The Sour Apple: The Fall and Fall of New Lakeside Ftestructuring Exercise In 2006, Go implemented a major restructuring strategy across the firm in hopes of turning things around. Two lossmaking subsidiaries in Chinaw were sold for a token amount of FtMEtS {8$'l) each, along with their net liabilities. The gain on disposal of the two subsidiaries totalled FtMBBB.96 million, which more than offset the loss from operations for FY2006. Under the SGX listing rules, companies which suffered losses for three consecutive years would be placed on its watchlist, while those which reported losses for five consecutive years would be delisted". Due to the gain from disposals, New Lakeside saw its first profit in three years. The other business of manufacturing animal feed, which required coal to dry the apple pulp, was closed down to limit the risk exposure of the escalating cost of coal. The fiscal year end was also changed from 31 December to 30 June - the reason given was to align the fiscal year to the apple pressing season in order to better reflect the Group's operating cycles\". Joint Venture with Zhonglu Go's efforts in rebuilding the Group initially appeared to be effective, based on the return to profitability in 2006 and 2007. Good news came in July 2008 when Shanghai-listed SDIC Zhonglu Fruit Juice Co. (Zhonglu) decided to invest 8$12.25 million of its manufacturing assets in New Lakeside, thereby acquiring a 24.57 per cent stake {98 million shares). As a producer and seller of fruit juice concentrates, Zhonglu was a leading player in the apple juice concentrate industry, with 14 per cent of the Chinese market's. Having an established industry player as a major shareholder could potentially hetp resolve New Lakeside's financing woes, improve its management support, and significantly increase its production in the short-run. New Lakeside, in turn, was able to offer Zhonglu better access to international capitaf through its SGX listing. Go expected the joint venture to generate immediate cost savings and increased profits through the ability to buy cheaper apples. Together with tighter cost control and a commercially - profitable arrangement. FY2003 was the second profitable year for New Lakeside since its 2004 listing. 84 The Sour Apple: The Fall and Fall of New Lakeside The First Special Audit The special audit uncovered numerous accounting irregularities, and reactions from Moore Stephens (the external auditors) and the directors of New Lakeside in response to the irregularities, were as follows: Special Audit Findings Responses from Moore Stephens by Chenghe and Directors Failure of subsidiary LFJ to Moore Stephens: Chenghe had not computed abide by China's enterprise the COS on a consolidated basis. With the accounting system resulted in an exclusion of the accounts of Lingyi factory, understatement of cost of sales a branch of LFJ, it was difficult to prove a (COS) and overstatement of substantial misstatement of COS. profits amounting to RMB 24.4 million (S$4.9 million). Directors: Agreed. Asset inflation - Assets bought for Moore Stephens: A reversal for the difference RMB 6.4 million were recorded at was done. about RMB 47.4 million. Directors: Satisfied at the reversal of the entry. Prepaid freight charges (on behalf Moore Stephen: Made a provision of RMB 4.1 of customers) of RMB 16.3 million million for long outstanding receivables were classified as receivables in Directors: To continue to monitor the LFJ's accounts when the recovery recoverability of these receivables and review was uncertain. the policy of freight prepayment. (a) Two unusual sales transactions (a) Directors believed those sales were (b) A physical stock count showed provided for by Moore Stephens. an overstatement of LFJ's stock (b) Directors assured that measures have of approximately RMB 2.8 million. been taken to ensure proper bookkeeping. Trouble Brewing in the Boardroom The IDs called for a meeting to review the findings of the special audit. Unconvinced by the "inadequate explanations" provided by the then- MD Sun Jiwei and Chief Financial Officer (CFO) Xu Lixin, the IDs discharged them from their duties to avoid "a dereliction of our duties for all shareholders". However, later in the same month, Sun was unexpectedly reinstated as the joint-MD, together with the appointment of another MD Go Twan Heng, who was also the majority shareholder. 82The Sour Apple: The Fall and Fall of New Lakeside Case Overview Ever since its SESDAQ' listing at a price of 32 cents per share in March 2004, New Lakeside Holdings Limited (New Lakeside) had issued a number of profit warnings and had been plagued by corporate governance issues and audit qualifications. Things worsened when its statutory auditor, LTC LLP (LTC), claimed that the Group had made "fraudulent misrepresentations" in their 2009 financial statements. By the time LTC reported the matter to the Minister of Finance for possible breach of the Companies Act in September 2010, the share price had plunged to 2 cents per shares. Despite a major restructuring exercise, the situation was beyond salvage for New Lakeside. On 1 November 2010, New Lakeside filed with the High Court to be placed under judicial management. The objective of this case is to allow a discussion of issues such as challenges for independent directors in a management- controlled company, accounting and auditing issues, and the roles of directors, auditors, regulators and other intermediaries. The Beginnings of New Lakeside Incorporated in Singapore in 2002, New Lakeside produced and sold apple juice concentrate to multinational corporations in the food & beverages industry. The Group had two wholly-owned subsidiaries - Sanmenxia Lakeside Fruit Juice Co. Lid (LFJ) and New Lakeside (Sanmenxia) Co. This is the abridged version of a case prepared by Athena Chan, Elaine Ang, Elicia Ng, Emily Sim, and Regina Lin under the supervision of Professor Mak Yuen Teen. The case was developed from published sources solely for class discussion and is not intended to serve as illustrations of effective or ineffective management. Consequently, the interpretations and perspectives in this case are not necessarily those of the organisations named in the case, or any of their directors or employees. This abridged version was prepared by Amanda Aw Yong under the supervision of Professor Mak Yuen Teen. Copyright @ 2012 Mak Yuen Teen and CPA Australia 80The Sour Apple; The Fall and Fall of New Lakeside Ltd {NLS}. The apple juice concentrate produced was used to make packet juice drinks, soft drinks, cider, yoghurt and candies. The Group also produced animal feed using apple pomace from the production of apple juice concentrate to supplement its main business. New Lakeside had customers in North America, Southeast Asia and Western Europe. In March 2004, New Lakeside became the first company (since August 2003) to close below its initial public offer (lPO) price, at 30.5 cents per share compared to its IPO price of 32 cents per share. Several other listings also fell below their IPO prices. Poor market confidence after a terrorist attack in Spain, a political standstill in Taiwan and correction on Wall Street were cited as reasons for the bearish Singapore market. Other analysts, however, attributed New Lakeside's low IF'O price to inherent problems with its business model - a single-product business which was highly leveraged. Absence of Profit Warning As 30 June 2004 approached, many Chinese companies listed on the Singapore Exchange began to issue profit warnings. As New Lakeside did not issue a profit warning, its reported net loss of Ftlv'lB 9.4 million ($551.95 million} for the six-month period ended 30 June 2004 shocked the market. In a statement to the 58):\The Sour Apple; The Fall and Fall of New Lakeside The Point of No Fteturn However, the joint venture with Zhonglu was not able to turn the situation around for the Group. More profit warnings came in July 2009 and again in January 2010. New Lakeside's financial statements raised a red flag, with net current liabilities reported at HMBQBJB million {83:19.1 million] and negative operating cashflows of Ftlvl312.74 million. This prompted the newly-appointed auditors, LTC, to warn investors of potential going concern risks. The situation worsened in January 2010 when the Group could not pay its debts. NLX was under pressure from a claim of FIMB22.?5 million arising from a guarantee given to a former subsidiary of the Group, LFJ. This reduced NLX to a state of insolvency, which sparked further immediate claims amounting to HMB24.5 million from two other banks\". To make matters worse, two other individual lenders15 also demanded the repayment of a S$6.56 million loan they had given to the Group in 2006. This raised signicant going concern issues for New Lakeside. Amid the mounting cash flow problems, CFO Oh Gim Tack resigned on 11 June 2010, after the failure to reach a consensus among the executive directors on how to resolve the issue\". A Trail of Audit Qualifications New Lakeside had several qualified auditors' opinions relating to significant accounting-related issues\". However. New Lakeside was not required to take mandatory courses of action to address those issues. Regulators also did not act. In April 2005, Moore Stephens issued an opinion with an emphasis of matter relating to trade debtors of FtMB?.3 million which had been outstanding for more than a year. In April 2006. the new auditors, TeoFoongWongLCLoong, qualified their opinion for FY2005, citing going- concern issues and their inability to form an opinion on the existence of inventories which were written off, write-off of freight charges, and validity and treatment of certain expenses. In April 200?, Baker Tilly also qualified 85 The Sour Apple; The Fall and Fall of New Lakeside The directors of the subsidiaries were also reappointed, together with other new directors on the New Lakeside boardi'. In the end. the IDs did not cast their vote to oust Sun and the directors of the subsidiaries. as they realised that their votes could not influence the decisions made as the executive directors held the majority of the Group's sharesa. Joint-MD Sun Sacked Over First Profit Warning Though New Lakeside appeared to be heading towards better times with the new structure. the Group released its first profit warning for the half-year ended 30 June 2005. While sales had increased, the larger increase in cost of production had eroded its profits. The Group expected the losses to persist in the subsequent half-year. Believing that its loss of HMB 66.2 million (S$13.? million} in the first half of 2005 was due to Sun's incompetence. the board ot directors terminated Sun's position as the joint-M09. Go then assumed the post of the sole MD. Following that. Professor Wang Sixin. an executive director. and general manager and director of two subsidiaries. also resigned. Shaken Confidence To make matters worse. the Group reported that it might suffer an estimated loss of Ftl'vtBtO million in its second half-year due to the shortage in raw materials and unfavourable weather conditions. In the end, FY2005 ended with an accumulated loss of FIMBQB million (33519.7 million). External auditors TeoFoongWongLCLoong also raised going ooncern issues, suggesting that New Lakeside might not be able to meet its financial obligations. The profit warnings continued into the first half of 2006, with a reported net loss of Ftllet2 million. However. the Group incurred lower losses. as compared to the first hall of 2005, due to the measures taken by the new management to minimise costs. Despite having implemented those steps. the Group still performed below market expectations. Coupled with the unauthorised HMBESO million guarantees made by LFJ (approved by MD Sun}, the financial position of New Lakeside could not be any worse. 83 The Sour Apple: The Fall and Fall of New Lakeside their opinion, citing going-concern issues and inability to verify unaudited management accounts of subsidiaries, which had been disposed of during the year. In October 200?. New Lakeside changed its financial year-end from December to June.The set of accounts issued in October 2003 were again qualified by Baker Tilly, this time citing their inability to verify financial guarantees given by a subsidiary and the recoverability of sundry receivables. Their report also contained an emphasis of matter relating to the company's ability to meet its financial obligations. In April 2009, New Lakeside changed its auditors to LTC, and in October 2009, when the company reported a net loss of FlMEtB4.9 million, the external auditors' opinion contained only an emphasis of matter, albeit an important one relating to 'material uncertainty which may cast significant doubt about ability to continue as going concern'. However, in September 2010, LTC informed the audit committee chairman that fraudulent representations may have been made in the course of the 2009 audit and therefore their audit opinion for 2009 could no longer be relied upon. LTC also made a report to the Minister of Finance. No More Juice With a net loss of Fllv'll384.9 million in FY2009 followed by another net loss of RIMES-4.1 million for the following financial year, the situation spiralled out of control. New Lakeside finally filed with the Court to be placed under judicial management\