, the Board minutes also record that no proper due diligence was done by the Group before entering into the joint
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venture agreement. This led Mr Sum to caution the Board, inter alia, that proper due diligence should always be conducted and the matter should have been deliberated at the board level before the Company committed, especially where such a large amount was involved. It appears that the management acted on a frolic of its own and did not keep the Board informed or updated on the transactions entered into by the Group. 2.8.5 The Board minutes also do not record any discussions in respect of DQYLs intention to secure the lease for the use of grasslands and agricultural lands. 2.8.6 However, we note that the Board has not made attempt, after the event, to ratify any of the financial commitments made by the Group. This suggests to us that the Board may still be insufficiently apprised of the material facts so to satisfy themselves that the Company and/or DQYL are indeed bound thereby. It is however outside the scope of this Report for us to offer any views on the legal and formal validity of the Groups financial commitments. 2.8.7 Further, the minutes of the AC meeting dated 29 May 2008 records that Mr. Tony Lo (Mr. Lo), external auditor from Grant Thornton, confirmed to Mr. Sum that internal auditors had already been appointed. Despite this confirmation, the Board meeting minutes suggest in fact there was no meaningful internal audit structure in place, if any, at all. Mr Sum had requested as early as in February 2009 that the internal auditors report directly to him. As at the date of this Report, the Company has not produced any internal audit report.
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ABCD

2011 KPMG Advisory Services Pte. Ltd.. All rights reserved.

Scope of our review

Restrictions on the use of Report

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Companys attitude to our fieldwork

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Announcement relating to the Early Redemption

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On 12 February 2010, the Company announced, inter alia,

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Major Financial Commitments entered into by the Group

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Non Compliance with Listing Manual and Accounting Standards

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See paragraph 21 of IAS10.

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The exchange rate of USD1 toSGD1.45 is applied throughout the Report

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No meaningful Corporate Governance

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