DMX Technologies Ltd - MANAGEMENT REPLY: What made PwC inquire about transactions from 2008-09 while finalising accounts for 2014?

More than eight months after its CEO and CFO were arrested in Hong Kong, the company is yet to publish its audited accounts for 2014, even as the shareholders wonder what triggered the police action.

24/9/2015 – DMX Technologies Group Ltd has fired its CEO Ms Jismyl Teo, CFO Mr Skip Tang and Executive Chairman Mr Emmy Wu, alleging serious misconduct and negligence in performing their duties.

The decision came days after the external investigation committee appointed by DMX's parent KDDI Corp submitted is report last month.

The committee was tasked to investigate alleged improper transactions of DMX in 2008 and 2009, which led to the arrest of its CEO and CFO on February 3.

DMX last traded on March 19, after which trading was suspended at the company's request.

Shareholders of DMX are not in a position to assess the damage as the company has not yet published its audited accounts for FY2014.

There are several questions that remain unanswered for them.

In this story we have raised questions relating to the conduct of the Board of the company, selective release of information about the developments, a delay in requesting suspension of trading in the shares, the role of the auditors, etc.

But before we delve deeper into those questions, here is the sequence of events so far this year.

On February 9, DMX announced that it was suspending indefinitely CEO Ms Teo and CFO Mr Tang from all executive duties.

In that announcement, the Board said that it took the decision after Ms Teo informed it about their arrest by Commercial Crime Bureau of the Hong Kong Police Force on February 3.

Ms Teo and Mr Tang were later released on bail.

In that announcement, the Board added:

'No formal charges have been laid by the HK Authorities against the Company or any of its officers (including the CEO and CFO). As the Company has not received information directly from the HK Authorities on the subject matter of their investigations, the Board is still trying to gather more information in relation to the facts surrounding the matter and any legal implications for the Company. Based on what the Board currently understands, the HK Authorities are investigating a suspected offence that took place in 2008, in which the CEO and the CFO may have involved the Company. The HK Authorities visited the Company's Hong Kong office to review records.'

The announcement also informed the appointment of Vice Chairman Mr Iwao Oishi as the interim CEO and the appointment of its Finance Manager Ms Astor Cheung Wai Yin as the interim CFO.

On February 9, the Board also appointed legal counsels in Hong Kong and Singapore to advise it on the legal implications.

On February 25, DMX applied to SGX-ST requesting waivers to publish 2014 annual report by April 1 and hold the AGM by May 31.

The company sought waivers on the grounds that the suspension of the CEO and the CFO hampered the preparation of the financial statements.

Also, its auditor Pricewaterhouse Coopers LLP, Singapore (PwC) requested certain information to be included in the 2014 annual report which the company was not in a position to provide, due to the sudden suspension of the CEO and the CFO.

Further, the Board mandated its Hong Kong legal counsel to conduct an investigation into the matters leading to the arrests of the CEO and the CFO and submit the report to the Board in March.

While seeking the waivers, the Board argued that the auditor can finalise the accounts for 2014 only after assessing the impact on the Hong Kong legal counsel's report on its scope of audit.

On March 24, the company announced that its Hong Kong legal counsel has submitted the investigation report to the Board.

The findings of the investigation indicated irregular accounting practices at two of the company's subsidiaries in 2008 and 2009.

On the advice of its legal counsel, DMX lodged a report with the Hong Kong Police Force on March 23.

Also, DMX requested SGX-ST to suspend the trading in its shares from March 25.

In its March 24 announcement, the company also mentioned seeking a further extension of time for finalising its 2014 accounts.

On April 1, SGX-ST grantedwaivers, allowing the company to announce 2014 financial statements by June 30, hold the AGM by August 31 and announce Q1 2015 earnings by August 15.

On June 30, SGX-ST extended the deadlines by 3 months.

In an announcement on May 12, DMX revealed that there was uncertainty whether accounts receivables arising from past transactions between the company and its clients and vendors were able to be collected, and even whether they existed at all.

The uncertainty extends to the asset values recorded in respect of supplies, and tangible and intangible fixed assets in connection with such transactions, it added.

Due to the uncertainties, KKDI Corporation – a majority shareholder with a 51.37% stake in DMX – recorded an extraordinary loss of JPY 33,798 mln (about US$281 mln) in its financials, as a possible future loss attributed to the alleged irregular transactions.

KDDI Corporation, a Japanese telecom operator, bought a majority stake in DMX in 2009.

On August 25, DMX announced that its parent company KDDI Corp had established an external investigation committee which submitted its report to the KDDI's Board on August 21.

DMX's Board said it was studying the report submitted by the external investigation committee to KDDI Corp.

Days later, on September 4, DMX fired Ms Jismyl Teo as its CEO and Mr Skip Tang as its CFO with immediate effect, on grounds of serious misconduct and negligence.

Three days after that, the company also fired its Executive Chairman Mr Emmy Wu for acting negligently.

It seems the Board's decisions to fire the CEO, the CFO and the Executive Chairman were based on the findings and contents of the report submitted by the external investigation committee to the Board of KDDI Corp.

The English report can be downloaded from KDDI Corp's website here.

According to the report, the contentious transactions and their accounting surfaced only after DMX appointed Pricewaterhouse Coopers LLP, Singapore (PwC) as its auditor from FY2014.

It succeeded, Deloitte & Touche LLP, which had been DMX's auditor since its incorporation in October 2001.

PwC is also the auditor of KDDI Corporation, which is why it was appointed as DMX's auditor.

According to the report, while PwC was conducting the audit to close DMX’s accounts for the year ended December 2014, the auditor discovered a shortage of certificates to vouch for the existence of certain transactions.

The auditor asked the company to submit a certificate, which DMX was unable to do within a given time.

Under such circumstances, on February 3, the then-CEO of DMX, Ms Jismyl Teo and the then-CFO of DMX, Mr Skip Tang were arrested by the Hong Kong Police on suspicion of suspected offences regarding the transactions performed between DMX and a Chinese company in 2008.

According to the report, 'In response to the arrest, DMX formed an internal investigating committee under the direction of the Audit Committee; furthermore, it appointed “a” law firm, thereby launching an internal investigation into suspected transactions in mainland China mainly handled by DMX Hong Kong and DMX Macao and in which DMX Beijing was involved between 2008 and 2009. During this internal investigation, the possibility of irregular accounting was indicated for some of the transactions between 2008 and 2009. This is how KDDI has come to recognize the possibility of irregular accounting for the transactions in question.'

The transactions related to the systems integration (SI) business of DMX whereby the company bought communication appliances from the suppliers and installed the same for the end users (being Chinese communications operators or CATV operators in China).

DMX's job also included the tasks of operating, maintaining, and managing the appliances.

The report also revealed a complicated five-step transaction process adopted by DMX.

In essence, it uses an agency to order the appliances, rather than going direct to the vendor.

It went like this:

In the first step, the end user concludes an agreement regarding implementation of the SI business with an import/export firm (IE firm).

In the next step, the IE firm orders the appliances from a subsidiary of DMX, and to integrate them.

In turn, DMX's subsidiary orders the communications appliances from an agency.

After that, the agency orders the supplier to supply the communication appliance.

Finally, the communication appliances are supplied by the supplier via the IE firm to the end user.

The report points out that only a few people at DMX were aware of the fact that an agency was involved in the purchase of appliances from the supplier.

Until the PwC auditor raised questions about the transactions in February, the report says that many believed the company received the appliances directly from the supplier.

Commenting on the accounting of the transactions, the report said that DMX had to pay the purchase price of the communication appliances to the agency within 30 days after the invoice date. The purchase price of the communication appliances was temporarily accounted for as inventory.

But when DMX sold the communication appliances, it accounted for 95% of the price as sales 14 days after delivery to the end user, before a payment of the sales price from the IE firm and without accounting for the purchase price of the delivered communication appliances as cost.

DMX booked the remaining 5% only after the final inspection at the end user.

The report emphasises that the payment from the IE firms was hardly ever received according to their agreements with DMX, which stipulated it would be carried out at each stage of appliance delivery, instalment, provisional inspection and final inspection.

The report added that in actual practice, the timing of payment was determined by negotiation between DMX and the end user, and it was normally severely delayed, according to DMX’s explanation.

Under such a collection practice, the payments made by the IE firm were delayed from the sales accounting period in most cases.

Therefore, most of the sales concerning the transactions in question were accounted for as accounts receivable.

According to our understanding on the accounting treatment explained in the report, DMX paid upfront for the purchases of communication appliances and recorded it as inventory on its books.

However, DMX was quick in booking sales even as the payments were not received from the customers for long periods.

Also, DMX has allegedly inflated profits by not booking the cost of appliances in its profit & loss statements, even as it recorded the sales of those appliances.

As a consequence, any reasonable investor would therefore assume DMX's cash reserve was depleting, and its inventory and account receivables ballooned, while its sales and profits were inflated.

The report goes on to add that not all of the transactions in question could be discovered.

Moreover, DMX has no certificates to substantiate the actual shipping of the communication appliances from the supplier and deliver them to the end user, nor any such certificates were received from the supplier or the end user.

This raises doubt whether the transactions in question ever took place, said the report.

In its ending comments in the report, the external investigation committee said:

"Firstly, in the present case, KDDI continued to be deceived for a long period from the acquisition to the finding of the case. The biggest cause of this failure was that KDDI could not proceed at the time of the acquisition with enough awareness that it was about to acquire a company in an area in which it lacked knowledge and experience, and so KDDI’s subsequent handling of subsidiary management became off the point, resulting in its poor move in risk management and not being able to evaluate the true picture of past DMX management until the end. In this sense, we have recognized again the importance of consciously aiming to realize “all’s well that begins well.”
Secondly, in the process of the investigation, on numerous times we have felt KDDI’s sound corporate culture, the passion of its officers and employees towards their work, and the depth of their care for the company while we were interviewing the officers and employees and reading relevant materials. Further, as stated in relation to recurrence prevention, KDDI is establishing suitable measures in terms of structures and policies, among others, for acquisitions and subsidiary management, although these measure are based on experiences different from the present case. This is why we believe that KDDI will surely be stronger and grow a great deal by using the failure of the present case as a stepping-stone, and we truly hope this will happen."

The report also made recommendations to KDDI Corp to improve its internal systems as well as strengthen its decision-making in matters like acquisitions.

But for the shareholders of DMX, there are more questions than answers at this point.

Investor Central. Asian insights for global investors. We ask the tough questions of Asian companies which global investors need answers to.

Question

1. Who raised the alarm with the Hong Kong Police?

This is one question that remains unanswered in the announcements of DMX and in the external investigation committee's report to KDDI Corp.

In its February 9 announcement, DMX's Board said it was informed about the arrests by the CEO herself.

It is remarkable that none of its directors were aware of the police action until the CEO informed the Board.

DMX's Board has five nominee directors of its parent KDDI Corp.

According to the external investigation committee's report to KDDI Corp, the arrests followed the information requests from PwC which remained unanswered by DMX.

We don’t know who alerted the Hong Kong police, but it seems reasonable to assume either DMX or KDDI Corp filed a complaint, which led to the arrests on February 3.

If that's indeed the case, how can the Board claim ignorance of the arrests?

And if the Board was aware of the developments, why were the developments of February 3 announced to the DMX's shareholders only on February 9?

Question

2. Was DMX's Board not aware of the reasons leading to the police action?

The external investigation committee's report to KDDI Corp clearly stated that the CEO and the CFO of DMX were arrested after DMX failed to provide a certificate supporting transactions in 2008 to its auditor PwC.

It is hard to believe that the Board of DMX might have not been aware of the information requests by PwC.

Perhaps it didn't. We don't know.

But assuming for a moment that it was aware, that makes us wonder why the company and its Board didn't announce this critical fact to shareholders, who only got to know about it after reading the investigation report submitted to KDDI Corp on August 25.

(Read the full story to get all 9 questions)

Management reply: With reference to our various announcements via SGX, we seek your understanding that investigations are presently ongoing and we are not in a position to provide any additional information to our published statements. This is pursuant to our obligations under the Listing Manual, whereby we may not engage in the selective disclosure of information to a single member or particular segment of the public. Please be assured that we will update shareholders on any material developments, including releasing the results of the current investigations once they are final.

We thank management for their reply.

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